As of September 23, 2014, the SEC added a new section (d) to Rule 506. Rule 506(d) applies to all Rule 506 offerings, i.e., Rule 506(b) and Rule 506(c) offerings. It is important that all companies raising capital by means of Rule 506 know and understand the new addition to Rule 506 because failing to comply with Rule 506(d) will disqualify the entire offering.
Rule 506(d) identifies certain persons that may potentially become “bad actors.” It also lists certain events (“disqualifying events” or “bad acts”). An offering cannot be made using Rule 506 if it includes a “bad actor” that is engaging or has engaged in a “bad act.” This blog post focuses on (1) who may be a potential “bad actor” and (2) what constitutes a “disqualifying event” or “bad act.” The follow up blog will discuss certain exceptions from disqualification and how to obtain waivers.
Who are the potential bad actors?
Rule 506(d)(1) casts a wide net in terms of who can potentially be a bad actor (and can destroy the Rule 506 exemption). Possible "covered persons" include:
- The issuer of the securities (as well as any predecessor of the issuer or any “affiliated issuer.” An affiliated issuer, as the name suggests, is an affiliate (a person who controls or is controlled by the issuer) who is also issuing securities in the same offering.
- Any director, executive officer, or other officer participating in the offering. (Participation can include such activities as preparing due diligence and/or disclosure documents or communicating with other participants in the offering, including potential investors. In general, when trying to determine whether a particular officer is “participating” when it comes to performing a “bad actor” check, err on the side of caution and assume that the SEC is likely to answer “yes”, particularly when it comes to smaller start-up companies which may not yet have well-entrenched and explicit divisions of labor and responsibility.)
- Any general partner or managing member of the issuer.
- Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities.
- Any “promoter” connected to the issuer in any capacity during the actual sale of securities. (The SEC defines “promoter” broadly: the term includes any natural person or legal entity that “directly or indirectly takes initiative” in founding the company, as well as any person who, in connection with the founding, receives (other than solely as underwriting compensation or in exchange for property) at least 10% of either the proceeds of any sale of securities by the issuer or at least 10% of any class of the securities themselves.)
- Any investment manager of the issuer (if the issuer is a pooled investment fund), as well as its directors, executive officers, other participating officers, general partners, and managing members.
- Any natural person or legal entity who has been or willed be paid to solicit purchasers of the offered securities (e.g. a placement agent), as well as their directors, executive officers, other participating officers, general partners, or managing members.
What constitutes a “disqualifying event” or a “bad act"?
Rule 501(d)(1)(i)-(viii) lists the bad acts. A bad actor is any of the covered persons who:
- Has been convicted within ten years of the sale (five years for issuers and their predecessors or affiliates) of any felony or misdemeanor in connection with the purchase or sale of any security; involving making any false filing with the SEC; or arising out of the business conduct of certain financial intermediaries;
- Is subject to any final order, judgment or decree entered within five years of the sale that at the time of the sale restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of a security, involving the making of a false SEC filing, or arising out of the conduct of certain types of financial intermediaries;
- Is subject to a final order from state securities regulators, insurance, banking, savings association or credit union regulators, federal banking agencies, the CFTC or the National Credit Union Administration that either (1) at the time of the current sale, bars the person from association with any entity regulated by such a commission, agency, etc.; engaging in the securities, banking, or insurance business; or engaging in savings association or credit union activities, or (2) constitutes a final order based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct.
- Is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons;
- Is subject to an SEC order (entered within five years of the current sale) that, at the time of the sale, orders the person to “cease and desist from committing or causing a violation or future violation” of 1) any scienter-based [i.e. intentional] antifraud provision of the federal securities laws (e.g. Section 10(b) and Rule 10b-5 of the Securities Exchange Act, Section 17(a) of the Securities Act); or 2) Section 5 of the Securities Act (dealing with selling unregistered securities (which have not received an exemption) in interstate commerce) (Cease and desist orders regarding violations which do not include a scienter (intent) element would not be included, and thus would not be disqualifying “bad acts.”)
- Is suspended or expelled from membership in, or barred from associating with a member of, a registered national securities exchange (e.g. NYSE) or an affiliated securities association (e.g. FINRA) for actions found to be inconsistent with the just and equitable principles of trade;
- Has filed either as a registrant or issuer, or who acted or was named as an underwriter for, any registration statement or Regulation A offering which, within the five years prior to the current securities offering, was the subject of an SEC stop order, refusal order, or an order suspending the Regulation A exemption, or who is currently the subject of an investigation or proceeding to determine whether such an order should be issued.
- Is subject to a USPS false representation order entered within five years of the current sale of securities, or who has received a temporary restraining order or preliminary injunction regarding conduct alleged by the USPS to constitute a scheme to obtain money or property through the mail by means of false representations.
Final thing to note is that Rule 506(d) is not triggered by actions of foreign courts or regulations, such as convictions, court orders or injunctions.
Given the serious, even devastating potential consequences that can follow from failing to catch a “bad actor” disqualification, I strongly encourage companies considering raising capital through a Rule 506 private placement to devote the necessary time and resources to ensuring that the company and its covered persons are in full compliance with the “bad actor” disqualification provisions of Rule 506(d).
This article is not a legal advice, and was written for general informational purposes only. If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga. Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.