On May 25, 2011, the SEC proposed amendments to its rules to implement Section 926 of the Dodd-Frank Act. Section 926 requires the SEC to adopt rules that disqualify securities offerings involving certain felons and other bad actors from relying on Rule 506 of Regulation D, a safe harbor from SEC registration for private placements.

The proposed amendments to Rule 506 would disqualify an offering that involves "covered persons," which include the issuer and any predecessor of the issuer or affiliated issuer, 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 remuneration for solicitation of purchasers in connection with the sale of securities in the offering and any director, officer, general partner or managing member of any such compensated solicitor.

The proposed amendments also include a list of events that would give rise to disqualification, which include:

  • criminal convictions;
  • court injunctions and restraining orders;
  • final orders of certain state and federal regulators;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or exposure from membership in, or suspension or bar from associating with a member of, a security self-regulatory organization;
  • SEC stop orders and orders suspending a Regulation A exemption; and
  • U.S. Postal Service false representation orders.

The proposal provides for a reasonable care exception under which a company can rely on the Rule 506 exemption, despite the existence of a disqualifying event, if it can show that it did not know and could not have known of the disqualification.  The burden would be on the issuer to establish that it exercised reasonable care, which would require an inquiry into the relevant facts, the nature of which would depend on the facts and circumstances. In order to avail itself of the reasonable care exception, an issuer should consider, beyond factual inquiry of the covered person, investigating publicly available databases and even taking further steps depending on the facts and circumstances. 

The proposal also provides that 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.

Under the proposal, the disqualification provisions would apply to all sales made under Rule 506 after the effective date of the amended provisions.  However, offerings made after the effective date would be subject to disqualification for all disqualifying events that had occurred within the relevant look-back period, regardless of whether the disqualifying event occurred before the enactment of the Dodd Frank Act or effectiveness of the amendments to Rule 506. This will likely be one of the more controversial aspects of this proposal, as individuals may be adversely affected if, for instance, they had negotiated a settlement with the SEC before the Dodd-Frank Act was enacted – had the person known at the time that the settlement would have the effect of losing Rule 506 safe harbor eligibility, the person may have negotiated a different settlement or even chosen to litigate the allegations.

The proposal also discusses other possible amendments, which will go beyond the specific mandate of the Dodd-Frank Act, to various other SEC rules to make bad actor disqualification more uniform across other exemption rules. Some of these additional proposals include applying the proposed bad actor disqualification provisions to other offerings such as Regulation A, Rule 505 of Regulation D and Regulation E.