Monday, December 10, 2018

Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings and Related Disclosure Requirements

Rule 506 of Regulation D of the Securities Act of 1933 is one of the most commonly used registration exemptions to raise investments for a private placement.

In July 2013, the SEC adopted a new provision for Rule 506, known as the "bad actor disqualification provision." The disqualification and related disclosure provisions appear as paragraphs (d) and (e) of Rule 506 of Regulation D.

As a result of Rule 506(d) an offering is disqualified from relying on Rule 506(b) and 506(c) of Regulation D if the issuer or any other person covered by Rule 506(d) has a relevant criminal conviction, regulatory or court order or other disqualifying event that occurred on or after September 23, 2013. Under Rule 506(e), for disqualifying events that occurred before September 23, 2013, issuers may still rely on Rule 506, but will have to comply with the disclosure provisions of Rule 506(e) discussed in part 6 of this guide.

Fortunately, Rule 506(d) does not apply to everyone associated with an issuer or its placement agent. The rule relates to "covered persons" which include:

  • the issuer, including its predecessors and affiliated issuers
  • directors, general partners, and managing members of the issuer
  • executive officers of the issuer, and other officers of the issuers that participate in the offering
  • 20 percent beneficial owners of the issuer, calculated on the basis of total voting power
  • promoters connected to the issuer
  • for pooled investment fund issuers, the fund’s investment manager and its principals
  • persons compensated for soliciting investors, including their directors, general partners and managing members
And not every criminal conviction, regulatory event or court order are disqualifying. Disqualifying events include

  • Certain criminal convictions involving the purchase or sale of a security; making a false filing with the SEC; the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. The criminal conviction must have occurred within ten years of the proposed sale of securities, or five years in the case of the issuer and its predecessors and affiliated issuers.
  • Certain court injunctions and restraining orders,  also involving the purchase or sale of a security, making a false filing with the SEC or the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities. Disqualification only applies for injunctions and restraining orders that are in effect at the time of the proposed sale of securities and were entered within the preceding five years.  Injunctions and court orders that have expired or are otherwise no longer in effect are not disqualifying, even if they were issued within the five-year look-back period.  For example, an injunction that was issued four years before the proposed offering but lifted before the offering occurred would not be disqualifying.
  • Final orders of certain state and federal regulators which bar the covered person from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities or are based on fraudulent, manipulative, or deceptive conduct and were issued within 10 years of the proposed sale of securities
  • Certain SEC disciplinary orders ommission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies, and investment advisers and their associated persons under Section 15(b) or 15B(c) of the Securities Exchange Act, or Section 203(e) or (f) of the Investment Advisers Act that:
    • suspend or revoke the person’s registration as a broker, dealer, municipal securities dealer or investment adviser
    • place limitations on the person’s activities, functions or operations
    • bar the person from being associated with any entity or from participating in the offering of any penny stock
    • Disqualification continues only for as long as some act is prohibited or required to be performed pursuant to the order.  As a result, censures and orders to pay civil money penalties, assuming the penalties are paid in accordance with the order, are not disqualifying, and a disqualification based on a suspension or limitation of activities expires when the suspension or limitation expires
  • Certain SEC cease-and-desist orders where the Commission orders to cease and desist from violations and future violations of the scienter-based anti-fraud provisions of the federal securities laws, including, for example Section 17(a)(1) of the Securities Act, Section 10(b) of the Securities Exchange Act and Rule 10b-5, Section 15(c)(1) of the Securities Exchange Act, Section 206(1) of the Investment Advisers Act, Section 5 of the Securities Act. Disqualification applies to cease-and-desist orders that were issued within five years before the proposed sale of securities and remain in effect.
  • SEC stop orders and orders suspending the Regulation A exemption applies if any covered person (as a registrant or issuer) has filed a registration statement or Regulation A offering statement that was the subject of a Commission refusal order, stop order or order suspending the Regulation A exemption within the last five years, or is the subject of a pending proceeding to determine whether such an order should be issued.
  • Suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member - if any covered person is suspended or expelled from membership in, or suspended or barred from association with a member of, a securities self-regulatory organization or “SRO” (i.e., a registered national securities exchange or national securities association, such as FINRA) for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade.
  • U.S. Postal Service false representation orders
Many disqualifying events include a look-back period (for example, a court injunction that was issued within the last five years or a regulatory order that was issued within the last ten years).  The look-back period is measured from the date of the disqualifying event—in the example, the issuance of the injunction or regulatory order—and not the date of the underlying conduct that led to the disqualifying event.
The SEC has published a complete guide to the Rule at https://www.sec.gov/info/smallbus/secg/bad-actor-small-entity-compliance-guide.htm
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Mark Astarita has 30 years of experience representing investors, brokers and issuers in their securities regulatory and litigation matters, including SEC and FINRA proceedings, arbitrations, and due diligence in connection with public and private offerings and investments. For more information call Mark at 212-509-6544 or send an email to mja@sallahlaw.com

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