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

January 14, 2014

4541Rule 506 (17 C.F.R. § 230.506), which is part of the Securities and Exchange Commission’s Regulation D, provides issuers with the opportunity to raise potentially unlimited amount of funds from accredited investors and no more than 35 non-accredited investors who satisfy specific knowledge and experience requirements.  Rule 506 is often used by growing companies raising large amounts of capital from sophisticated investors, including venture capitalists. Rule 506 may also be used by public companies that are raising funds in a private placement to avoid the expense and delay of registering the securities under the Securities Act of 1933. 

Recently the Securities and Exchange Commission (“SEC”) adopted new Rules 506(d) and (e) 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.  In general, Rule 506(d) disqualifies an offering from relying on Rule 506(b) and 506(c) of Regulation D if the S031378_240x180issuer 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 will have to comply with the disclosure provisions of Rule 506(e) discussed below.  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 and serves as the basis for the following summary of the provisions of Rule 506(d).

First of all, understanding the categories of persons that falls within Covered Persons for purposes of Rule 506(d) is important because issuers are required to conduct a factual inquiry to determine whether any Covered Person has had a Disqualifying Event (see below), and the existence of such an event will either disqualify the offering from reliance on Rule 506 or will have to be disclosed to investors.  In general, Covered Persons include the issuer, including its predecessors and affiliated issuers; directors, general partners, and managing members of the issuer; executive officers of the issuer, and other officers of the issuers that participate in the offering; 20% beneficial owners of the issuer, calculated on the basis of total voting power; promoters connected to the issuer; for pooled investment fund issuers, the fund’s investment manager and its principals; and persons compensated for soliciting investors, including their directors, general partners and managing members.

In my next post in this series, we will examine Disqualifying events.