On May 25, 2011, the U.S. Securities and Exchange Commission (the “SEC”) proposed amendments to Rules 501 and 506 of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”).1 Regulation D is a series of rules that provide a safe harbor for the limited offer and sale of an issuer’s securities without registration under the Securities Act. Rule 506 of Regulation D is commonly relied upon by private investment funds to avoid registration under the Securities Act. Under the proposal, a securities offering involving certain felons and other bad actors would be unable to rely on the safe harbor from Securities Act registration provided by Rule 506. The proposal would implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) which requires the SEC to adopt Rule 506 disqualification provisions that are substantially similar to the disqualification provisions contained in Rule 262 of Regulation A (which is an exemption from registration for certain small offerings) under the Securities Act. Comments on the proposed amendments should be submitted to the SEC by July 14, 2011.

If an offering qualifies for the Rule 506 exemption,2 an issuer can raise unlimited capital from an unlimited number of accredited investors and up to 35 non-accredited investors. In its current form, Rule 506 does not impose any bad actor disqualification requirements. Under the proposal, an offering would be unable to rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a disqualifying event such as a criminal conviction, court injunction or restraining order. These provisions would be codified as a new paragraph (c) of Rule 506.

Covered Persons. Under proposed Rule 506(c), the following persons could disqualify an issuer from relying on Rule 506 if they are the subject of a disqualifying event (collectively, “covered persons”):

  • the issuer and any predecessor of the issuer or affiliated issuer;3
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10% 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 (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering (e.g., placement agents); and
  • any director, officer, general partner, or managing member of any such compensated solicitor.

Importantly, the SEC is not currently proposing to include as covered persons the investment advisers of issuers, or the directors, officers, general partners or managing members of such investment advisers; however, the SEC is requesting comment as to whether proposed Rule 506(c) should be expanded to include such persons, particularly with respect to pooled investment funds and private funds. Also note that under the proposal, the term “officer” is defined under Securities Act Rule 405 and includes “a president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer, and any person routinely performing corresponding functions with respect to any organization.” The SEC notes that placement agents may have large numbers of employees that would come within this definition, but many of whom would not have any involvement with any particular offering. Accordingly, the SEC is requesting comment on whether disqualification should be reserved for executive officers performing policy-making functions for a covered person or whether disqualification should apply only to officers actually involved in the offering.  

Disqualifying Events. Under proposed Rule 506(c), the following could constitute “disqualifying events”:

  • criminal convictions (in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; 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) within ten years before the sale of securities (or five years, in the case of issuers, their predecessors and affiliated issuers);
  • court injunctions and restraining orders (in connection with the purchase or sale of any security; involving the making of any false filing with the SEC; 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) 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 such conduct or practice;
  • final orders of certain state regulators (such as state securities, banking and insurance regulators) and federal regulators4 (if the order is based on fraudulent, manipulative or deceptive conduct, there is a ten year look-back; if the order bars a covered person from engaging in specified activities, the order would be disqualifying for as long as the bar was in effect);
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons for so long as such orders are in effect;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization for the duration of the suspension or expulsion;
  • SEC stop orders and orders suspending a Regulation A exemption issued within five years before such sale; and
  • U.S. Postal Service false representation orders entered within five years before such sale.

Reasonable Care Exception. To clarify the issuer’s obligations under the proposed Rule 506(c), the proposal provides a “reasonable care” exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. To establish reasonable care, the issuer would be expected to conduct a factual inquiry, the nature and extent of which would depend on the facts and circumstances of the situation.

Waivers. The SEC 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.

Transition Issues. All sales made under Rule 506 after the effective date of the proposed provisions would be subject to the disqualification provisions. However, in applying the relevant look-back provisions, an issuer must look back at all disqualifying events that occurred within the relevant look-back periods – even those that pre-date the effective date of the amendments to Rule 506. Finally, issuers may regain eligibility to rely on Rule 506 if they are able to terminate their relationship with the bad actor whose involvement triggers the disqualification.

Amendment to Form D. Under the proposal, the signature block of Form D would contain a certification confirming that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(c).

Other Possible Amendments. The proposal also requests comment on applying the new bad actor disqualification provisions proposed for Rule 506 offerings uniformly to offerings under Regulation A, Rule 505 of Regulation D and Regulation E and offerings under Rule 504 of Regulation D. In addition, for all disqualifying events that are subject to an express lookback period under current law (e.g., criminal convictions within the last five or ten years, court orders within the last five years), the SEC is considering providing a uniform ten-year look back period, to align with the ten-year look-back period required under the Dodd-Frank Act for specified regulatory orders and bars.