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Rule 506 is by far the most widely used Regulation D exemption for conducting private placements. According to the SEC, about 90-95% of all private placements are conducted pursuant to Rule 506. This Rule permits sales of an unlimited dollar amount of securities without Securities Act registration, provided certain requirements are satisfied. Traditionally, issuers relied on Rule 506(b) that allows unlimited amounts to be raised from accredited investors and up to 35 non-accredited investors, so long as there was no general solicitation and advertising and other conditions were met. In implementing Section 201(a) of the JOBS Act, the SEC added a new Rule 506(c) that allows general solicitation and advertising in Rule 506 offerings so long as all purchasers of the securities are accredited investors and the issuer takes reasonable steps to verity their accredited investor status. 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:
As you can see, the list of potential “bad actors” that an issuer will need to vet can potentially be a long one, especially, for example, if they will be working with several different placement agents. That being the case, a company seeking to raise money in a Rule 506 private placement should be proactive in determining if they are subject to bad action disqualification at time they are offering or selling securities in reliance of Rule 506. Some steps a company should take include adding bad actor disqualification representations and covenants in their placement agency agreements or securities distribution agreements and asking all participants covered by Rule 506(d) to complete a bad actor questionnaire and/or certification (and bring-downs of the same if the offering is long-lived). Also, the issuer may add a provision in its bylaws requiring each “covered person” to notify it of a potential or actual bad actor event. Further, the issuer should check and re-check public databases for any triggering events. We will talk more about the reasonable care exception in the next blog. 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:
Only “bad acts” occurring on or after September 23, 2013 can destroy the exemption; those occurring prior to that date require disclosure, but do not themselves destroy the exemption. One important thing to note here is that this cut-off refers to the date of the conviction, order, etc. in question, not the underlying activities which eventually resulted in that action. For example, a broker who was suspended on October 1, 2014 for activity that occurred on June 3, 2014, would be a “bad actor” under the Rule, because the actual suspension occurred on or after September 23. Accordingly, the relevant look-back periods in the Rule are measured from the date of conviction or sanction, not from the date when the conduct occurred. 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).
Read more commentary from Arina Shulga on the legal aspects of operating new and growing businesses at Business Law Post.
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.
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