Get Ready to Fill Out Bad Actor Questionnaires

New SEC Rule 506(d) disqualifies securities offerings from reliance on the private placement exemption of Rule 506 of the Securities Act if certain felons and other “bad actors” are involved in the offering.  The persons covered by the rule include the company itself, any placement agent or other compensated solicitor, and each of their respective directors, executive officers, or any officer involved in the private placement, as well as holders of 20 percent of the voting securities of the company. The disqualification also covers the general partners of a private fund, and its principals and officers.

Such persons would become bad actors if after September 23, 2013, they became subject to (among other offenses):

  • criminal convictions in connection with the sale of securities or making false statements to the SEC;
  • court orders, judgments or decrees in connection with the purchase or sale of securities or in connection with the business of a broker/dealer or investment advisor;
  • final orders of state or federal bank, insurance or securities regulators, which bar the person from associating with an entity regulated by such commission or otherwise engage in the business of securities, insurance or banking;
  • disciplinary orders of the SEC that suspend or revoke such person’s registration as a broker/dealer or investment adviser, limits such person’s activities or operations, bars such person from association with any entity or from participating in an offering of penny stock, or prohibits future violations of anti-fraud rules and laws.

Each of these bad acts is associated with look-back periods, generally 5 or 10 years. Bad acts that occur before the period began would not bar the issuer from relying on Rule 506.  However, any company engaged in a private placement is required to furnish each potential investor a written description of any matters that would have triggered disqualification under the rule had the events occurred before September 23, 2013.

A company that is unaware of a covered person’s disqualification would not be barred from relying on Rule 506 if it is able to establish that it has exercised reasonable care in inquiring whether any disqualifications exist. That last point is the important one.  You can be sure that we securities lawyers will now have a new questionnaire for companies and their officers and others to fill out.

The bad actor rule was enacted as required by the Dodd-Frank Act.  State regulators have been complaining for years that because they are pre-empted from reviewing Rule 506 transactions, fraudsters have been filing Form Ds and checking the 506 box with impunity as part of their nefarious schemes to steal from the public.  “Of course this deal is on the up and up; we even filed it with the SEC”, was commonly believed to be what investors were told.  Now no one thinks crooks are going to pack it in because of this new rule. And asking the rest of us to spend time and effort checking whether anyone involved in a real deal has an SEC rap sheet will be intrusive and expensive.  Certainly, a deal which is entirely fraudulent could close anyway, since there is nothing here that allows state regulators to hold the process up for review; they are still pre-empted.  But the bad actor rule will be effective against small broker dealers which, while listed at FINRA BrokerCheck®, will now have real liability for not disclosing their disqualification.  As to the larger banks, I’m sure that when they plead to a bad act going forward, they will get a pass.  Read Rule 506(d)(2)(iii), which states that “[disqualification] shall not apply . . . if, before the relevant sale, the court or regulatory authority that entered the relevant order . . .  advises in writing (whether contained in the relevant . . . order . . . or separately to the [SEC]) that disqualification . . . should not arise as a consequence of such order . . .”   I’m looking forward to reading the order settling the federal government’s charges against JP Morgan in the Madoff Case, which was of course a fraud conducted through 506 private placements.  Anyone out there think that the order won’t have a reference to Rule 506(d)(2)(iii)?  If so, call me, because I may have a bridge to sell you.

John A. Myer is a corporate and securities lawyer with Myer Law PLLC in Seattle, Washington.   This posting does not constitute legal advice.