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Reg D (Rule 506) - SEC proposes 'Bad Actor' Disqualification

Roger Wiegley, Corporate Law Advisers LLP


The Securities and Exchange Commission has proposed amendments to Rule 506 of Regulation D under the Securities Act of 1933 that would disqualify "bad actors" from participating in private placements that rely on Rule 506 for an exemption from the registration requirements of the Securities Act. The proposed amendments, adopted May 25, 2011, can be found in SEC Release No. 33-9211. A copy of the Release is available at http://www.sec.gov/rules/proposed/2011/33-9211.pdf. The comment period for the proposed amendments expired on July 14, 2011.

The proposed amendment were issued pursuant to Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which requires the SEC to adopt rules disqualifying certain "felons and other 'bad actors'" from relying on Rule 506.

Rule 506 is part of Regulation D, which was originally adopted in 1982. Regulation D creates an exemption from registration for certain small offerings (Rules 504 and 505) and a safe harbor for offerings greater than $5 million (Rule 506). This is an important distinction, for reasons discussed below. Rule 506 is merely a safe harbor; that is, if the requirements of Rule 506 are met, the private placement will be deemed to fall within the exemption found in the Securities Act itself. However, that is not to say that an offering outside Rule 506 is not also exempt.

Regulation D covers three types of private placements, as follows:

Rule 504

Rule 504 is an exemption for offers and sales of securities up to $1,000,000 in the aggregate in any 12-month period. This Rule is available to issuers that are not subject to the periodic reporting requirements of the Exchange Act of 1934 and are not "blank check" companies (i.e., no business purpose other than acquiring another company). General solicitations are permitted under Rule 504 if they are restricted to accredited investors. The issuer need not restrict purchaser's right to resell the offered securities. The Rule 504 exemption was created by the SEC pursuant to authority provided by Section 3(b) of the Securities Act.

Rule 505

Rule 505 is an exemption for offers and sales of securities up to $5 million in the aggregate in any 12-month period. Under this Rule, securities may be sold to an unlimited number of "accredited investors" and up to 35 "unaccredited investors", i.e., investors who do not satisfy the wealth standards found in the definition of "accredited investor" in Rule 501 of Regulation D and who need not be "sophisticated". The issuer must give non-accredited investors disclosure documents that generally are equivalent to those used in registered offerings. Purchasers must buy for investment only and not for resale. The issued securities are restricted, meaning that the investors may not sell the securities for six months or longer without registering them or selling pursuant to an available exemption from registration. General solicitation or advertising to sell the securities is not allowed. Like Rule 504, this Rule is an exemption from registration created by the SEC pursuant to authority granted by Section 3(b) of the Securities Act.

Rule 506

Rule 506 describes private placements that will be deemed to be exempt from the registration requirements of the Securities Act, regardless of amount. The requirements of Rule 506 are: (i) there can be no general solicitation or advertising to market the securities; (ii) sales of the securities may be made to an unlimited number of accredited investors but not more than 35 sophisticated unaccredited investors; and (iii) certain information must be provided to non-accredited investors. As in the case of Rule 505, there are restrictions on resale. This safe harbor relates to Section 4(2) of the Securities Act, which provides an exemption for "transactions by an issuer not involving any public offering". The authority of SEC to create exemptions under Section 3(b) of the Securities Act is limited to offerings of not more than $5 million.

The SEC Release states that Rule 506 is "by far the most widely used Regulation D exemption, accounting for an estimated 90-95% of all Regulation D offerings and the overwhelming majority of capital raised in transactions under Regulation D." Interesting facts, but Rule 506 is not itself an exemption. Again, this issue is discussed below.

The SEC's proposed amendments to Rule 506 would prohibit the following persons from participating in Rule 506 offerings if they have been convicted of, or are subject to court or administrative sanctions for, certain specified violations of law ("Disqualifying Events"): (i) issuers, (ii) their directors, officers, general partners, managing members and beneficial owners of more than 10%, (iii) persons paid (directly or indirectly) to solicit purchasers in connection with sales in the offering (e.g., underwriters and placement agents), (iv) directors, officers, general partners and managing members of such compensated solicitors, and (v) certain other persons, such as promoters.

Disqualifying Events include the following:

(i) felony and misdemeanor convictions (A) in connection with the purchase or sale of a security, (B) involving the making of a false filing with the SEC or (C) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if occurring within the five years (in the case of issuers) or ten years (in the case of other covered persons) before the Rule 506 sale;

(ii) injunctions and court orders against engaging in or continuing conduct or practices (A) in connection with the purchase or sale of a security, (B) involving the making of a false filing with the SEC or (C) arising out of the conduct of the business of an underwriter, broker, dealer, investment advisor or paid solicitor, if issued within the five years before the Rule 506 sale;

(iii) final orders issued by federal banking regulators, the National Credit Union Administration or state securities, banking, credit union or insurance regulators that (A) bar a person from engaging in securities, insurance, banking, saving association or credit union activities, or from association with an entity regulated by the regulator issuing the order, if in effect at the time of the Rule 506 sale, or (B) are based on a violation of any law or regulation prohibiting fraudulent, manipulative, or deceptive conduct, if entered within the ten years before the Rule 506 sale;

(iv) Certain SEC orders (including suspension or revocation of registration as a broker, dealer, or investment advisor, or imposing limitations on such activities) or suspension or expulsion from, or being barred from association with, a national securities exchange or national securities association for "conduct inconsistent with just and equitable principles of trade," if in effect at the time of the Rule 506 sale;

(v) Being named as an underwriter in, or filing, a registration statement or a Regulation A offering statement as to which a stop order or suspension order was issued within the five years before the Rule 506 sale, or being the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued, if such investigation or proceeding is taking place at the time of the Rule 506 sale; or

(vi) U.S. Postal Service false representation orders entered within the five years before the Rule 506 sale, or being subject, at the time of such sale, to certain U.S. Postal Service temporary restraining orders or injunctions.

The proposal also sets out 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.

The SEC Release asks for comments on the idea of applying the newly proposed provisions uniformly to offerings under (i) Rules 504 and 505 of Regulation D, (ii) Regulation A (providing for simplified disclosure and transactional requirements for companies offering $5 million or less of securities, but which requires the filing of an offering statement subject to review by the SEC) and (iii) Regulation E (exempting from registration under the Securities Act certain offerings of securities by small business investment companies registered under the Investment Company Act of 1940 or closed-end investment companies that are regulated as a business development companies under the 1940 Act).

Under the proposed amendments, the disqualification would apply to sales after the effective date of the amendments, and the "look-back" period for the Disqualifying Events would apply to such sales, regardless of whether the Disqualifying Event occurred before adoption of the amendments or, indeed, before adoption of Dodd-Frank.

Missing Link?

The SEC Release is 91 pages long, yet it fails to address a rather important point-Rule 506 is merely a safe harbor, not an exemption. Hence, if the SEC claims that an issuer failed to meet the registration requirements of Section 5 of the Securities Act because a "bad actor" made Rule 506 unavailable, the issuer can simply say that it was relying on Section 4(2) of the Securities Act, not Rule 506. The SEC's Enforcement Division would then be in the awkward position of arguing that certain procedures, if followed by some individuals, are within the exemption provided by Section 4(2) of the Securities Act, but if the very same procedures are followed by other individuals they are not within the scope of Section 4(2). The statute itself makes no such distinction. How, then, can the identity of the participants define a "public offering" for purposes of Section 4(2) when the only factor in the governing statute is procedural, i.e., the "public" nature of the offering. The SEC has never claimed, and is not claiming now, that Rule 506 is the only means of meeting the requirements of Section 4(2). Indeed, countless private placements in amounts greater than $5 million were made before Regulation D was adopted and many more have been made outside Regulation D since the 1982 adoption. (In fact, the only way to be sure a private placement is made in reliance on Regulation D is the filing of Form D, which, apropos of this discussion, in not a requirement for an exemption under Section 4(2) of the Securities Act, it is merely a requirement for reliance on the safe harbor of Rule 506.) To be sure, the traditional "4(2) offerings" were typically made only to institutional investors and did not involve more than a small number of offerees (some Wall Street firms advised that the number of offerees should be limited to 25, some advised a limit of 50, and one prominent firm said that purchasers should be limited to 25 but the number of offerees was not relevant so long as there was no general solicitation). However, those strict requirements reflected an abundance of caution of the part of law firms advising issuers and placement agents. Regulation D, particularly Rule 506, was an attempt by the SEC to provide some guidance on the type of private placement that would be within the exemption provided by Section 4(2). Thus, when one says that they are relying on Rule 506, they really mean that they are relying on Rule 506 to be certain that they meet the requirements for the exemption provided by Section 4(2). A person could follow the procedures in Rule 506 and simply say they are relying on the exemption in Section 4(2). This is more than a semantic distinction. If the SEC brings an enforcement action for failure to register securities under Section 5 and the defendant claims an exemption under Section 4(2), how will the SEC show that it is the identity of the participants, not just the procedures followed, that is relevant to an interpretation of Section 4(2)?


Roger Wiegley, Corporate Law Advisers LLP, rwiegley@corporatelawadvisers.com

Roger Wiegley has been a corporate and securities lawyer for thirty years, including 17 years as a partner at major Wall Street law firms and 10 years in-house at financial services firms. He is the founding partner of Corporate Law Advisers LLP (www.corporatelawadvisers.com) and the CEO of The Corporation Secretary (www.thecorpsec.com). The focus of his firm and his company is support for small businesses, venture capital firms, and broker-dealers.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Roger Wiegley. This work reflects the law at the time of writing. June, 2011.