On July 10, 2013, the Securities and Exchange Commission (the “SEC”) adopted final rules implementing amendments to Rule 506 to disqualify issuers and other market participants from relying on Rule 506 if “felons and other ‘bad actors’” are participating in the Rule 506 offering, as required by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).1

The Final Rules. To implement Section 926 of the Dodd-Frank Act, the final rules prohibit an issuer from relying on the Rule 506 registration exemption if the issuer or any other “covered person” had a “disqualifying event.” The final rules provide an exception from disqualification if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.  

Covered Persons. Covered persons include:  

  • directors and certain officers, general partners and managing members of the issuer;  
  • 20 percent beneficial owners of the issuer;  
  • promoters;  
  • investment managers and principals of pooled investment funds; and  
  • persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor.

Disqualifying Events. Disqualifying events include:

  • criminal convictions (occurring within 10 years of the proposed sale of securities, or five years in the case of the issuer and its predecessors and affiliated issuers) in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries;  
  • court injunctions and restraining orders (occurring within five years of the proposed sale of securities) in connection with the purchase or sale of a security, making of a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries;  
  • final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration, or state regulators of securities, insurance, banking, savings associations, or credit unions that:
    • bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or  
    • are based on fraudulent, manipulative, or deceptive conduct and are issued within 10 years of the proposed sale of securities;  
  • certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisors and their associated persons;  
  • SEC cease-and-desist orders relating to certain anti-fraud and registration requirements of the federal securities laws;  
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities;  
  • suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with an SRO member; and  
  • U.S. Postal Service false representation orders issued within five years of the proposed sale of securities.  

Reasonable Care Exception. The final rules provide an exception from disqualification if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The SEC notes that the steps an issuer should take to exercise reasonable care will vary according to the particular facts and circumstances of the bad actor and the offering. The instructions to the new Rule 506(d)(2)(iv), which contains the reasonable care exception, state that “[a]n issuer will not be able to establish that is has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.”  

Transition Issues. Under the SEC’s proposed rules, the new disqualification provisions would have applied to all sales made under Rule 506 after the effective date of the amendments and offerings made after the effective date would have been subject to disqualification for all disqualifying events that occurred within the relevant look-back periods. However, based on comments provided to the proposing rules, the SEC determined that the Rule 506 disqualification should not be triggered on the basis of disqualifying events that occurred before the effective date of the rule amendments. Instead, the final rules require written disclosure of matters that would have triggered disqualification except that they occurred before the effective date of the new disqualification rules.  

Changes to Form D. The final rules amend the signature block of Form D to add a certification requiring issuers who are claiming a Rule 506 exemption to confirm that the offering is not disqualified from reliance on Rule 506 for one of the reasons stated in Rule 506(d).  

Effectiveness. The final rules will go into effect sometime in September on the date that is 60 days following publication of the rules in the Federal Register.