Megan Muir

Earlier this summer, together with some of my partners within DLA Piper (Christopher Paci, Jason Harmon, Darryl Steinhause and Wesley Nissen), I wrote an article about new SEC regulations concerning private offerings. The final rules issued in July 2013 by the SEC go into effect on September 23, 2013. Below is a summary of the changes with respect to the disqualification of certain “bad actors” in connection with private offerings.  Also, attached is a sample Rule 506 Covered Person Questionnaire seeking information about potentially disqualified individuals and entities. The full article also contains a discussion of new rules allowing general solicitation in certain private fundraising as well as a discussion of certain proposed private offering rule changes that are not yet final. That piece may be found here.

The Dodd-Frank Act, enacted in 2010, required the SEC to adopt rules to prohibit use of the Rule 506 exemptions under Regulation D for securities offerings in which certain “bad actors” are involved, whether or not general solicitation or general advertising are used in the offering. Rule 506 is the exemption from registration requirements used in many private offerings, including most startup financings. To fulfill this Dodd-Frank requirement, the SEC has adopted rules that disqualify an issuer from selling securities in reliance upon the Rule 506 exemption if the issuer, its board members, certain of its officers and its large shareholders, among others covered by the rule, have experienced a “disqualifying event.” This is similar to existing bad actor rules, such as those found in Rule 505 of Regulation D, which relies on the disqualification provisions set forth in Rule 262 of Regulation A.

Disqualifying events include criminal convictions in connection with sales of securities, certain SEC civil and administrative actions and certain other orders from financial service industry regulatory authorities. If the issuer or other covered person is deemed a bad actor under this rule, the Rule 506 exemption will not be available to the issuer.

Who is impacted?

Any issuer that wants to make use of the exemption provided by Rule 506, regardless of whether the issuer engages in general solicitation or general advertising, will need to exercise reasonable care to prevent a covered person with a disqualifying event from participating in the offering.

“Covered persons” include:

  • the issuer of the securities (including its affiliates and predecessors), including its directors, certain officers, general partners and managing members
  • holders of 20 percent or more of the voting control of the issuer
  • investment managers (and their principals) of pooled investment funds and
  • promoters and those compensated for soliciting investors (including the principals of entities performing such services).

Officers of an issuer will be “covered persons” to the extent they are involved with or participate in the offering. In the adopting release, the SEC noted that the determination of which officers will be deemed to have “participated in” an offering will be a question of fact: “Participation in an offering would have to be more than transitory or incidental involvement, and could include such activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.”

What will disqualify an issuer from using Rule 506?

“Disqualifying events” for covered persons include the following:

  • convictions for securities-related crimes that have occurred within 10 years of the proposed sale of securities or 5 years if the relevant covered person is the issuer or its predecessors/affiliates
  • securities-related injunctions and restraining orders and similar sanctions such as SEC stop orders and US Postal Service false representation orders, each if within the 5 years prior to the proposed sale
  • final orders from various banking agencies and regulators of securities, insurance and financial institutions that prohibit the covered person from engaging in the business of securities, insurance or banking or that are based upon fraudulent, manipulative or deceptive conduct and which were issued within 10 years of the proposed offering
  • SEC disciplinary or cease-and-desist orders and
  • suspension or expulsion from membership in a self-regulatory organization such as FINRA.

Disqualifying events that occurred before the new rules become effective

Only events that occur after the new rules become effective (60 days after publication in the Federal Register) will be considered “disqualifying events.” However, issuers will need to disclose events that occurred prior to the effective date of the rules if they would have been considered disqualifying if they occurred after the effective date.

Impact on issuers

Issuers will need to evaluate entities and individuals that hold or are being considered for roles that would be deemed covered persons (among them directors, officers, promoters or prospective purchasers of the issuer’s securities) to determine whether any disqualifying events have occurred with respect to such persons. For events that occurred prior to the effective date of the rules, issuers will need to disclose information about such disqualifying events in their offering materials. For events occurring after the effective date of the rules, if covered persons experience disqualifying events, then the issuer will not be able to rely upon the exemption from registration contained in Rule 506.

In preparing for an offering, issuers will need to obtain updated information regarding covered persons. A sample questionnaire requesting information from an investor is available here. For entities such as hedge funds that may have continuous offerings, periodic updates will need to be undertaken. The SEC did not issue specific guidance for the frequency of such updating, but it did indicate that it expects “that issuers will manage [the need for periodic updating] through contractual covenants from covered persons to provide bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances,” which gives some indication of the type of factual inquiry and updating that is expected.

Effectiveness of final rules

The final rules regarding the “bad actor” disqualification can be found here; also, see the SEC’s Fact Sheet regarding such disqualification here. The rules are effective beginning September 23, 2013.

A sample questionnaire for review with your legal counsel is available here: Sample Rule 506 Covered Person Questionnaire.


The SEC has issued guidance with respect to the new “bad actor” rules that apply to offerings relying on the registration exemption in Rule 506 of Regulation D of the Securities Act of 1933.  Some of the terms used in the new rules are discussed in more detail, providing guidance as to the application of the rules.  Below are excerpts from the SEC’s guide, with additional detail regarding the concept of “covered persons” in the rule as well as transition / timing concerns.  See the full document for additional guidance provided.

Executive officers and participating officers of the issuer:

Executive officers.  The term “executive officer” means a company’s president, any vice president in charge of a principal business unit, division or function (such as sales, administration or finance), any other officer who performs a policy-making function or any other person who performs similar policy-making functions.

Officers who participate in the offering. 

The term “officer” means a president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, as well as any person who routinely performs corresponding functions.


Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

The rules affect only sales of securities made on or after September 23, 2013.

Sales of securities made before the effective date of the bad actor provisions will not be affected by the disqualification and disclosure requirements, even if such sales are part of an offering that continues after the effective date. Only sales made after the effective date of the amendments will be subject to disqualification and mandatory disclosure.

Disqualifying events that occur while an offering is underway.

Sales made before the occurrence of the disqualifying event will not be affected by it, but sales made afterward will not be entitled to rely on Rule 506 unless the disqualification is waived or removed, or, if the issuer is not aware of a triggering event, the issuer may be able to rely on the reasonable care exception.