The Dodd-Frank Wall Street Reform and Consumer Protection Act, enacted by Congress in July 2010, includes the requirement that the SEC implement a rule to ban persons who are subject to certain sanctions and disciplinary proceedings or who have been convicted of a felony or misdemeanor related to the purchase or sale of a security from being able to use the securities registration exemption under Rule 506 of Regulation D of the Securities Act of 1933. Regulation D includes three separate exemptions that may be used by issuers of securities to avoid the securities registration requirements. Rule 506 is, by far, the most widely used exemption by issuers under Regulation D. Most private funds, including hedge funds, use the Rule 506 exemption, which is likely the main reason why Congress enacted a law to restrict the use of this exemption.
The SEC's proposed rule, now out for public comment until July 14, 2011, if implemented as proposed, would apply the bad-actor events that occurred prior to the enactment of the provision under Dodd-Frank. This application of the proposed rule to pre-existing convictions and sanctions is likely to cause the most opposition to the proposed rule. The opposition will argue that if Congress wanted convictions and sanctions that occurred prior to the enactment of Dodd-Frank to serve as a disallowance of the use of the exemption, they could have stated so in the law. Indeed, two of the SEC's commissioners, Kathleen Casey and Troy Paredes, stated that the retroactive approach included in the SEC's proposed rule was the primary reason they could not support it. In spite of the lack of support from Commissioners Casey and Paredes, the vote by the full Commission was 3-2 in favor of going forward with the rule as proposed.
The disqualifying events that are applied to the issuer of the securities, its directors, officers, general partners and managing members, 10 percent or more beneficial owners and promoters, and persons who solicit investors for compensation include:
- Criminal convictions in connection with the purchase or sale of a security, making a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries, which events occurred within 10 years of the proposed 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, making a false filing with the SEC, or arising out of the conduct of certain types of financial intermediaries, which occurred within five years of the proposed sale of securities
- Certain final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies, or the National Credit Union Administration, which were issued within 10 years before the proposed sale of securities
- Suspension or expulsion from membership in a self-regulatory organization (SRO) or from association with a SRO member
- SEC stop orders suspending the use of an exemption within five years before the proposed sale of securities
- U.S. Postal Service false representation orders issued within five years before the proposed sale of securities
The SEC, in its proposed rule, asks for public comment whether final orders issued by the SEC or the CFTC also should be included as a disqualifying event.
The SEC also asks for comment as to whether these disqualifying events should be applied to other securities registration exemptions under Rule 504 of Regulation D, and Regulation A and Regulation E under the Securities Act. Rule 505 of Regulation D already includes disqualifying events as a bar from using that exemption. Congress did not address those exemptions in its Dodd-Frank provision regarding the disqualification of bad actors from the use of the securities registration exemption under Rule 506.
The proposed rule would provide an exception to the disqualification if the issuer relying upon the exemption could show that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed.
The exemption under Rule 506 is the exemption of choice for most issuers under Regulation D due in large part to the exemption's status under Section 18 of the Securities Act as a “covered security.” That status means that the state securities or “blue sky” laws registration requirements for such offerings are pre-empted. Accordingly, the issuer only has to file a post-sale notice and payment of a fee to any state in which the securities are being sold. If the issuer was not able to rely on the Rule 506 exemption, it would not be able to rely upon the “safe harbor” exemption under Regulation D and the federal preemption of blue sky securities registration provisions.