SEC Disqualifies “Bad Actors” from Investing in Private Placements


On July 10, 2013, the Securities and Exchange Commission (the “SEC”) voted unanimously to adopt a “bad actor” disqualification for Rule 506 private placement offerings under Regulation D. The new Rule 506(d) will prevent issuers from relying on Rule 506 when certain “bad actors” are associated with the issuer. Under the final disqualification rule, an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “disqualifying event.”

Covered Persons

Under the final disqualification rule, the exemption under Rule 506 will not be available if a “Covered Person” has engaged in a disqualifying event. The term “Covered Person” includes the following:

  • The issuer, its predecessors and affiliated issuers.
  • Directors and certain officers, general partners and managing members of the issuer.
  • 20% beneficial owners of the issuer.
  • Promoters.
  • Investment managers and principals of pooled investment funds.
  • Persons compensated for soliciting investors as well as the general partners, directors, officers and managing members of any compensated solicitor.
Disqualifying Events

Under the final rule, a disqualifying event includes:

  • Criminal convictions in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The criminal conviction must have occurred within 10 years of the proposed sale of securities (or five years in the case of the issuer and its predecessors and affiliated issuers).
  • Court injunctions and restraining orders in connection with the purchase or sale of a security, making of a false filing with the SEC or arising out of the conduct of certain types of financial intermediaries. The injunction or restraining order must have occurred within five years of the proposed sale of securities.
  • Final orders from the Commodity Futures Trading Commission, federal banking agencies, the National Credit Union Administration or state regulators of securities, insurance, banking, savings associations or credit unions that bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years of the proposed sale of securities.
  • Certain SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons.
  • SEC cease-and-desist orders related to violations of certain anti-fraud provisions and registration requirements of the federal securities laws.
  • SEC stop orders and orders suspending the Regulation A exemption issued within five years of the proposed sale of securities.
  • Suspension or expulsion from membership in a self-regulatory organization (“SRO”) or from association with an SRO member.
  • U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.
  • Reasonable Care Exception

    The final rule provides an exception from disqualification when the issuer can show it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The SEC did not define precisely what constitutes “reasonable care,” but it stated that whether the steps taken are “reasonable” is an objective determination to be made by the issuer in the context of the particular facts and circumstances of each purchaser and transaction.

    Disclosure of Pre-Existing Disqualifying Events

    Disqualification applies only for disqualifying events that occur after the effective date of this rule. Matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

    Effective Date and Cautionary Steps for Issuers

    The rules become effective on September 23, 2013. Issuers should take steps to establish that reasonable care has been exercised before a challenge arises. The adoption of robust policies and procedures to identify “bad actors” may help overcome the burden of proving reasonable care when “bad actors” are inadvertently involved in a transaction. Desirable steps might include the periodic questioning of Covered Persons, written plans and policies, routing audits and consistent application of the issuer’s “bad actor” policies.

    Public companies thinking of relying on the Rule 506 exemption should consider whether their current annual D&O questionnaires sufficiently address the types of information that would lead to disqualification. Modifications may be necessary to the extent that current questionnaires do not address all potential disqualifying events.

    If you have questions about the new “bad actor” rules, contact any member of Clark Wilson LLP’s Corporate Finance & Securities Group.