Rule 506 “Bad Actor” disqualification questionnaire

December 4, 2014

check-listCompanies interested in relying of Rule 506 of Regulation D as an exemption from registered under the federal securities laws must now be mindful of compliance with Rules 506(d) and (e), which were adopted by the Securities and Exchange Commission (SEC) with an effective date of September 23, 2013 (the “Rule 506(d) Effective Date”) to implement Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Section 926 required the SEC to adopt rules that disqualified securities offerings involving certain “felons and other ‘bad actors’ ” from reliance on Rule 506. (See Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings, SEC Release No. 33-9414 (July 10, 2013)) The rules were drafted to be “substantially similar” to Rule 262 under the Securities Act, which contains the disqualification provisions of Regulation A under the Securities Act (see § 151:87), and also cover matters enumerated in Section 926 of the Dodd-Frank Act (including certain state regulatory orders and bars). See 17 C.F.R. § 230.506(d) and (e). In general, Rule 506(d) disqualifies an offering from relying on either Rule 506(b) or Rule 506(c) if the issuer or any other person covered by Rule 506(d) (referred to herein collectively as the “Covered Persons”) has a relevant criminal conviction, regulatory or court order or other disqualifying event (referred to herein collectively as the “Disqualifying Events”) that occurred on or after the Rule 506(d) Effective Date. Under Rule 506(e), for disqualifying events that occurred before the Rule 506(d) Effective Date, issuers may still rely on Rule 506, but must comply with certain disclosure requirements included in Rule 506(e).

A guide to compliance with the “bad actor” rule issued by the SEC (see: http://www.sec.gov/info/smallbus/secg/bad-actor-small-entity-compliance-guide.htm) is a helpful resource.  Companies relying on Rule 506 must review and revise their tools and techniques for ensuring compliance and make sure that any potential Disqualifying Event is discovered before a sale has occurred and steps are taken to seek a waiver or change relationships so that a party associated with a Disqualifying Event is not deemed to be a Covered Person. For example, questionnaires for directors, officers, principal shareholders and others circulated during the offering process will need to be revised to include questions that track the Covered Persons and Disqualifying Events described above and inquiries will also need to be made of persons participating in the offering who are not directors, officers or principal shareholders.

The Rule 506 “bad actor” disqualification questionnaire at § 151:156 can be used to identify individuals and entities involved in the sale of company securities and gather information on prior actions of individuals and entities involved in the sale of company securities.  In addition, responses to the questionnaires should be verified through third-party search services (i.e., “background checks”) to compare the responses and identify/reconcile any discrepancies. Finally, further due diligence will be needed with respect to various categories of organizational Covered Persons to determine who within such organizations have the requisite power and authority in relation to the offering to be deemed Covered Persons in their own right. Additional steps may be taken and the overall goal is to be sure that even if a Disqualifying Event with respect to a Covered Person is not uncovered the issuer is appropriate situated to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a disqualifying event was required to be disclosed.