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Dodd-Frank

SEC Proposes Rule 506 Bad Actor Disqualifications

by   |   May 25, 2011

The SEC has proposed rules under Section 926 of the Dodd-Frank Act to disqualify offerings involving felons and other “bad actors” and associated persons  from relying on Rule 506 of Regulation D in private placements.  The proposed rules have the potential to impose significant burdens on public and private companies as well as hedge funds, private equity groups and venture capital funds.

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 and the Obvious Challenges

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.

Public companies often rely on Rule 506 for issuing securities in M&A transactions or raising capital in PIPE transactions.  So public companies would have to us “reasonable care” to  investigate whether any 10% beneficial owners are subject to any disqualifying events described below.  Although they SEC might narrow the definition of the term “officer” in the final rules, a public company would have investigate the background of every vice president.

Smaller companies raising capital would have the above challenges and more.  They will have to investigate the background of every potential purchaser who might end up owning 10% of their stock, for fear that those purchasers could disqualify the issuer from using Rule 506 in the future.  They will have to select board members with care.

Private equity sponsors, hedge funds and venture capital funds will have to consider their fund raising procedures as well.  If a placement agent is used that receives a commission, you will have to investigate the general partners, directors, officers and managing members of the placement agent.  The rules apparently will apply across managed funds because of the “affiliated issuer” language which includes those under common control.

Disqualifying Events

It looks like you will have to be a white collar criminal defense attorney to know if any covered person has been subject to a “disqualifying event.”  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 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:
    • Associating with a regulated entity.
    • Engaging in the business of securities, insurance or banking.
    • Engaging in savings association or credit union activities. \

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

  • Certain SEC 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;
  • SEC 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.

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