Bad Boy Disqualifiers Are Coming Soon: Time to Upgrade Diligence Procedures Now

Over two years ago, the Dodd-Frank Act instructed the SEC to impose “bad boy disqualification” on Rule 506 private placements. Proposed rules were published, but we are still waiting for the final rules, which were due over a year ago.

Despite the long wait, the SEC has placed the final rules on its 2013 rulemaking agenda. Further, the JOBS Act, enacted last year, instructed the SEC to amend Rule 506 to lift the ban on general solicitation. This rulemaking is also overdue but anxiously awaited. The then-Director of the SEC’s Division of Corporation Finance stated recently, as have several other commentators, that the SEC needs to impose the bad boy disqualification before it lifts the ban on general solicitation. We therefore think there is a high chance these changes to Rule 506 will get finalized at the same time.

The bad boy disqualifiers have the power to halt your offering in its tracks, immediately upon adoption. We therefore think this is a good time to refresh your memory about the coming changes, and talk about what you can do now to get ready.

Overview of the Rule.

Under the new rules as proposed, an issuer may not rely on Rule 506 if certain individuals or entities associated with the offering have a history that includes a past violation of securities law or similar infraction. This so-called “bad boy disqualifier” is modeled after similar disqualifiers that apply to offerings under Regulation A and Rule 505 of Regulation D. In fact, Congress required that the Rule 506 disqualifier be “substantially similar” to Regulation A’s disqualifier (which is also applicable to Rule 505 offerings), and then went on to mandate additional disqualifications. This means that the final rules are likely to look a lot like the proposed rules, since the SEC has limited discretion under the statute.

Wide Scope.

While the concept behind the rule is straightforward, several aspects of the rule hide traps for the unwary. First, the scope of the rule is much wider than you might expect. It is not limited to executive officers and directors of the issuer. If adopted as proposed, the rule would disqualify offerings based on the history of a very large number of persons associated with the offering, including:

  • The issuer and any predecessor of the issuer or affiliated issuer;
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10% or more of any class of the issuer’s equity securities;
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
  • any director, officer, general partner or managing member of any such compensated solicitor.

While the rule as proposed does not include investment advisers per se, the SEC solicited comment on this point, and they may add certain categories of investment advisers before they finalize the rule.

Note that the list includes, among others, the placement agent as well as its directors, officers, general partners and managing members. It does not matter whether the individual in question works on the offering. Throughout, the rule refers merely to officers and not to “executive officers,” potentially capturing lower-level employees with no actual policymaking role. The list even includes passive investors in the issuer, if they own 10% or more. Finally, “affiliated issuers” are also included. An affiliate can be any person who controls the issuer, is controlled by the issuer, or is under common control with the issuer. Thus under some circumstances, this could pull in surprising persons such as portfolio companies or sister entities.

While there have been calls to modify the rule to address some of its seemingly overbroad applications, it is unclear whether this will happen. It is important to keep in mind that the SEC has only a small amount of room under the statute to alter the content of the disqualifications.

Similarly, you might assume that only serious criminal convictions would hold the power to disqualify an issuer. That is not so. The proposed rule applies to any felony or misdemeanor: (A) in connection with the purchase or sale of any security; (B) involving the making of any false filing with the Commission; or (C) arising out of conduct of the business of an underwriter, broker, or dealer. In some jurisdictions, it is possible to be convicted of a misdemeanor without any proof of fraudulent intent. In New York, for example, an issuer could, at least in theory, be convicted of a misdemeanor based on an inadvertent failure to file a notice form.

Further, the “bad acts” covered by the rule go beyond securities-related criminal convictions to include:

  • Court orders that bar the individual from engaging in certain types of securities-related activities;
  • Certain agency orders that are based on a violation of anti-fraud laws, or that bar the individual from engaging in certain types of securities-, banking-, or insurance-related activities;
  • Certain SEC orders that suspend or revoke registration, or that impose certain kinds of limitations and bars on certain securities-related activities;
  • Suspensions or expulsions from (or from associating with a member of) a national securities exchange or registered securities association, for conduct inconsistent with just and equitable principles of trade;
  • SEC stop orders or suspension orders relating to a Reg A offering – as well as currently pending investigations and proceedings to consider issuing one;
  • Certain U.S. Postal Service orders relating to conduct alleged to violate anti-fraud laws.

As proposed, the coverage is extremely broad. For example, as drafted, the rule would forbid participation by a broker-dealer who was previously subject to an order issued by a state regulatory agency, even though the broker-dealer is still registered and legally operating in that state. It would disqualify an offering due to a pending investigation to consider issuing a stop order in connection with a Reg A offering, even if such an order is never issued.

The rule also does not require that the “bad acts” be of recent vintage. In many instances, the rule looks back as far as ten years. The proposal does not provide any grandfathering for disqualifying events that took place before the rule’s adoption.

Waivers.

As proposed, the rule would make limited allowance for waivers, upon application to the SEC. The standard is fairly subjective, and would require the issuer to demonstrate “good cause” and lack of prejudice to any other SEC action. The SEC would have to conclude that it would not be “necessary under the circumstances” to deny the use of Rule 506 to the issuer. While it’s hard to say how difficult it would be to get such a waiver, we think it would be difficult to convince the SEC to grant a waiver of a disqualification that was discovered late in the game because the issuer had failed early on to conduct adequate due diligence, discussed below.

Due Diligence Defense.

There is one important exception to the disqualification rules, and that is for an issuer who exercised “reasonable care” to discover the disqualifying facts but was unable to, despite having conducted the requisite due diligence. This means that an issuer who discovers a disqualifying event mid-way through an offering will not necessarily lose the ability to rely on Rule 506, so long as it could not have discovered it sooner through the exercise of reasonable care.

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