The SEC recently proposed rules to implement the requirement under the Dodd-Frank Wall Street Reform and Consumer Protection Act to disqualify securities offerings involving certain “felons and other ‘bad actors’” from relying on the Rule 506 safe harbor exemption from registration under the Securities Act of 1933, as amended. The proposed rules are substantially similar to the current “bad actor” disqualification provisions of Regulation A under the Securities Act, but simplify the framework under Regulation A. The period for public comment on the proposed rules ends on July 14, 2011.
Under the proposed rules, the following types of events by a “covered person” involved in a securities offering will disqualify reliance on Rule 506 as a safe harbor for the offering:
- a felony or misdemeanor conviction in the last five years for issuers and in the last 10 years for all other covered persons in connection with the purchase or sale of any security, involving 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;
- a court injunction or restraining order within the last five years involving the same subject matter described above in the first bullet;
- a final order of certain state regulators that either (i) at the time of sale bars the covered person from engaging in or associating with certain securities-, insurance- or banking-related businesses, activities or entities, or (ii) was based on any law or regulation prohibiting fraudulent, manipulative or deceptive conduct entered within the last 10 years;
- a SEC disciplinary order that at the time of sale suspends or revokes such person’s registration with the SEC, places limitations on such person or bars such person from being associated with any entity or from participating in a penny stock offering;
- suspension or expulsion from membership in a self-regulatory organization, such as a registered national securities exchange, or association with a member of such organization;
- as an issuer or underwriter, having a registration statement be subject to a stop order or order suspending a Regulation A exemption within the last five years or being the subject of a pending proceeding at the time of sale; and
- a U.S. Postal Service false representation order within the last five years or being subject to a temporary restraining order or preliminary injunction with respect to conduct alleged to have violated the false representation statute that applies to U.S. mail.
For purposes of the proposed rules, a “covered person” would include:
- the issuer, including 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 (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
- any director, officer, general partner or managing member of any such compensated solicitor.
As offerings relying on the Rule 506 safe harbor were not previously subject to such “bad actor” disqualification provisions, these proposed rules will significantly increase the burden on issuers by requiring inquiry into potential disqualifying events. In order to address the potential difficulty in ascertaining disqualifying events by all “covered persons,” the SEC has proposed including an exception from disqualification for offerings where the issuer establishes that “it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed” with respect to a covered person. The issuer must make a factual inquiry, but the nature and scope of such inquiry will vary based on the circumstances of the participants in the offering.