Securities and Exchange Commission adopts final rules on disqualification of “bad actors” from reliance on Rule 506 (part 2)

January 16, 2014

4541In the first post in this series we looked generally at Rule 506, today we will focus in on Disqualifying Events.

Disqualifying Events for purposes of Rule 506(d) include certain criminal convictions; certain court injunctions and restraining orders; final orders of certain state and federal regulators; certain SEC disciplinary orders; certain SEC cease-and-desist orders; SEC stop orders and orders suspending the Regulation A exemption; suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member; and U.S. Postal Service false representation orders.  Many disqualifying events include a look-back period (e.g., a court injunction that was issued within the last five years or a regulatory order that was issued within the last ten years).  The look-back period is measured from the date of the disqualifying event—in the example, the issuance of the injunction or regulatory order—and not the date of the underlying conduct that led to the disqualifying event.

Rule 506(d) does provide an exception from disqualification when the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering.  The steps an issuer should take to exercise reasonable care will vary according to particular facts and circumstances and the Instruction to the Rule states that an issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualification exists.  If all else fails, issuers may seek waivers from disqualification by the SEC based either on good cause shown or a determination by a court or regulatory authority as to whether disqualification under Rule 506 should arise as a consequence of an order, judgment or decree issued by such court or authority.

S031378_240x180It is important to emphasize that the disqualification, disclosure and certification requirements in Rules 506(d) and (e) apply to all Rule 506 offerings (i.e., both Rule 506(b) and 506(c) offerings) and that their provisions will require that issuers 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.  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.