SEC Guidance on Rules Disqualifying Bad Actors from Participating in Rule 506 Offerings

On December 4, 2013, the SEC updated its Compliance and Disclosure Interpretations (“C&DI’s”) including new guidance on the rules disqualifying bad actors from participating in Rule 506 offerings.


The Dodd-Frank Act required the SEC to implement rules which disqualify certain Rule 506 offerings based on the individuals involved in the Issuer and related parties.  On July 10, 2013, the SEC adopted such rules by amending portions of Rules 501 and 506 of Regulation D, promulgated under the Securities Act of 1933.  The new rules went into effect on September 23, 2013.  The new rule disqualifies the use of Rule 506 as a result of certain convictions, cease and desist orders, suspensions and bars (“disqualifying events”) that occur on or after September 23, 2013, and adds disclosure obligation in Rule 506(e) for disqualifying events that occurred prior to September 23, 2013.

Rule 506 provides that disqualifying events committed by a list of specified “covered persons” affiliated with the Issuer or the offering would result in disqualification from using Rule 506 or require disclosure to investors prior to their purchasing securities.  In particular, covered persons include:

  • The Issuer and any predecessor of the Issuer or affiliated Issuer;
  • Any director, general partner or managing member of the Issuer and executive officers (i.e., those officers that participate in policymaking functions) and officers who participate in the offering (participation is a question of fact and includes activities such as involvement in due diligence, communications with prospective investors, document preparation and control, etc.);
  • Any beneficial owner of 20% or more of the outstanding equity securities of the Issuer calculated on the basis of voting power (voting power is undefined and meant to encompass the ability to control or significantly influence management or policies; accordingly, the right to elect or remove directors or veto or approve transactions would be considered voting);
  • Investment managers of Issuers that are pooled investment funds; the directors, executive officers, and other officers participating in the offering; general partners and managing members of such investment managers; the directors and executive officers of such general partners; and managing members and their other officers participating in the offering (i.e., the hedge fund coverage; the term “investment manager” is meant to encompass both registered and exempt investment advisers and other investment managers);
  • Any promoter connected with the Issuer in any capacity at the time of the sale (a promoter is defined in Rule 405 as “any person, individual or legal entity, that either alone or with others, directly or indirectly takes initiative in founding the business or enterprise of the issuer, or, in connection with such founding or organization, directly or indirectly receives 10% or more of any class of issuer securities or 10% or more of the proceeds from the sale of any class of issuer securities other than securities received solely as underwriting commissions or solely in exchange for property”);
  • Any person who has been or will be paid, either 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.

Disqualifying events include:

  • Criminal convictions (felony or misdemeanor) within the last five years in the case of Issuers, their predecessors and affiliated issuers, and ten years in the case of other covered persons, in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Court injunctions and restraining orders, including any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security; involving the making of a false filing with the Commission; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;
  • Final orders issued by a state securities commission (or any agency of a state performing like functions), a state authority that supervises or examines banks, savings and associations, or credit unions, state insurance regulators, federal banking regulators, the CFTC, or the National Credit Union Administration that, at the time of the sale, bars the person from association with any entity regulated by the regulator issuing the order or from engaging in the business of securities, insurance or banking or engaging in savings association or credit union activities; or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the last ten years before the sale;
  • Any order of the SEC entered pursuant to Section 15(b) or 15B(c) of the Exchange Act or section 203€ or (f) of the Investment Advisors Act that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment advisor; places limitations on the activities, functions or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock;
  • Is subject to any order of the SEC entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation of future violation of any scienter-based anti-fraud provision of federal securities laws (including, without limitation, Section 17(a)(10) of the Securities Act, Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, Section 15(c)(1) of the Exchange Act and Section 206(1) of the Advisor Act, or any other rule or regulation thereunder) or Section 5 of the Securities Act;
  • Suspension or expulsion from membership in, or suspension or bar from association with, a member of an SRO, i.e., 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;
  • Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, 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, including temporary or preliminary orders entered within the last five years.

The new rule includes an exception from disqualification for offerings in which the Issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed because of the presence or participation of a covered person.  Moreover, the SEC can grant a waiver of disqualification if it determined that the Issuer has shown good cause that disqualification is not necessary under the circumstances.

SEC C&DI Guidance

On December 4, 2013, the SEC updated its C&DI, including new guidance on the rules disqualifying bad actors from participating in Rule 506 offerings.

A summary of the SEC guidance includes:

  • Issuers must determine if they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 506.  However, an Issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual disqualifying event under a contractual agreement, bylaw requirement, undertaking in a questionnaire or certification or the like.  For a continuous, delayed or long-lived offering, the Issuer must update its factual inquiry periodically through bring-downs of representations, questionnaires and certifications, negative consent letters or database searches.  The C&DI does not specify a recommended frequency for such updates.
  • If a placement agent becomes subject to a disqualifying event while an offering is ongoing, the Issuer could continue to rely on Rule 506 for future sales in that offering if the “engagement with the placement agent was terminated and the placement agent did not receive compensation for future sales.” Alternatively, if the disqualifying event affected only the covered control persons of the placement agent, the Issuer could continue to rely on Rule 506 for that offering if such persons were terminated or no longer performed roles with respect to the placement agent that would cause them to be covered persons for purposes of Rule 506(d).
  • Under Rule 506(d), an “affiliated issuer” is an affiliate of the Issuer “that is issuing securities in the same offering, including offerings subject to integration” pursuant to Rule 502(a) of Regulation D.  This provision implies that hedge fund Issuers will not have to make inquiry of their portfolio companies regarding disqualifying events.
  • The bad actor disqualification rules apply to all compensated solicitors whether licensed as a broker-dealer or not and whether or not required to be licensed as a broker-dealer;
  • A covered person does not include persons whose sole involvement with a Rule 506 offering is as members of a compensated solicitor’s deal or transaction committee that is responsible for approving such compensated solicitor’s participation in the offering.
  • Participation in an offering is not limited to solicitation of investors. Examples of participation in an offering include participation or involvement in due diligence activities or the preparation of offering materials (including analyst reports used to solicit investors), providing structuring or other advice to the Issuer in connection with the offering, and communicating with the Issuer, prospective investors or other offering participants about the offering. To constitute participation for purposes of the rule, such activities must be more than transitory or incidental. Administrative functions, such as opening brokerage accounts, wiring funds, and bookkeeping activities, would generally not be deemed to be participating in the offering.
  • Convictions, orders, bars and suspensions in jurisdictions other than the United States do not trigger disqualification.
  • Disqualification is triggered only by orders to cease and desist from violations of scienter-based provisions of the federal securities laws, including scienter-based rules. An order to cease and desist from violations of a non-scienter based rule would not trigger disqualification, even if the rule is promulgated under a scienter-based provision of law. For example, an order to cease and desist from violations of Exchange Act Rule 105 would not trigger disqualification, even though Rule 105 is promulgated under Exchange Act Section 10(b).
  • It is not necessary to seek a waiver of Rule 506(d) from the SEC staff if the relevant court or administrative order includes language stating that disqualification under Rule 506(d) should not arise as a result of the order.
  • The reasonable care exception applies whenever the Issuer can establish that it did not know and, despite the exercise of reasonable care, could not have known that a disqualification existed under Rule 506(d)(1). This may occur when, despite the exercise of reasonable care, the Issuer was (i) unable to determine the existence of a disqualifying event, (ii) was unable to determine that a particular person was a covered person, or (iii) initially reasonably determined that the person was not a covered person but subsequently learned that that determination was incorrect.
  • Issuers will still need to consider what steps are appropriate upon discovery of Rule 506(d) disqualifying events and covered persons throughout the course of an ongoing Rule 506 offering. An Issuer may need to seek waivers of disqualification, terminate the relationship with covered persons, provide Rule 506(e) disclosure, or take such other remedial steps to address the Rule 506(d) disqualification.
  • No waiver may be sought or granted from the disclosure obligation under 506(e).
  • Rule 506(e) requires only disclosure of events that would have triggered disqualification at the time of the offering had Rule 506(d) been applicable. Because events outside the applicable look-back period and orders that do not have continuing effect would not trigger disqualification, Rule 506(e) does not mandate disclosure of such matters in order for the Issuer to be able to rely on Rule 506.
  • Issuers are required to provide all investors with the Rule 506(e) disclosure for all compensated solicitors who are involved with the offering at the time of sale and their covered control persons.
  • Rule 506(d) disqualification does not apply if the Issuer is not offering securities at the time, and no disclosure need be made relating to compensated solicitors who are no longer involved in the offering at the time of sale.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of, the OTC Market’s top source for industry news, and the producer and host of, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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