SEC Proposes to Disqualify Felons and Other “Bad Actors” From Rule 506 Offerings

Rule 506 under Regulation D, the most widely used exemption from the registration requirements of the Securities Act of 1933, permits issuers to offer and sell securities to an unlimited number of “accredited investors” and up to 35 non-accredited investors. On Wednesday, May 25, 2011, the SEC issued proposed rules that would deny the Rule 506 exemption to persons who have been involved in certain “disqualifying events” described in the release. The proposed amendments are in accordance with Section 926 of the Dodd-Frank Act, which requires the SEC to adopt rules denying the availability of securities offering exemptions where certain “felons and other ‘bad actors” are involved.

The proposed disqualification rule would apply to the issuer (including its predecessors and affiliates, as well as the issuer’s directors, officers, general partners and managing members), 10 percent beneficial owners and promoters of the issuer, and persons compensated for soliciting investors to the issuer (including the solicitor’s general partners, directors, officers and managing members). Under the proposed amendments, Rule 506 would be unavailable if the issuer or any other covered person identified above had a “disqualifying event,” which would include: (i) criminal convictions; (ii) court injunctions and restraining orders; (iii) final orders of certain federal and state regulators (such as state securities, banking and insurance regulators); (iv) SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons; (v) suspension or expulsion from membership in, or suspension or bar from associating with a member of, a securities self-regulatory organization; (vi) SEC stop orders and orders suspending a Regulation A exemption; and (vii) U.S. Postal Service false representation orders. Notably, the SEC is proposing a “reasonable care” exception, under which an issuer would be permitted to rely on Rule 506, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification.

Comments on the proposed revisions are due by July 14, 2011 and may be submitted using the SEC’s Internet comment form, or by sending an email to rule-comments@sec.gov and including File No. S7-21-11 on the subject line. For additional information, please contact Zac Rosenberg, Compliance Consultant by email at zachary.rosenberg@corecls.com or by phone at (619) 278-0020.