Previously, I summarized the Securities and Exchange Commission’s implementing regulations of Title II of the JOBS Act, lifting the ban on general solicitation for offerings exempt under Rule 506 of Regulation D, which were finalized on July 10, 2013. At the same meeting, the SEC also finalized regulations which implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires the SEC to exclude certain felons and other “bad actors” from reliance on Rule 506.
Release No. 33-9414, entitled “Disqualification of Felons and Other ‘Bad Actors’ from Rule 506 Offerings,” is the final version of the rule and can be found here. “Bad actor” (or “bad boy”) disqualification provisions disqualify securities offerings from reliance on an exemption from registration if the issuer or other key persons (such as underwriters, placement agents, or directors, officers, or significant shareholders of the issuer) have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws. While such provisions can be found elsewhere in federal and state securities regulations, Rule 506 did not previously include any.
Section 926 of the Dodd-Frank Act required the SEC to implement bad actor disqualification provisions for Rule 506 offerings that are “substantially similar” to those in Rule 262 of Regulation A, and also imposed a list of additional disqualifying events. Rule 262 covers the issuer and certain other persons associated with the issuer or the offering, including issuer predecessors and affiliated issuers; directors, officers and general partners of the issuer; beneficial owners of 10% or more of any class of the issuer’s equity securities; promoters connected with the issuer; and underwriters and their directors, officers, and partners. Rule 262 disqualifying events include felony and misdemeanor convictions, injunctions and court orders, and the filing of a registration statement that is the subject of a proceeding to determine whether a stop order should be issued. The additional events specifically required by Section 926 are certain final orders issued by state securities, banking, credit union, and insurance regulators, federal banking regulators, and the National Credit Union Administration that bar certain activities or are based on violations involving certain fraudulent, manipulative, or deceptive conduct; and certain securities-related felony and misdemeanor convictions. Here is a summarized list of disqualifying acts under the final rule:
The rule contains a reasonable care exception, which would allow an issuer to maintain its Rule 506 exemption if it could show that it did not know and, in the exercise of reasonable care, could not have know that disqualifying event had occurred with respect to someone covered by this regulation. The rule offers no “safe harbor” to establish reasonable care, but rather states that the nature and scope of what an issuer needs to do is based on individual facts and circumstances.
The SEC originally proposed rule amendments to implement Section 926 of the Dodd-Frank Act on May 25, 2011. The proposed bad actor disqualification provisions largely tracked those of Rule 262, but differed in some respects because of new terms and concepts that have been introduced in securities regulation since Rule 262 was adopted as well as the types of companies that typically take advantage of Rule 506 as opposed to those that avail themselves of Regulation A. At the time they were proposed, both I and others had some concerns about the regulations and the impact they would have on small companies raising funds (see this post regarding my views and this post on the Angel Capital Association’s views). The disqualification provisions finally adopted are generally consistent with the 2011 proposal, with the following exceptions:
These changes make the rule somewhat easier to comply with, by for instance, reducing the number of shareholders or officers who could trigger a disqualification. Also, the exclusion of acts committed prior to the effectiveness of the rule will prevent the potential unfair situation where someone negotiated a civil or administrative settlement in connection with a securities case but never expected his company to be prevented from raising new capital.
Nonetheless, the central issue remains: this rule will increase costs for startups raising capital. They will be required to conduct background checks on a potentially wide group of persons associated with the issuer and will need to have their legal counsel review their structure and history to determine exactly who will need to undergo background checks. The consequences for the issuer (and its principals) of losing an exemption from securities registration are just so high, that I fear that this regulation may chill capital formation for startups. This, combined with the new proposed rules on filing Form D (which I’ll discuss soon in another post) may be a much greater setback for startups than the benefits gained from lifting the ban on general solicitation.
© 2013 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
Read more articles by Alexander Davie at Strictly Business, a business law blog for entrepreneurs, emerging companies, and the investment management industry.
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