Andrew Ledbetter

As expected per the Dodd-Frank Act, the SEC yesterday proposed to add “bad actor” exclusions to Regulation D Rule 506.  Similar to Regulation D Rule 505, Regulation A, Regulation E and state limited offering exemptions, the amendment would disqualify offerings from the use of Rule 506 if the issuer or certain persons involved in the offering have, during the relevant look-back period, faced criminal, civil or administrative orders involving a variety of securities or other financial services industry matters.  If the proposed rule is adopted, entrepreneurs and investors will need to be even more careful when recruiting executives and directors to join the company.  The company will also want to consider doing additional diligence regarding individuals or companies assisting them with sales of securities, as well potential significant investors.

The proposed rule would apply to the following persons:

  • the issuer and any predecessor of the issuer or affiliated issuer;
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10% or more of any class of the issuer’s equity securities;
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
  • any director, officer, general partner, or managing member of any such compensated solicitor.

The proposed rule would include the following disqualifying events:

  • criminal convictions in connection with the purchase or sale of any security or involving false SEC filings within the past ten years (five years in the case of issuers, predecessors and affiliated issuers);
  • court injunctions and restraining orders in connection with the purchase or sale of any security or involving false SEC filings within the past five years;
  • final orders of state securities, banking, savings association, credit union, or insurance regulators, or of a federal banking agency or the National Credit Union Administration, that (i) at the time of sale bars the person from engaging in the business of securities, insurance or banking or from engaging in savings association or credit union activities, or (ii) that found a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct and were entered within the past ten years;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons in effect at the time of sale;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;
  • being the registrant, issuer or named underwriter in any registration statement or Regulation A offering statement that was the subject of a refusal order, stop order, or order suspending the Regulation A exemption within the past five years, or at the time of sale being the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; and
  • U.S. Postal Service false representation orders entered within the past five years or, at the time of sale, being subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the U.S. Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

There would be a “reasonable care” exception, under which an issuer does not lose the benefit of Rule 506 if it can show it did not know and, in the exercise of reasonable care, could not have known of the disqualification.  As proposed, the bad actor exclusions would apply to any offering, including any sales made as part of an ongoing offering, that occurs after the effective date of the proposed rule change (even if the event occurred before the enactment of the Dodd-Frank Act).

Comments on the proposed rule are due on or before July 14, 2011.  The SEC has indicated that it intends to adopt rules on this topic between August and December 2011.

The proposing release is available at http://www.sec.gov/rules/proposed/2011/33-9211.pdf.

[Post updated to add final 2 sentences to first paragraph.]