A new rule proposed by the SEC on May 25 would add a hurdle for companies seeking to raise capital in a private placement offering. Rule 506 of Regulation D (“Rule 506”) provides a “safe harbor” from the registration requirements of the Securities Act for securities sold to accredited investors and up to 35 non-accredited investors. The SEC’s proposed new rule would prohibit the use of Rule 506 if felons or other “bad actors” are involved in the offering.

This article summarizes the new “bad actor” rule proposed by the SEC, and its implications for companies seeking to conduct private placement offerings under Rule 506. The SEC’s proposing release for the new rule can be found at: http://www.sec.gov/rules/proposed/ 2011/33-9211.pdf.

In accordance with its rulemaking authority and pursuant to the recently enacted Dodd- Frank Act, the SEC proposed the new rule to “disqualify felons and other ‘bad actors’ who have violated Federal and State securities laws from continuing to take advantage of the Rule 506 private placement process” and “reduce the danger of fraud in private placements.”

The SEC’s proposed rule would prohibit companies from relying on Rule 506 to raise capital if they, or certain persons involved in the private placement, were:

  • Convicted of a crime, or subject to a court injunction or order, in connection with:
    • selling or purchasing a security
    • making false filings with the SEC, or
    • their activities on behalf of financial intermediaries;
  • Subject to final orders based on fraudulent, manipulative, or deceptive conduct;
  • Subject to certain SEC disciplinary orders;
  • Suspended or expulsed from membership in a self-regulatory organization (SRO) or from association with an SRO member;
  • Subject to SEC stop orders and orders suspending a Regulation A exemption; or
  • Subject to US Postal Service false representation orders.

The proposed rule would also prohibit reliance on Rule 506 by issuers that are subject to certain final orders from state securities, insurance, banking, savings association or credit union regulators, or federal banking agencies.

In most cases, these “disqualifying events” would be triggered if the date of conviction or sanction occurred in the last 5 or 10 years before the private placement offering in question.

Although the proposed rule would not apply retroactively to private offerings that predate the effective date of the rule, the look-back periods, if applicable, would apply to convictions and sanctions that occurred before the effective date of the rule.

Where the proposed rule could get particularly complicated for issuing companies is in its scope regarding the persons it deems are “involved” in a private placement offering. These include, in addition to the issuing company itself, the following:

  • The issuing company’s predecessors and any affiliated issuers;
  • Directors, officers, general partners, and managing members of the issuing company;
  • Ten percent beneficial owners of the issuing company;
  • Any promoters connected with the issuing company at the time of sale; and
  • Any persons compensated for soliciting investors, including directors, officers, general partners, and managing members of any compensated solicitor.

“Officers” includes officers and vice presidents of an organization, whether or not they

are connected to the private offering in question. Therefore, the scope of the rule could be significant, such as where a financial institution or broker-dealer acts as the placement agent and/or the initial purchaser in the offering.

The proposed rule would provide an exception from disqualification if the issuing company could show that it (1) did not know that a disqualification event existed at the time of the private placement offering and (2) exercised reasonable care in making the determination that no disqualification event existed. Under the proposed rule, issuing companies would be expected to conduct factual inquiries, the nature and extent of which would depend on the facts and circumstances of the situation.

Although disqualification under the proposed rule would prohibit an issuing company from selling securities in reliance on the Rule 506 safe harbor, the proposed rule would not prevent an issuing company that is subject to disqualification from selling securities in a registered offering or under a different registration exemption.


The SEC is seeking comments to its proposed version of the “bad actor” rule by July 14, so the final version may vary. However, in its current form, companies seeking to raise capital in private placement offerings pursuant to Rule 506 will need to conduct additional due diligence investigations through management questionnaires and interviews of all the parties involved in such offerings (including their directors, officers, general partners and managing members). These investigations will need to address the various “bad actor” disqualifications set forth in the new rule. If the new rule is adopted, this additional due diligence will become standard in private placement offerings moving forward.