The New Rule 506(d) and Bad Actors


At its latest meeting, the Securities and Exchange Commission approve the rule that lifted the ban on general solicitation and advertising for certain private placements. The SEC also adopted the new rule that disqualifies felons and other bad actors from participating in certain securities offerings. The first rule was mandated by the JOBS Act. The “bad actor” rule was mandated by Dodd-Frank.

The bad actor rule makes private placements a bit harder and will require private funds and companies to do more homework in connection with the fundraising. That’s because an issuer cannot rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a “bad actor disqualification.”

I think the starting point is who is covered by the rule. The rule applies to

  • The issuer, including its predecessors and affiliates
  • Directors, executive officers, general partners, and managing members of the issuer
  • Any other officer participating in the offering
  • Anyone who holds 20% or more of the outstanding voting equity securities
  • Investment managers and principals of pooled investment funds
  • Any general partner or managing member, director, executive officer or other officer participating in the offering of a fund sponsor
  • Solicitors paid to sell the securities investors as well as the general partners, directors, officers, managing members or other officer participating in the offering

For fund managers registered with the SEC the employees affected are a narrower group than those in Item 11 on Form ADV. That part of the Form ADV disclosure applies to all employees, other than employees performing only clerical, administrative, support or similar functions. Plus the Form ADV includes all of the officers, partners, directors, and certain affiliates.

The big difference is the 20% threshold for ownership in the company. For startups, that would likely pull some angel investors into the “actor” category.

It’s not clear what to do if the 20% investor is an entity. The rule does not seem to cover that circumstance. I suppose that if Bernie Madoff set up Scumbag Bernie Investor LLC to invest in the fund that would be a mere facade to hide his ownership. If the entity has multiple owners and officers it seems that a single “bad actor” inside the investor should not taint the whole entity.

The other fuzzy item is “officers participating in the offering.” The SEC had declined to merely use job title as the defining line. That would have included everyone who had the title of vice president.

Participation in an offering would have to be more than transitory or incidental involvement, and could include activities such as participation or involvement in due diligence activities, involvement in the preparation of disclosure documents, and communication with the issuer, prospective investors or other offering participants.

I’m not sure how I feel about that guidance. A lot of people end up reviewing the Private Placement Memorandum.

Of those relevant actors to determine if they were bad, they need to have been involved in a “disqualifying event” which includes:

  • Criminal convictions in connection with financial fraud.
  • Subject to an order of judgement that limits involvement in the securities industry.
  • Subject to an order of judgement that limits involvement in the banking industry
  • Subject to an order of judgement from the CFTC.
  • Subject to a US Postal Service false representation order.

The actual list is much more convoluted, long, and unwieldy. That means putting together a questionnaire will be difficult. For private fund adviser, it does not match up squarely with the Form ADV disclosures and is not as clearly written as the Form ADV disclosures.

The default would be to put together a questionnaire and just use the text of Rule 505(d). I’m not sure it’s comprehensible by a non-lawyer. Actually, I’m not sure it’s easily comprehensible by a lawyer. I just added it to my questionnaire for Form ADV, making it extend to four pages.

The next question is how much diligence you need to conduct to determine if one of your “actors” is a “bad actor”? The rule requires the issuer to exercise “reasonable care.” Which in “light of the circumstances, the issuer made a factual inquiry into whether a disqualification exists.”

That’s the kind of fuzziness that keeps a compliance officer up at night.

Fortunately, the SEC offers some color to the “reasonable care” in the release.

For example, we anticipate that issuers will have an in-depth knowledge of their own executive officers and other officers participating in securities offerings gained through the hiring process and in the course of the employment relationship, and in such circumstances, further steps may not be required in connection with a particular offering.

So the questionnaire approach should work for employees, unless you have some suspicion that an employee has been up to no good.

What about for investors?

Factual inquiry by means of questionnaires or certifications, perhaps accompanied by contractual representations, covenants and undertakings, may be sufficient in some circumstances, particularly if there is no information or other indicators suggesting bad actor involvement.

That’s enough to let me fall asleep at night. Maybe I’ll need just a little bourbon to take the edge off.