On July 10, 2013, the same day the SEC has adopted final rules eliminating the prohibition against general solicitation and advertising in Rules 506 and 144A offerings as required by Title II of the JOBS Act, the SEC adopted new rules disqualifying felons and other bad actors from participating in Rule 506 offerings as required by Section 926 of the Dodd-Frank Act.
Background
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 go into effect on September 10, 2013. The new rule is not retroactive; that is, the disqualification provision will only apply to disqualifying events that occur after September 10; however, mandatory disclosure provisions for preexisting events have also been added.
Bad actor or “bad boy” disqualification provisions disqualify an Issuer from relying on an exemption if the Issuer or certain persons associated with the Issuer and its predecessors and affiliates (including underwriters, placement agents, director, officers, general partners, promoters and significant shareholders) have been convicted of, or are subject to, court or administrative orders related to securities fraud and certain other enumerated laws. Prior to the new rule, Rule 506 did not have a bad actor disqualification (although Rule 505 and Regulation A did). The new rule is similar to the existing Rule 262 of Regulation A disqualifying bad actors from participating in Regulation A offerings, in that it encompasses all of the bad actor disqualifications in Rule 262, but also adds additional disqualifying events. In addition, the new rule does not modify the existing Rule 262 or other bad actor disqualification rules, but rather is limited to Rule 506 offerings.
New Rule 506(d) Disqualifying Felons and Other Bad Actors
A. Covered Persons
New Rule 506(d) applies to the following categories of persons (“covered persons”):
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; and 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 that has been or will be paid, either director 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.
Events relating to certain affiliated issuers are not disqualifying if they predate the affiliate relationship. That is, any disqualifying event associated with an affiliated issuer that arose before the affiliation does not disqualify an offering if the affiliated issuer is not (i) in control of the issuer or (ii) under common control, together with the issuer, by a third party that controlled the affiliated issuer at the time such disqualifying event occurred.
B. Disqualifying Events
New Rule 506(d) enumerates the following disqualifying events:
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 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, and 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 the 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 the 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 a 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 SEC added a definition of Final Order to the definitions of Rule 501 to mean “a written directive or declaratory statement issued by a federal or state agency… under applicable statutory authority that provides for notice and an opportunity for hearing, which constitutes a final disposition or action by that federal or state agency.”
Reasonable Care Exception
The new rule includes an exception from disqualification for offerings where 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. The steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances—provided, however, that if no investigation or steps have been taken, there can be no reasonable care exception. Issuers will need to conduct background checks and solicit information via questionnaires or certifications and perhaps contractual representations and covenants. If a broker dealer is involved, the issuer can rely on them to some extent in the performance of background checks and due diligence. Publicly available databases and information should be reviewed. If circumstances give an issuer reason to question or investigate further, they are obligated to do so.
Where an offering is continuous or long-term, factual information and inquiry should be updated on a reasonable basis.
Waivers
The SEC received many comments seeking to limit the disqualification provisions as written. As opposed to going that route, the SEC is relying on the procedure whereby a covered person can seek a waiver of the disqualification to limit disqualification on a case-by-case basis where appropriate. As written, 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.
In addition, disqualification will not apply if the court or regulatory authority that entered the relevant order, judgment or decree advised in writing that disqualification should not result from the order, judgment or decree.
Timing
Events relating to certain affiliated issuers are not disqualifying if they predate the affiliate relationship. That is, any disqualifying event associated with an affiliated issuer that arose before the affiliation does not disqualify an offering if the affiliated issuer is not (i) in control of the issuer or (ii) under common control, together with the issuer, by a third party that controlled the affiliated issuer at the time such disqualifying event occurred.
However, an issuer is required to furnish, to any purchasers, a written description of any matter that would have caused disqualification but for the fact such event occurred prior to the effective date of the new rules.
The Author
Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com
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 SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, 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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