Overview

On May 25, 2011, the Securities and Exchange Commission (the “Commission”) proposed amendments to rules as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Section 926 of Dodd-Frank requires the SEC to adopt rules that prohibit certain “felons and other ‘bad actors’” from participating in securities offerings conducted in reliance upon the safe harbor from registration under the Securities Act of 1933, as amended, provided under Rule 506 of Regulation D. See Release No. 33-9211 http://www.sec.gov/rules/proposed/2011/33-9211.pdf.

Section 926 of Dodd-Frank requires the Commission to create rules that are “substantially similar” to Rule 262. Rule 262 provides for the disqualification of certain bad actors from participating in offerings conducted Pursuant to Regulation A. Regulation A is an exemption from securities registration for offerings not exceeding $5 million in a rolling 12-month period for companies not required to file periodic reports with the Commission. While there are several structural differences between Rule 262 and the proposed rules, the impact is similar, though the proposed rules expand the list of disqualifying events. The amendments proposed by the Commission will incorporate the substance of Rule 262 while simplifying its framework by restructuring the Rule 262 disqualifiers into two lists—one of potentially disqualified persons and the other of disqualifying events. This new regime will be codified as new paragraph (c) of Rule 506. Further, there will also be a “reasonable care” exception as discussed below. Finally, the Commission’s waiver authority provided for in Rule 262 will be preserved.

Persons Subject to Disqualification

Those people subject to disqualification under proposed Rule 506(c), referred to as “Covered Persons,” include:

  • the issuer, including any predecessor of the issuer or affiliated issuer;
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10 percent 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 (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.1

Events Subject to Disqualification

Those events subject to disqualification under proposed Rule 506(c), referred to as “Disqualifying Events,” include:

  • criminal convictions (five-year look-back for issuers, ten-year look-back for other covered persons);
  • court injunctions and restraining orders;
  • final orders of certain state regulators (including state securities, banking and insurance regulators) and federal regulators;
  • Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulator organization;
  • Commission stop orders and orders suspending a Regulation A exemption; and
  • U.S. Postal Service false representation orders.2

Reasonable Care Exception

The Commission also proposes a “reasonable care” exception. Under this exception, an issuer would not lose the benefit of the safe harbor provided by Rule 506, despite the existence of a disqualifying event, if it is able to show that it did not know, and could not have known using reasonable care, of the disqualification. The reasonable care exception requires that the issuer show that a factual inquiry had occurred, the nature and extent of which would be based on the facts and circumstances of the potential disqualifying event.

 Waivers

Regulation A permits issuers to seek waivers from disqualification from the Commission. The Commission may grant a waiver if it determines that the issuer has shown good cause “that it is not necessary under the circumstances that the [registration] exemption… be denied.3” The Commission proposes to carry over the current wavier provisions from Rule 262 to the new disqualification provisions.

Comment Period

The SEC is looking for comments on a broad range of topics, including the phase-in of the new rule and a determination regarding whether or not certain provisions should be grandfathered as to prior bad acts. It is also worth noting that the actual mechanism and time frame of seeking and receiving a waiver has not yet been developed and comments in this area will have a far-reaching impact on medium- to large-size issuers, as well as others in the distribution chain. Another area where interested parties may want to comment regards the inclusion of 10 percent beneficial owners of an issuer’s equity in the list of bad actors. Commenters should consider the practical aspects of compliance by certain issuers, such as hedge funds and REITS, that engage in continuous sales and regular redemptions, because the determination of who holds 10 percent of the issuer’s securities may be a moving target. Finally, it will be important to comment on whether or not the list of disqualifying events is overly broad and inappropriately includes events that are merely administrative rather than fraudulent.

All comments must be received on or before July 14, 2011. It should be noted that Dodd-Frank requires the SEC to issue the above discussed rules no later than July 21, 2011.