Background

Earlier this year, Rule 506, a part of Regulation D under the Securities Act,1 was amended by adding a paragraph that prohibits issuers and others from participating in Rule 506 offerings if, among other things, they have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.2 The new provision became effective on September 23, 2013.3 The new provision applies to the bad acts of the issuer and any of its predecessors and affiliated issuers, the issuer’s participating directors and officers, beneficial owners of at least 20% of the issuer’s outstanding voting equity, significant shareholders, promoters, investment managers, and compensated solicitors involved in the offering (each a “covered person”). Prior to the amendment, Rule 506 did not impose any bad actor disqualification requirements.

If a covered person engages in an event that triggers disqualification under the new Rule 506, the relevant securities offering will no longer have available Rule 506’s protection. Rule 506 disqualifying events under the new rule include, among others, felony and misdemeanor criminal convictions in connection with the purchase or sale of securities or false SEC filings, court injunctions and restraining orders within the last five years related to the purchase or sale of securities or false SEC filings; final orders issued by state banking, credit union, and insurance regulators, Federal banking regulators and the National Credit Union Administration barring association with regulated entities of the type those regulators oversee and dealing with fraudulent, manipulative, or deceptive conduct; disciplinary or stop orders issued by the SEC; suspension or expulsion from membership in a Self- Regulatory Organization (such as FINRA or a stock exchange); stop orders applicable to a registration statement; and false representation orders by the U.S. Postal Service within the last five years.  

The new disqualifications apply only to triggering events occurring after effectiveness of the new rules. For triggering events occurring prior to the effectiveness of the new rules, in lieu of disqualification, the issuer must provide written disclosure to each purchaser of its securities, at a reasonable time prior to sale, disclosing matters that would have triggered disqualification had they occurred before the effective date of the new disqualification provisions. The final rule includes a reasonable care exception from disqualification that will apply if an 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. Issuers must also exercise reasonable care in determining whether a disqualification exists, however, the SEC did not specify what constitutes reasonable care, stating instead that the determination is a fact specific inquiry, dependent upon a number of circumstances, and requiring a factual inquiry into whether any disqualification exists. The nature and scope of the factual inquiry will depend on the facts and circumstances concerning the issuer and the participants involved. Issuers may also request waivers from disqualification, which may be granted by the SEC when good cause is shown. In addition, disqualification will not apply if an authority issuing the relevant judgment or order determines and advises the SEC that disqualification should not arise.

Recent SEC Guidance

On December 4, 2013, the SEC issued guidance for the application of the Regulation D “bad actor”
provision. For ease of reference, the guidance issued has been excerpted from the SEC web site and is attached as
Annex A hereto.