Compliance Guide: Disqualification of Felons and Other "Bad Actors" from Rule 506 Offerings
In 2013, the SEC introduced "bad actor" disqualification provisions under Rule 506 of Regulation D, implementing Section 926 of the Dodd-Frank Act. This compliance guide provides a comprehensive look at how these provisions impact issuers seeking to rely on Rule 506 exemptions, covering disqualifying events, exceptions, waiver processes, disclosure requirements, and transitional considerations.
1. Overview of Rule 506 Bad Actor Disqualification
Rule 506(d) prohibits reliance on Rule 506(b) or 506(c) if the issuer or any "covered person" has a relevant criminal conviction, regulatory or court order, or similar disqualifying event occurring after September 23, 2013. For events before this date, issuers may still rely on Rule 506 but must comply with disclosure requirements under Rule 506(e).
2. Covered Persons
Understanding which individuals and entities are covered by Rule 506(d) is essential for issuers, as any disqualifying event among these persons may either disqualify the offering or trigger disclosure requirements. Covered persons include:
Issuers, predecessors, and affiliates: Includes entities under common control involved in the offering.
Directors, general partners, and managing members of the issuer: Includes Board members, general partners, and managing members.
Executive officers and participating officers of the issuer: Includes those with policy-making roles or substantial involvement in the offering.
20% beneficial owners: Holders of 20% or more of the issuer's voting securities, determined by total voting power.
Promoters: Individuals or entities involved in founding or organizing the issuer, or receiving 10% or more of any class of securities.
Investment managers and principals for pooled funds: Investment advisers or managers of pooled funds and their officers and managers.
Compensated solicitors: Includes broker-dealers and others paid for soliciting investors.
3. Disqualifying Events
The following events trigger disqualification:
Certain criminal convictions related to securities transactions, SEC filings, or the business of brokers, dealers, or investment advisers.
Court injunctions and restraining orders concerning securities transactions, SEC filings, or securities business within five years.
Final orders from state and federal regulators that bar association with a regulated industry or are based on fraudulent conduct, within 10 years.
SEC disciplinary orders related to suspensions, revocations, or limitations on securities-related activities.
SEC cease-and-desist orders issued within five years for scienter-based anti-fraud provisions or Section 5 violations.
SEC stop orders or pending proceedings related to previous registration statements or Regulation A filings within five years.
SRO suspensions or expulsions for conduct inconsistent with equitable trading principles.
U.S. Postal Service false representation orders for fraudulent mail activities within five years.
The look-back period is based on the date of the disqualifying event, not the date of the underlying conduct.
4. Reasonable Care Exception
Issuers may rely on a reasonable care exception if they can show they didn’t know and, with reasonable inquiry, couldn’t have known that a disqualifying event existed among covered persons. The level of inquiry required depends on the specific context of the offering.
5. Waivers
Waivers for good cause may be granted by the SEC if disqualification is deemed unnecessary under the circumstances. To evaluate a waiver request, the SEC considers factors such as the issuer’s level of responsibility for the misconduct, duration of the event, remedial steps taken, and potential impact if the waiver is denied.
For additional guidance on waivers, please contact our office prior to reaching out to the SEC directly. Our team can provide insight into the process and offer tailored advice to strengthen your request.
6. Disclosure of Pre-Existing Disqualifying Events
For disqualifying events occurring before September 23, 2013, issuers may rely on Rule 506 but must disclose these events in writing to investors prior to any sale. Failing to disclose pre-existing events disqualifies the issuer unless they can show they did not know, and couldn’t reasonably have known, about the disqualifying event.
Disclosure Timing: Must be given a reasonable time before the sale under Rule 506.
Disclosure Content: Issuers should provide clear, prominent disclosures to ensure transparency regarding any pre-existing events.
7. Transition Issues
The bad actor rules apply only to sales made after September 23, 2013. Sales prior to this date remain unaffected. However, any sales following a disqualifying event cannot rely on Rule 506 unless a waiver or exception applies.
During ongoing offerings: Any disqualifying event during an offering requires immediate cessation of sales until the event is addressed through a waiver or other resolution.
Post-discovery of pre-existing events: If a disqualifying event from before September 23, 2013, is discovered mid-offering, the issuer must ensure compliance with disclosure requirements.
Key Takeaway
Issuers must conduct thorough inquiries to identify any potential disqualifying events among covered persons before relying on Rule 506 exemptions. Waivers and the reasonable care exception provide options for addressing disqualification, while pre-existing events require careful disclosure.
For specific guidance on waiver requests or to navigate disclosure requirements, please reach out to our office to discuss your situation and help streamline the compliance process.
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