Beware of Felons and Other “Bad Boys” in Private Securities Offerings


On May 25, 2011, the SEC announced a proposed rule to implement Section 926 of the Dodd Frank Act, which would make the Rule 506 registration exemption unavailable to offerings involving certain felons and other “bad boys.”   The SEC’s release states that Rule 506 offerings account for more than 90 percent of all securities offerings made, and the majority of capital raised, under the SEC’s Regulation D – hence the increased scrutiny.

Under the proposed rule (PDF), Rule 506 will be unavailable if the issuer, its directors, officers and certain other insiders and affiliates, including brokers, finders and 10% beneficial owners, have a “disqualifying event.”  These events include, among others:

  • certain felony and misdemeanor convictions in connection with the purchase or sale of a security, involving false filings with the SEC or arising out of the conduct of certain financial intermediaries (convictions must occur within ten years before a sale of securities, or five years in the case of issuers and their affiliates);
  • court injunctions and restraining orders within the past five years in connection with the purchase or sale of a security, involving false filings with the SEC or arising out of the conduct of certain financial intermediaries;
  • final orders from state securities, insurance, banking, savings association or credit union regulators, federal banking agencies or the National Credit Union Administration that bar the issuer from associating with a regulated entity, engaging in the business of securities, insurance or banking, or engaging in savings association or credit union activities, or orders that are based on fraudulent, manipulative or deceptive conduct and issued within ten years before the proposed sale of securities; and
  • certain state and federal disciplinary orders relating to brokers, dealers, municipal securities dealers, investment companies and investment advisers and their associated persons.

The proposed rule contains an exemption from disqualification if the issuer did not know and, in the exercise of reasonable care, could not have known of a disqualification.

The SEC will receive public comments on its proposed rule until July 14, 2011.

OUR TAKE:  In addition to other due diligence, issuers should be vetting their covered persons for “disqualifying events” before conducting any private offerings under Rule 506.  For issuers contemplating a Rule 506 offering, the proposed rule may dictate that issuers present questionnaires to covered persons to confirm the absence of any “disqualifying events.”  In addition, these issuers may include in their form investor documents appropriate representations from covered persons to protect against any “bad boy” participation in the offering.

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