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Dodd-Frank Focus: “Felons and other Bad Actors”

June 10, 2011

On May 25th, the SEC published for comment proposed amendments implementing Section 926 of the Dodd-Frank Act.  The proposal affects Rule 506 of Regulation D of the Securities Act, which offers safe harbor from registration of offerings by certain issuers.

Photo by downing.amanda. Some rights reserved.

The Commission is being required to adopt rules that disqualify securities offerings involving certain “felons and other bad actors” from reliance on Rule 506 of Regulation D. The rules must be “substantially similar” to Rule 262, the disqualification provisions of Regulation A under the Securities Act, and must also cover matters enumerated in Section 926 (including certain state regulatory orders and bars). In a seemingly unprecedented act of humanity, the proposing release includes a chart comparing the provisions of Current Rule 262, Section 926 of the Dodd-Frank Act, and proposed Rule 506(c). See 76 FR 31518 at 31535.

Overview. Regulation D provides three exemptions that a company can use to avoid registration, the most widely used of which is Rule 506. If an offering qualifies for the Rule 506 exemption, an issuer can raise unlimited capital from an unlimited number of accredited investors and up to 35 non-accredited investors. Under the proposed rule, an offering would be unable to rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “disqualifying event” such as a criminal conviction, court injunction, or restraining order.

Covered Persons. The disqualification provisions of Rule 506(c) would apply to:

  • the issuer and any predecessor of the issuer or affiliated issuer;
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10% or more of any class of the issuer’s equity securities;
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
  • any director, officer, general partner, or managing member of any such compensated solicitor.

Disqualifying Events. The proposed rule would classify the following as disqualifying events:

  • criminal convictions within the last 5 to 10 years;
  • court injunctions and restraining orders within the last 5 years;
  • final orders of certain state regulators (such as state securities, banking and insurance regulators) and federal regulators within the last 10 years;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons;
  • suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization;
  • SEC stop orders and orders suspending a Regulation A exemption within the last 5 years; and
  • U.S. Postal Service false representation orders within the last 5 years.

Reasonable Care Exception

The proposal includes 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.

Retroactivity. Perhaps the most controversial aspect of the proposed rule is its retroactive effect. As written, the proposed rule would disqualify persons from reliance on Rule 506 for conduct that predated the Dodd-Frank Act.

Comments should be submitted on or before July 14, 2011. View the proposed rule here.



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