Legal Blog

Beware of Bad Actors in Private Placements

Companies raising capital in private placements rely upon an exemption from registration, with one of the most popular being found in Rule 506 of Regulation D.  The Securities and Exchange Commission (SEC) estimated that approximately 90% to 95% percent of all Regulation D offerings in 2012 were made under Rule 506.  Private placements are often done pursuant to Rule 506 because of the unlimited amount that can be raised from investors and the corresponding exemption from states’ securities laws (or “blue sky” laws) provided certain requirements are met.  And, private placements made under Rule 506(b) can be done relatively quickly and cost-effectively provided that the company only offers its securities to accredited investors and does not engage in any general solicitation.  But this valuable exemption from registration is not available to those companies that are “bad actors”.

The “bad actor” disqualification is found in Rule 506(d), which was adopted by the SEC in September 2014 in connection with the Dodd-Frank Wall Street Reform and Consumer Protection Act.  Under Rule 506(d), an issuer is a “bad actor” and disqualified from relying on an exemption from registration under Rule 506 if the issuer or certain “covered persons” related to the issuer was convicted of certain felonies and misdemeanors related to U.S. state and federal securities fraud and certain other laws known as “disqualifying events”.  Since the changes to Rule 506 were adopted on September 23, 2013, only those disqualifying events that occurred on or after such date will disqualify an issuer from relying upon Rule 506.  However, an issuer must comply with the disclosure provisions of Rule 506(e) and disclose any disqualifying events that occurred prior to such date.  Similarly, if a disqualifying event occurs during an offering, then sales made prior to such a disqualifying event would be exempt under Rule 506 but sales made after such an event would not.

Under Rule 506(d)(1) the following is a list of the potential bad actors:

  • the issuer and its predecessor companies or affiliated company,
  • any director, general partner, management member, executive officer, or other officer participating in the offering,
  • any beneficial owner of 20% or more of the issuer’s securities, based on voting power, with the requirement to look through 20% owners that are entities to their controlling persons;
  • promoters of the offering who are connected to the issuer in any way at the time of sale,
  • any person (and its directors, general partners, and managing members) who is compensated, directly or indirectly, in connection with soliciting investors in connection with the offering, and
  • for pooled investment funds or any investment manager to an issuer that is a pooled investment fund, such fund, and its investment manager, and their directors, executive officers, and other principals.

A covered person is a “bad actor” under Rule 506(d), and the company is disqualified from relying on an exemption under Rule 506 if the covered person:

  • has been convicted of any felony or misdemeanor (1) in connection with the purchase or sale of any security; (2) involving making any false filing with the SEC; or (3) arising out of the business conduct of certain financial intermediaries, in each case within ten years of the sale (five years for issuers and their predecessors or affiliates);
  • is subject to any final order, judgment or decree entered within five years of the sale that, at the time of the sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice (1) in connection with the purchase or sale of a security, (2) involving the making of a false SEC filing, or (3) arising out of the conduct of certain types of financial intermediaries;
  • is subject to a final order from state securities commission, banking, insurance, commissions, or appropriate federal agencies that either (1) at the time of the current sale, bars the person from association with any securities self-regulatory organization, or (2) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years of such sale;
  • is subject, at the time of the sale, to an SEC order entered under certain provisions relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons;
  • is subject to an SEC order, entered into within five years of the sale, that, at the time of the sale, orders the person to “cease and desist from committing or causing a violation or future violation” of (1) any scienter-based antifraud provision of the federal securities laws, or (2) Section 5 of the Securities Act of 1933, as amended;
  • is suspended or expelled from membership in, or barred from associating with a member of, a registered national securities exchange or an affiliated securities association for actions found to be inconsistent with the just and equitable principles of trade;
  • has filed as a registrant or issuer, or who acted or was named as an underwriter for, any registration statement or Regulation A offering which, within the five years prior to the sale, was the subject of an SEC stop order, refusal order, or an order suspending the Regulation A exemption, or is currently the subject of an investigation or proceeding to determine whether such stop order or suspension should be issued; or
  • is subject to a United States Postal Service (USPS) false representation order entered within five years of the sale or is subject to a temporary restraining order or preliminary injunction regarding conduct alleged by the USPS to constitute a scheme to obtain money or property through the mail by means of false representations.

The list of covered persons makes clear that the universe of potential bad actors that could disqualify a company from relying on an exemption under Rule 506 is much more extensive than the company itself and its officers and directors, and the list of disqualifying events is beyond.  And, prior to selling any securities under Rule 506, the burden is on the company, who will have to certify on the Form D filed in connection with such sale that is not disqualified under Rule 506(d), to ensure that neither it nor any of its covered persons have been convicted of a disqualifying event prior to September 23, 2012 (or if prior to such date, has disclosed such event to investors).  While a company that is disqualified under Rule 506(d) may be able to seek a waiver under certain circumstances, such a waiver is not guaranteed and would cause a delay in the closing of the private placement.

What can a company do to ensure that it is not disqualified?  There are several steps that a company can take, including, among other things:

  • performing background searches in various public and private databases on all covered persons prior to nomination, appointment, or engagement for disqualifying events, and performing such searches at regular intervals (there are companies that can provide this service);
  • amending the company’s bylaws or operating agreement to include a requirement that each director, manager, or officer notify the company of a disqualifying event;
  • requiring covered persons participating in the sale of securities to complete before commencing the sale of securities questionnaires that address the specific disqualifying events and to immediately notify the company if a disqualifying event occurs after such sales;
  • including representations from all investors, even those owning less than 20% of the outstanding securities, that such investor (and its controlling persons) have not had a disqualifying event and covenants that such investor will immediately notify the company if a disqualifying event occurs;
  • including a representation from underwriters, investment managers, or any other person or entity engaging in a sale that such covered person (and its principals, directors, managing members, etc.) do not have a disqualifying event and covenants that such person or entity will immediately notify the company if a disqualifying event occurs; and
  • if the sale is on-going, re-performing searches for disqualifying events and requiring bring-down representations, certifications, and questionnaires.

No system, however, is foolproof. Even after making a factual inquiry and taking various prophylactic steps, a company could later discover that a covered person with a disqualifying event participated in the sale.  Rule 506(d)(2)(iv) sets forth a “reasonable care” exception for cases in which a company did not know, and could not have known, about the facts giving rise to its disqualification.  The “reasonable care” exception is very specific to the facts and circumstances and requires that if a company has any reason to question the veracity of any responses that the company takes additional steps to be reasonably sure that no disqualifying event has occurred.

If a bad actor participates in a company’s private placement, the consequences could be devastating.  Companies should take care in ensuring that they are not disqualified under Rule 506(d) not just when considering a private placement but also as part of its ongoing corporate governance.


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