The Securities and Exchange Commission (“SEC”) has proposed amendments to Regulation D and Form D that, if adopted, would disqualify certain “felons” and other “bad actors” from reliance on the safe harbor from securities registration provided under Rule 506 of Regulation D under the Securities Act of 1933 (the “Proposal”). The Proposal would also prohibit such persons from claiming “covered securities” status for purposes of the preemption of state Blue Sky laws, afforded by reliance on Rule 506 of Regulation D. Issuers with disqualifiers would still be able to effect private placements under Section 4(2) of the Securities Act of 1933, but would not have the benefit of the preemption of state securities laws afforded by reliance on Rule 506.

The Proposal is intended to implement Section 926 of the Dodd-Frank Act (“Section 926”). Section 926 requires the SEC to issue implementing rules by July 21, 2011 for Rule 506 offerings that are “substantially similar” to Rule 262 — the bad actor disqualification provisions of Regulation A — and that also include an expanded list of disqualifying events, enumerated in Section 926. Comments are due on July 14, 2011.

Requirements of the Proposed Rule.

Under the Proposal, covered persons (“Covered Persons”) cannot rely on the exemption from registration of securities provided by Rule 506 if such Covered Persons had a disqualifying event within a certain period of time.

Who Are the Covered Persons?

  • The issuer, including any predecessor and affiliated issuers, and promoters;
  • directors, officers, general partners, and managing members of the issuer;
  • any beneficial owner of 10 percent or more of any class of the issuer’s equity securities; and
  • persons who are compensated (directly or indirectly) for soliciting investors, e.g., placement agents), as well as general partners, directors, officers, and managing members of the compensated solicitor.

In the Proposal, the SEC notes that the proposed rules do not apply to investment advisers of issuers, or the directors, officers, general partners, or managing members of such investment advisers. The SEC is requesting comment on whether investment advisers and their directors, officers, general partners, and managing members should be included as Covered Persons.

What Are Disqualifying Events?

  • Criminal convictions in connection with the purchase or sale of a security, the making of any type of “false filing” with the SEC or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, or investment adviser. The criminal conviction must have occurred within ten years of the sale of securities (or five years, in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, the making of any type of “false filing” with the SEC or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, or investment adviser. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
  • Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies; or the National Credit Union Administration that bar the issuer from:
    1. associating with a regulated entity;
    2. engaging in the business of securities, insurance, or banking; and
    3. engaging in savings association or credit union activities; or
    4. that constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale.
  • SEC orders under Section 15(b) or 15(c) of the Securities Exchange Act of 1934, or Section 203(e) or 203(f) of the Investment Advisers Act of 1940, that at the time of sale:
    1. suspend or revoke registration as a broker, dealer, municipal securities dealer, or investment adviser;
    2. places limitations on the activities, functions, or operations of such persons; or
    3. bars such persons from being associated with any entity or from participating in the offering of any penny stock.
  • Suspension or expulsion from membership in a “selfregulatory organization” (“SRO”) or suspension or bar from association with an SRO member, which would be disqualifying for the period of suspension or expulsion.
  • Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities.
  • U.S. Postal Service false representation orders issued within five years prior to the proposed sale of securities.

The SEC is soliciting comment on whether the Commodity Futures Trading Commission should be added to the list of regulators whose final orders are disqualifying.

The SEC acknowledges the potential difficulty of ascertaining whether disqualifying events may apply to the Covered Person, and the Proposal includes an exception from disqualification if the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event existed.