Days of Felons and Bad Actors May Be Numbered in So Far Certain Securities Offerings Are Concerned

The Securities and Exchange Commission has proposed a rule to deny certain securities offerings from qualifying for exemption from registration if they involve certain “felons and other bad actors.”

The proposed rule would implement a provision of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Regulation D provides three exemptions that a company can use to avoid registration under the securities laws, 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 and restraining order.

“The Dodd-Frank Act requires the Commission to adopt rules that would make this safe harbor unavailable if a felon and other ‘bad actor’ is involved in the offering,” said SEC Chairman Mary L. Schapiro. “Our proposals would implement the Dodd-Frank Act requirement in a balanced and tailored way.”

Public comments on the SEC’s proposal should be received by July 14, 2011.

Background

When an individual or a company seeks to offer or sell a security such as a stock or bond, the offering must generally be registered with the SEC. However, a regulation known as Regulation D provides three exemptions that a company can use to avoid such registration.

One of the most widely used exemptions is Rule 506. That rule accounts for more than 90 percent of the offerings made – as well as the overwhelming majority of capital raised – under Regulation D. 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.

Section 926 of the Dodd-Frank Act requires the SEC to adopt rules that would deny this exemption to any securities offering in which certain “felons and other ‘bad actors” are involved.

Section 926 of the Dodd-Frank Act requires the new rules to be “substantially similar” to the bad actor disqualification provisions of another limited offering exemptive rule – Rule 262 of Regulation A – which is an exemption from registration for certain small offerings.

Requirements of the Proposed Rule

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.”

Covered Persons

The proposed rule would cover the issuer, including its predecessors and affiliated issuers, as well as:

- Directors, officers, general partners and managing members of the issuer.

- 10 percent beneficial owners and promoters of the issuer.

- Persons compensated for soliciting investors, as well as the general partners, directors, officers and managing members of any compensated solicitor.

Disqualifying Events

Under the proposed rule, a “disqualifying event” would include:

- 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 would have to 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 1112 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 would have to have occurred within five years of the proposed sale of securities.

- Final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from:

(i) Associating with a regulated entity.

(ii) Engaging in the business of securities, insurance or banking.

(iii) Engaging in savings association or credit union activities. 

(iv) Or orders that are based on fraudulent, manipulative or deceptive conduct and are issued within 10 years before the proposed sale of securities.

- Certain Commission disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons, which would be disqualifying for as long as the order is in effect;

- Suspension or expulsion from membership in a “self-regulatory organization” or from association with an SRO member, which would be disqualifying for the period of suspension or expulsion;

- Commission stop orders and orders suspending the Regulation A exemption issued within five years before the proposed sale of securities; and

- U.S. Postal Service false representation orders issued within five years before the proposed sale of securities.

Reasonable Care Exception

The proposed rule would provide 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 disqualification existed.

Application to Pre-Existing Disqualifying Events

Under the proposal, pre-existing convictions, suspensions, injunctions and orders would be disqualifying.

Comment Solicited on Additional Changes

The proposing release seeks public comment on other possible changes, including:

- Adding the SEC and the Commodity Futures Trading Commission to the list of regulators whose final orders are disqualifying.

- Applying the new rules on a uniform basis to other exemptive rules that are currently subject to bad actor disqualification and to all offerings under Regulation D.

What’s Next?

The Commission is seeking public comments on the proposed rule that should be received by July 14, 2011. The Commission will review the comments it receives and consider them in preparing the final rules required to be adopted by Section 926.

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