"bad actor" rules are likely to increase the risks and costs
associated with Rule 506 offerings.
The U.S. Securities and Exchange Commission (SEC) has
announced proposed rules1
that would deny the safe-harbor exemption provided by Rule 506 of Regulation D
to securities for any offering involving certain "felons and other 'bad
actors'" under the Securities Act of 1933 (the "Securities
Act"). The period for comments on the proposed rules expires on July 14,
The proposed rules include the following disqualifying
that, in most instances, contain look-back provisions of between five and 10
As proposed, the new rules would apply to all sales of
securities made in reliance on Rule 506 after the effective date of the final
rules. An event that occurred before enactment of the Dodd-Frank Act or the
effectiveness of the new rules would still be a disqualifying event if it
occurred during the applicable look-back period. In addition, if a
disqualification should arise during an offering, any sale made while the
disqualification exists would not be entitled to the safe-harbor exemption
provided by Rule 506.
The proposed rules would be applicable to the following
"Reasonable Care" Exception
Under a proposed "reasonable care" exception, if
there is a disqualifying event at the time of a sale, the issuer may still rely
on the safe harbor provided by Rule 506 if it can establish that it did not
know, and in the exercise of reasonable care, could not have known of the
disqualifying event at the time of the sale. However, an issuer would not be
able to rely on the "reasonable care" exception unless it could
demonstrate that it made a factual inquiry into whether any disqualifications
existed at the time of sale.
Other Proposed Amendments
In addition, the SEC seeks comment on whether it would be
beneficial to implement uniform disqualifying rules applicable to Regulation A,
Regulation E and other sections of Regulation D.
What This Means for Issuers
An issuer that complies with all of the provisions of
Rule 506 other than the bad actor provisions might be entitled to rely on the
statutory exemption provided by Section 4(2) of the Securities Act. However, an
offering made in reliance on the statutory exemption provided by Section 4(2)
would not constitute an offering of a "covered security" under the
Securities Act; thus, state registration and review requirements would not be
preempted by federal securities laws and would apply to the offering.
Furthermore, issuers would then be subject to, and would still have to address,
any state-level bad actor disqualifications.
Issuers that choose to rely on revised Rule 506 will need
to implement processes and procedures that would exhibit that they exercised
reasonable care in conducting their offerings. In this regard, such processes
and procedures would have to take into account the risk that bad actors could
be present; the availability of other screening and compliance mechanisms; and
the cost and burden of the inquiry. At a minimum, issuers would need to
consider updating the questionnaires typically used in connection with private
placements to address the new bad actor disqualifications and should consider
searching publically available databases and other sources for relevant
information regarding a covered person's status as a bad actor. In a continuous
offering, an issuer will need to take reasonable steps before subsequent sales
to ensure that circumstances have not changed regarding a covered person's
status as a bad actor.3
The proposed rules, if adopted in their present form, are
likely to increase the risks associated with Rule 506 offerings and the costs
of such offerings. However, it is likely that, over time, standard practices
and procedures as to what constitutes reasonable care will be developed that
should reduce the risks and costs posed to issuers by the bad actor
About Duane Morris
Duane Morris has an online Financial Services Reform
Center - www.duanemorris.com/FinancialReform
- which includes the firm's comprehensive series of Alerts analyzing the
provisions of the Dodd-Frank Act and emerging policies, as well as videos and
links to relevant government websites. Duane Morris' attorneys are monitoring
the rules and regulations released under the Dodd-Frank Act, as well as the
regulatory agencies' interpretive guidance, to continuously update the Financial
Services Reform Center.
For Further Information
If you have any questions regarding the proposed rules
discussed in this Alert, including how they may affect your company,
please contact Robert P.
S. Lese, Howell
J. Reeves, Heather Carmody,
A. Roth, Chad
J. Rubin, any member
of the Securities
Law practice, any member
of the Mergers
and Acquisitions practice or the lawyer in the firm with whom you are
regularly in contact.
legal alerts and updates and the Duane Morris website
Alert has been prepared and published for informational purposes only and is
not offered, or should be construed, as legal advice. For more information,
please see the firm's full
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