SEC Proposes Amendments to Disqualify "Bad Actors" from Relying on the Rule 506 Safe Harbor under Regulation D
May 26, 2011
At its open meeting on May 25, 2011, the Securities and Exchange Commission (the “SEC”) voted 3-2 to propose amendments to Rule 506 (“Rule 506”) of Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), together with conforming amendments to Form D, in order to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”). Rule 506 is the most widely used of the three exemptive safe harbors in Regulation D, and permits sales of an unlimited dollar amount of securities without registration under the Securities Act to an unlimited number of accredited investors and up to 35 sophisticated non-accredited investors, subject to certain conditions including in particular that there be no general solicitation, appropriate resale restrictions are implemented, and applicable information requirements are satisfied.
Section 926 of Dodd-Frank requires the SEC to adopt rules disqualifying certain “felons and other ‘bad actors’” from relying on the Rule 506 safe harbor. Pursuant to Section 926, these new rules must be “substantially similar” to the disqualification provisions set forth in Rule 262 of Regulation A under the Securities Act, but must also include certain other predicates for disqualification (including in particular certain state regulatory orders and bars).
The SEC’s proposed amendments to Rule 506 would prohibit (1) issuers (including predecessors and affiliated issuers), (2) their directors, officers, general partners, managing members and significant (10%+) beneficial owners of equity securities, (3) persons paid (directly or indirectly) to solicit purchasers in connection with sales in the offering (e.g., underwriters and placement agents), (4) directors, officers, general partners and managing members of such compensated solicitors, and (5) certain other persons (such as promoters), from participating in Rule 506 exempt securities offerings if they have been convicted of, or are subject to court or administrative sanctions for, certain specified violations of law. Proposed disqualifying events and time periods, which will be set forth in new paragraph (c) of Rule 506, include:
- Criminal Convictions. Felony and misdemeanor convictions (a) in connection with the purchase or sale of a security, (b) involving the making of a false filing with the SEC or (c) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if occurring within the five years (in the case of issuers) or ten years (in the case of other covered persons) before the Rule 506 sale.
- Court Injunctions and Restraining Orders. Injunctions and court orders against engaging in or continuing conduct or practices (a) in connection with the purchase or sale of a security, (b) involving the making of a false filing with the SEC or (c) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if issued within the five years before the Rule 506 sale.
- Final Orders of Certain Federal and State Regulators. Final orders issued by federal banking regulators, the National Credit Union Administration or state securities, banking, credit union or insurance regulators that (a) bar a person from engaging in securities, insurance, banking, saving association or credit union activities, or from association with an entity regulated by the regulator issuing the order, if in effect at the time of the Rule 506 sale, or (b) are based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct, if entered within the ten years before the Rule 506 sale.
- SEC Disciplinary Orders and Certain Actions Relating to a Securities Self-Regulatory Organization. Certain SEC orders (including suspension or revocation of registration as a broker, dealer, or investment advisor, or imposing limitations on such activities) or suspension or expulsion from, or being barred from association with, a national securities exchange or national securities association for “conduct inconsistent with just and equitable principles of trade,” if in effect at the time of the Rule 506 sale.
- Stop Orders and Regulation A Suspension Orders. Being named as an underwriter in, or filing, a registration statement or a Regulation A offering statement as to which a stop order or suspension order was issued within the five years before the Rule 506 sale, or being the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued, if such investigation or proceeding is taking place at the time of the Rule 506 sale.
- U.S. Postal Orders. U.S. Postal Service false representation orders entered within the five years before the Rule 506 sale, or being subject, at the time of such sale, to certain U.S. Postal Service temporary restraining orders or injunctions.
The proposal also sets out a “reasonable care” exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. The proposing release indicates the issuer would be expected to conduct a factual inquiry, the nature and extent of which would be fact- and circumstance-dependent, to rely on this exception.
The SEC also proposed the possibility of making potential additional changes to its rules in order to make “bad actor” disqualification more uniform across other exemptive rules, and is soliciting public comment on these proposals. First, those proposals would apply the newly proposed provisions uniformly to offerings under Rule 505 of Regulation D (permitting companies to offer up to $5.0 million of restricted securities in any 12-month period to an unlimited number of accredited investors and up to 35 non-accredited investors who, unlike Rule 506, need not be “sophisticated”), Regulation A (providing for simplified disclosure and transactional requirements for companies offering $5.0 million or less of securities, but which requires the filing of an offering statement subject to review by the SEC) and Regulation E (exempting from registration under the Securities Act certain offerings of securities by small business investment companies registered under the Investment Company Act of 1940 (the “1940 Act”) or closed-end investment companies that are regulated as a business development companies under the 1940 Act), all of which are currently subject to some version of disqualification, and to Rule 504 of Regulation D (permitting most companies that are not reporting companies to offer and sell up to $1.0 million of restricted securities in any 12-month period, or unrestricted securities in cases where the issuer complies with applicable state law requirements), which currently is not. In addition, those proposals would, for disqualifying events subject to an express look-back period, provide a uniform ten-year look-back period to align the various exemptions with the only time period explicitly set out in Dodd-Frank (rather than the five- or ten-year periods imported from Regulation A).
Of particular note at the open meeting was the discussion of the transition period applicable to the amended rule. Under the proposed amendment, Rule 506 sales made after the effective date would be subject to disqualification for all disqualifying events occurring within the relevant look-back periods (subject to certain limited grandfathering provisions), even if the disqualifying events occurred before the effectiveness of the amendments to Rule 506 or before enactment of Dodd-Frank. Although the SEC indicated in the proposal its belief that Congress intended for all past disqualifying events to be taken into account under the new disqualification rules, Dodd-Frank includes no explicit statement of Congressional intent regarding retroactive application, and the two dissenting Commissioners largely focused on this retroactive application of the statute as the reason for voting against the proposal.
The comment period for the proposed amendments expires on July 14, 2011. A copy of SEC Release No. 33-9211 is available at http://www.sec.gov/rules/proposed/2011/33-9211.pdf.
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