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New Rule 506(d) "Bad Actor" Disqualification - A Continuous Diligence Headache for Emerging Companies

Jonathan C. Guest, Benjamin Hron, James Coffey, Joseph Bartlett, Partners, McCarter & English LLP



As required by the Dodd-Frank Act, the SEC in July 2013 adopted Rule 506(d) to "disqualify felons and other bad actors" from Regulation D private offerings. New Rule 506(d) identifies persons and triggering events that can disqualify an offering from relying on Rule 506 - the most widely used registration exemption for private placements of securities, resulting in billions of dollars of investment proceeds each year. The new rule has important consequences for emerging companies, and not just when they are raising capital. The rule became effective on September 23, 2013.

Rule 506 has long appealed to companies for several reasons: no limits on the amount of capital that can be raised or the number of investors (if accredited) and pre-emption of state securities (blue sky) regulation. Traditionally, compliance with Rule 506 wasn't difficult, and it could safely be ignored except when raising money. New Rule 506(d) changes the landscape. If a company cannot rely on Rule 506, it loses the most usable and cost-efficient means to raise money, especially in large amounts. Just as important, disqualification will trigger state law compliance for each state in which the securities are offered - sometimes a daunting task.

Companies that are planning to conduct a Rule 506 offering must learn the rule and keep it in mind as they seek investors, recruit officers and directors, and work with certain other persons and entities. If someone turns up as a "bad actor" due to a triggering event after that date, the Rule 506 exemption for the offering is no longer available. Even an event before that date can have negative consequences.

The events triggering disqualification are clearly stated in the rule (more detail below) and, broadly speaking, involve criminal convictions, court injunctions or final orders of the SEC and other federal and state government agencies arising from past noncompliant offers and sales of securities, any false SEC filing, or violative conduct in the securities industry. The persons and entities to which this applies - so-called covered persons - that can disqualify a company, however, is a long laundry list, and not always so obvious in its application.

"Covered persons" includes, among others, the company itself and any predecessor entity, its directors and executive officers as well as officers who participate in an offering. It also includes 20% shareholders, i.e., beneficial owners of at least 20% of the company's outstanding equity securities regardless of class and calculated based on voting power. Voting securities includes preferred stock or other securities conferring the right to elect directors or otherwise influence management or control corporate direction. Another group of covered persons are promoters, a broad category that captures persons and entities that have relationships with the company or its Rule 506 offering. Promoters are persons and entities that helped to found the company as well as anyone, in connection with starting the business, who becomes a 10% shareholder or receives 10% of the proceeds of any class of the company's securities.

The "sting" of the triggering event for a "bad actor" that disqualifies a company from Rule 506 is long: ten years for a "covered person" (five years for an issuer, its predecessor or affiliated issuer) convicted of a felony or misdemeanor in connection with the purchase or sale of a security, or making a false filing with the SEC, or arising out of activities as a securities professional. A five-year period is triggered for any person subject to a court order enjoining the person from engaging in certain practices that violate the securities laws. Disqualification also applies to persons who are barred or suspended by various federal and state agencies from involvement with a range of financial institutions or subject - within the ten preceding years - to a final order arising from violation of laws that prohibit fraudulent, manipulative or deceptive conduct. The rule identifies other disqualifying events as well.

The potentially harsh results of the rule can be avoided, but advance planning is in order. The most practical will be if a company can demonstrate that it didn't know about the disqualifying event and could not have known despite exercising reasonable care. Rule instructions make clear that establishing reasonable care requires actual evidence of making a factual inquiry - a quick oral inquiry isn't likely to suffice. If the disqualifying event occurred before September 23, 2013 (the rule's effective date), reliance on Rule 506 isn't prohibited, but all prospective investors must be informed, which of course could undermine their interest. A company can also seek relief from the SEC in a showing of good cause that the Rule 506 exemption shouldn't be denied, or from the relevant court or state agency that its order or decree should not be construed to bar reliance on the exemption. Each of these takes time and resources, and can add uncertainty to the outcome of the offering.

As noted above, planning ahead is the most prudent approach. That could mean, for example, detailed questionnaires required from each covered person, whether as part of the hiring or appointment process, or when an outside adviser is engaged. There could be hardly anything worse during a private placement than a belated discovery that a director or officer, or much-desired investor, has a disqualification "skeleton" in the closet. Early stage companies often don't bother with background checks - maybe they'll need to reconsider. New Rule 506(d) will also require ongoing attention. For example, a company may consider a periodic inquiry (perhaps similar to questionnaires public companies use to verify annual proxy statement information) to be sure that no disqualifying event has occurred in the preceding year. It also means monitoring the 20% beneficial ownership threshold if, for example, a current shareholder enlarges its stake in the company. For good or ill the SEC, in implementing Dodd-Frank, forces most companies to keep their eyes on Rule 506 nearly all the time.


[1] In 2011, Rule 506 private placements accounted for approximately $895 billion raised, which was more than public offerings during the same period.

Jonathan Guest, Partner, jguest@mccarter.com

Jonathan Guest concentrates his practice in corporate and securities law including debt and equity finance (public and private offerings including shelf regulations, registered direct offerings, PIPEs and rights offerings), corporate governance (Sarbanes-Oxley compliance), and domestic and cross-border mergers and acquisitions. He has also advised early-stage companies concerning matters of entity selection, capital structure, "angel" and venture capital finance, secured loans, executive compensation, intellectual property protection, and technology licensing. Jonathan's clients include publicly-traded U.S., Canadian, U.K. and Australian companies involved in pharmaceuticals and drug development, oil and gas as well as natural resource exploration and production, and commercial real estate. He has also advised companies engaged in telecommunications, e-commerce, and software. Jonathan has extensive experience with federal and state securities law matters encountered by foreign companies seeking to raise capital and have their securities traded in the United States. Prior to joining McCarter & English, Jonathan was a partner at one of the largest international law firms.

Mr. Guest has been selected as one of Massachusetts Super Lawyers for 2004-2011.

Full Bio (http://www.mccarter.com/Jonathan-Guest/)

Benjamin M. Hron, Special Counsel, bhron@mccarter.com

Ben Hron is a business law attorney whose practice focuses on advising private companies, most in the life sciences and information technology industries, on general corporate matters, angel and venture capital financing, mergers and acquisitions, securities law compliance and strategic collaborations. He also represents investors in connection with the financing of private companies. Ben has extensive experience working with entrepreneurs and emerging companies, often getting involved when a business is still in its infancy and helping guide the founders through the formative early stages of their company's development. Ben also co-chairs the McCarter & English seminar series for entrepreneurs at the Cambridge Innovation Center.


Full Bio (http://www.mccarter.com/Benjamin-M-Hron/)

James F. Coffey, Partner, jcoffey@mccarter.com

James F. Coffey is a partner in McCarter's Corporate, Securities and Financial Institutions Practice Group. He has extensive experience providing strategic counsel to companies in critical phases of transition, including start-ups and early stage development companies seeking angel funding as well as fully mature businesses seeking insight on exit strategies. Mr. Coffey represents emerging companies in several business sectors. Some of his early stage development clients include companies in social networking, carbon credit technology, alternative energy, information technology, e-commerce, life sciences and consumer products, among others.



Full Bio (http://www.mccarter.com/James-F-Coffey/)

Joseph W. Bartlett, Special Counsel, JBartlett@McCarter.com

Joseph W. Bartlett is special counsel in the Corporate, Securities and Financial Institutions practice. A recognized pioneer of the national private equity and venture capital bar, Mr. Bartlett contributed to the original models for private equity and fund of fund partnerships. His experience extends to alternative investments, venture capital, emerging companies, corporate restructurings, private equity and buyouts. Mr. Bartlett's practice includes serving as counsel to asset managers, including those of major public and private equity funds, with a focus on technology companies, and he has also served as trustee of a series of public mutual funds and chair of a public REIT. His venture fund work began with the first Greylock fund, and he has drafted documents for several of the largest and most successful LBO funds.

Full Bio (http://www.mccarter.com/Joseph-W-Bartlett/)

McCarter & English, LLP

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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, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from McCarter & English, LLP. This work reflects the law at the time of writing in October 2013.