Federal Securities Law: Dodd-Frank Act Required It, So the SEC Adds to Rule 506(d)

At the headline level--Section 926 of the Dodd-Frank Act requires felons and other bad actors to be excluded from participation in Rule 506 offerings and requires the SEC to write and adopt rules to make it happen.

The SEC adopted the "bad actor" rules for Rule 506 offerings that I argue falls short of the anticipated Dodd-Frank Act Section 926 mandate because, I argue, Section 926 of Dodd-Frank had actually anticipated that the felons and "bad actors" who committed felonies before the rule amendment, and not merely afterward, would be be disqualified.

Given that Rule 506 is the most frequently relied-upon Securities Act exemptive rule, the impact of issuers shifting away from it could be significant. The SEC's approach was guided by the imperative to preserve the intended benefits of Rule 506, which might otherwise be impaired.

Congress Issued a Mandate in Dodd-Frank: Felons and "Bad Actors" Should Not Be Qualified to Participate in Rule 506 Offerings

The SEC itself establishes that Section 926 calls for disqualifying felons and "bad actors" for past felonies and bad acts because the SEC initially proposed a rule that disqualified issuers where a "bad actor" was "bad" in the past and is affiliated with the issuer today.  

All Felons and "Bad Actors" Almost Were Disqualified

In the SEC's proposed rule that issuer with a felon or "bad actor" unquestionably would have fbeen disqualified.

But if a felony or bad act was before September 23, 2013, Not Disqualified

In final rulemaking, the SEC departed from this direction by providing an exception for any felonies and bad acts that occurred before September 23, 2013. The final rule does not disqualify felons and bad actors from being directors, officers or owners, unless the felony or bad act happens after September 23, 2013. An issuer controlled by a person who committed a felony before September 23, 2013 can rely on Rule 506, if it makes a disclosure of the felony.  

But if not disqualified, a situation arises requiring disclosure

When the SEC established a pre-September 23, 2013 exception, it also was thoughtful enough to provide tools for investors to know more about their management team to the extent of their pre-September 23, 2013 felonies and bad acts.  The SEC stated, "We believe the disclosure requirement will serve as a useful tool to alert investors to the presence of certain participants in offerings under Rule 506 and allow them to make more informed investment decisions."

A disclosure requirement does not always mean prominent

Issuers are given wide lattitude in determining the content and placement of these disclosures. The SEC is foremost in acknowledging, "As there is no prescribed format, the disclosure could be inserted in a non-prominent manner, such that an investor who reads the material in a cursory fashion could remain unaware of the participation of bad actors in the offering."  

On the Positive Side, the SEC Took into Account that Rule 506 Offerings Are Creatures of the Market and Will Survive Anyway

A disclosure of felons and "bad actors" can sometimes be contained, and should possibly be expected, in some PPM's involving people alive before September 23, 2013.  But the disclosure is not required to be prominent. The investor needs a magnifying glass, and the SEC justifies this with "Issuers could benefit from having flexibility in the manner of disclosure."

Another intriguing justification by the SEC of this disclosure requirement is, "Without a disclosure requirement, investors may have the mistaken impression that bad actors are no longer allowed to participate in Rule 506 offerings." True, because Dodd-Frank Act Section 926 intended the felons and the "bad actors" to be disqualified from Rule 506 offerings.   Felons and "bad actors" who became such before September 23, 2013 really had good luck. The SEC correctly points out that investors have not fully appreciated that felons and "bad actors" are being allowed to participate in Rule 506 offerings. But did Congress intend the SEC to disqualify felons and bad actors or to create a disclosure regime? Here, the SEC gave Congress the disqualification rule it wanted only as to future events, and as to past events the SEC created an exception that needs a disclosure regime, that in turn needs another exception.

"... we have imposed a disclosure requirement rather than disqualification for pre-existing events"

The SEC announced that issuers will need to make factual inquiry to determine whether disclosure is required and, if applicable, prepare the mandatory disclosure for investors. Also, rather than provide the mandatory disclosure, issuers may decide to take steps to avoid having to make a disclosure, such as making changes to personnel or retaining different compensated solicitors.

Reasonable Care Exception

The reasonable care exception is an exception to the disclosure requirement described above. Adopting a disclosure requirement gave rise within the SEC to a desire to assuage possible concerns in the private placement market about the disclosure requirement. 

According to the SEC adopting release, "The 'reasonable care' exception allows continued reliance on the Rule 506 exemption, despite the existence of a disqualification with respect to a covered person, if the issuer can show that it did not know and, in the exercise of reasonable care, could not have known that the disqualification existed at the time of the sale of securities. We anticipate that the “reasonable care” exception will provide benefits to the efficiency of the private placement and capital formation process by removing a significant disincentive to issuers' use of Rule 506 that would have arisen if disqualification were applied on a strict liability basis. Without a reasonable care exception, issuers might choose not to undertake offerings in reliance on Rule 506, because of the risk of Section 5 or blue sky law violations in circumstances that the issuer cannot reasonably predict or control."

Henceforth, disqualification of a corporate issuer under Rule 506 results if any directors, officers or 20%-or-more owners of the issuer or affiliates is a "bad actor".

A higher ownership threshold of 20% replaces 10% as the ownership level that will give a "bad actor" disqualification to a corporation who would like to conduct a Rule 506 offering.  Beforehand, any "bad actors" owning less than 10% of an issuer were ignored in respect of disqualification. Not only are these under-10% owners continuing to be ignored, now, under the amended disqualification provisions, "bad actors" who own more than 10% and less than 20% of the issuer are also being ignored.

There are many more exceptions to the disqualification requirements and the disclosure requirements found in Rule 506(d).

The full text of Rule 506(d) reads: 

(d) “Bad Actor” disqualification. (1) No exemption under this section shall be available for a sale of securities if the issuer; any predecessor of the issuer; any affiliated issuer; any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer; any beneficial owner of 20% or more of the issuer's outstanding voting equity securities, calculated on the basis of voting power; any promoter connected with the issuer in any capacity at the time of such sale; any investment manager of an issuer that is a pooled investment fund; any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities; any general partner or managing member of any such investment manager or solicitor; or any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor:

(i) Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors and affiliated issuers), of any felony or misdemeanor:

(A) In connection with the purchase or sale of any security;

(B) Involving the making of any false filing with the Commission; or

(C) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(ii) Is subject to any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:

(A) In connection with the purchase or sale of any security;

(B) Involving the making of any false filing with the Commission; or

(C) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(iii) Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that:

(A) At the time of such sale, bars the person from:

(1) Association with an entity regulated by such commission, authority, agency, or officer;

(2) Engaging in the business of securities, insurance or banking; or

(3) Engaging in savings association or credit union activities; or

(B) Constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale;

(iv) Is subject to an order of the Commission entered pursuant to section 15(b) or 15B(c) of the Securities Exchange Act of 1934 (15 U.S.C. 78 o (b) or 78 o-4(c)) or section 203(e) or (f) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the time of such sale:

(A) Suspends or revokes such person's registration as a broker, dealer, municipal securities dealer or investment adviser;

(B) Places limitations on the activities, functions or operations of such person; or

(C) Bars such person from being associated with any entity or from participating in the offering of any penny stock;

(v) Is subject to any order of the Commission entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:

(A) Any scienter-based anti-fraud provision of the federal securities laws, including without limitation section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1)), section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b)) and 17 CFR 240.10b-5, section 15(c)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78 o (c)(1)) and section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; or

(B) Section 5 of the Securities Act of 1933 (15 U.S.C. 77e).

(vi) Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;

(vii) Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale,was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or

(viii) Is subject to a United States Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

(2) Paragraph (d)(1) of this section shall not apply:

(i) With respect to any conviction, order, judgment, decree, suspension, expulsion or bar that occurred or was issued before September 23, 2013;

(ii) Upon a showing of good cause and without prejudice to any other action by the Commission, if the Commission determines that it is not necessary under the circumstances that an exemption be denied;

(iii) If, before the relevant sale, the court or regulatory authority that entered the relevant order, judgment or decree advises in writing (whether contained in the relevant judgment, order or decree or separately to the Commission or its staff) that disqualification under paragraph (d)(1) of this section should not arise as a consequence of such order, judgment or decree; or

(iv) If the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known that a disqualification existed under paragraph (d)(1) of this section.

Instruction to paragraph (d)(2)(iv). An issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.

(3) For purposes of paragraph (d)(1) of this section, events relating to any affiliated issuer that occurred before the affiliation arose will be not considered disqualifying if the affiliated entity is not:

(i) In control of the issuer; or

(ii) Under common control with the issuer by a third party that was in control of the affiliated entity at the time of such events.

(e) Disclosure of prior “bad actor” events. The issuer shall furnish to each purchaser, a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification under paragraph (d)(1) of this section but occurred before September 23, 2013. The failure to furnish such information timely shall not prevent an issuer from relying on this section if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter or matters.

Instruction to paragraph (e). An issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist. The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants.