The Reg D Bad Actor Rule: Rule 506d

What the Rule 506(d) Bad Actor Disqualification Actually Means

Rule 506(d) says you cannot use the Rule 506 exemption under Regulation D if certain key people in your deal have a recent history of securities fraud or specific regulatory infractions. That is the whole mechanic. If a covered person in your offering has a disqualifying event, the exemption is gone.

The rule attaches to people, not just to you. The issuer, the people who run it, large owners, and anyone paid to help raise the money all get pulled into the analysis. If one of them has a problem in their history, the problem becomes your problem.

So the practical answer is simple. Before you launch, you need to know who your covered persons are and whether any of them has a disqualifying event. You cannot fix this after the money comes in.

The Consequence of a Disqualified Offering

A disqualifying event strips the issuer of the ability to rely on Rule 506. That is the immediate consequence, and it is mechanical.

Here is why that matters. Rule 506 is what lets you sell securities without registering them with the SEC. Take that away, and you may be running an unregistered, non-exempt securities offering. That creates rescission risk – investors can potentially demand their money back – along with regulatory exposure at the federal and state level.

This is a strict test. It does not ask whether the person is a good person, whether they have changed, or whether the event was unfair. It asks a narrow factual question: did a covered person have a disqualifying event inside the look-back window? If yes, the exemption is off the table unless a specific carve-out applies.

The Purpose Behind the Rule

The SEC’s goal is to keep serial fraudsters out of the private placement market. Rule 506 offerings do not get reviewed before they go out, so the SEC wanted a gate that blocks people who have already been sanctioned for securities-related conduct.

The tension is that the SEC does not run that gate for you. There is no agency that clears your team in advance. Instead, the burden sits on the issuer to screen its own participants and to get it right before selling a single interest.

That is the part sponsors underestimate. The rule is not the SEC watching your deal. It is the SEC telling you that if you let a disqualified person into the deal, you lose the exemption – and you are the one who has to catch it.

The Most Dangerous Sponsor Misconception: Assuming Only the Lead GP Matters

Most first-time sponsors think the same thing: my record is clean, so my offering is fine. That is the wrong test. Rule 506(d) does not screen the founder. It screens the deal, and the deal includes everyone who holds significant equity, directs the entity, or raises capital for it.

So your clean background protects your part of the picture. It does nothing about the co-GP you brought in for their operational experience, or the anchor investor who wrote the big check.

The “Lead Sponsor Only” Myth

The SEC does not grade you as a person. It looks at the covered persons attached to the issuer and asks whether any of them has a disqualifying event.

That means your spotless history is irrelevant if your co-GP has an SEC cease-and-desist order, or if an anchor LP who owns 20% or more of the issuer has a disqualifying event in their past.

Here is the practical problem. You assemble a management team the way most sponsors do – you find people you trust, you like their experience, you split the economics, and you go raise money. Nobody runs a background check on anybody. That is the vulnerability.

One disqualified covered person can take the whole 506 exemption down. Not their piece of it. All of it.

The Blind Spot for Capital Raisers

The biggest blind spot is the person you bring in to help find investors. A compensated solicitor is a covered person, which means their regulatory history becomes your problem the moment you pay them to raise for the deal.

If it were me, this is where I would be most careful. Sponsors handshake with marketers and “capital consultants” all the time without ever checking their FINRA or SEC history.

That promoter may have a bar, an expulsion from a self-regulatory organization, or an order you never asked about. You inherited it the instant they started raising money for you.

There is a second issue buried in that arrangement. Paying someone to solicit investors can raise a broker-dealer question separate from the bad actor rule. That is a different problem, but it lives in the same conversation, so flag it with counsel when you set the arrangement up.

The takeaway is simple. You are not screening yourself. You are screening the roster – every GP, every 20% owner, and every person you pay to bring in capital.

Who Must Be Screened: Defining “Covered Persons”

Rule 506(d) applies to a specific list of people it calls “covered persons.” That list includes the issuer, its directors, its managing members, anyone who owns 20% or more of the voting equity, and the promoters and paid solicitors working the deal. If a person falls into one of these categories, you screen them. There is no discretion here.

The Issuer and the Management Team

The issuer itself is a covered person, and so are its predecessor entities and any affiliated issuers connected to the offering.

From there, the rule reaches the people running the deal: directors, general partners, managing members, and officers who participate in the offering.

The word “participating” matters. An officer is only covered if they actually take part in the offering – meaning they have real influence over how the deal gets structured, marketed, or sold. A ceremonial title with no involvement does not automatically pull someone in. But if the person is helping decide how the raise happens, they are in.

The practical takeaway is simple. Everyone on your management team who touches the offering gets screened. Do not try to argue someone out of the category because their title sounds minor.

20% Beneficial Owners (And the Friction They Cause)

Any person who beneficially owns 20% or more of the issuer’s outstanding voting equity securities is a covered person. That threshold is based on voting equity, not total capital, but for most sponsors the practical effect is that a large anchor investor lands inside the rule.

This is where you run into a real-world problem. Anchor LPs often see themselves as passive money. They wrote a big check, and they do not expect to fill out a background questionnaire to do it.

From your point of view, that resistance is a problem you cannot afford. You cannot waive the requirement, and you cannot decide their history does not matter because they are “just an investor.” If they cross 20% of the voting equity, their disqualifying event is your disqualifying event.

So you collect their information the same way you collect everyone else’s. Frame it as a standard closing item, not a personal accusation. In practice, that is the only way to protect the exemption.

Promoters and Compensated Solicitors

A promoter is anyone brought in to organize the business or actively market the offering. In a modern fund or syndication, that usually means co-organizers, capital-raising partners, and anyone paid to help bring investors into the deal.

Compensated solicitors sit in the same bucket. If you are paying someone to find investors, they are a covered person, and the reach does not stop there. The directors and officers of a compensated solicitor are also covered.

That last point catches sponsors off guard. If you engage a marketing firm or a placement entity to solicit investors, you are not just screening the entity. You are screening the people who run it.

What Constitutes a Disqualifying Event?

Not every bad thing in a covered person’s past triggers Rule 506(d). The rule targets serious securities, finance, and fraud-related infractions, not general criminal history. A DUI from three years ago will not blow your exemption. A recent SEC cease-and-desist order for fraud will.

The specific categories are listed in the rule itself. What follows is the plain-English version, organized the way a sponsor actually needs to think about it.

Securities and Financial Convictions

The rule targets criminal convictions – felony or misdemeanor – connected to the purchase or sale of a security, the making of a false filing with the SEC, or the conduct of certain financial intermediaries like brokers and investment advisers.

The word to focus on is “connected.” The conviction has to relate to securities or financial misconduct. Something like securities fraud, wire fraud in a deal context, or lying on an SEC filing is the kind of thing that matters.

Unrelated criminal history generally does not trigger Rule 506(d). A DUI, a bar fight, a shoplifting charge from years ago – those do not automatically disqualify anyone under this rule. That does not mean you ignore them from a business or disclosure standpoint. It means they are not the mechanical trigger the rule is built around.

Regulatory Orders and Expulsions

Civil and administrative actions can disqualify a covered person even without a criminal conviction.

On the state side, a final order from a state securities commission, a state banking or credit union regulator, or a state insurance regulator can trigger disqualification when it bars the person from associating with a regulated entity or is based on fraudulent conduct. The CFTC and federal banking regulators are treated the same way.

On the federal securities side, SEC disciplinary orders, cease-and-desist orders relating to fraud, and orders suspending or revoking registration all count. So does expulsion or suspension from a self-regulatory organization, meaning FINRA.

The practical point: if someone on your covered-person list has a regulatory history with any of these bodies, you cannot assume it is harmless. You need to know what the order actually said and when it was entered.

The Line Between Disqualification and Disclosure

Rule 506(d) took effect on September 23, 2013. Timing matters, because an event’s date can change the result.

As a general matter, disqualifying events that occurred before that date do not automatically kill the exemption. Instead, they usually require written disclosure to investors describing the matter. Events on or after that date can disqualify the offering outright.

This is a determination I would not leave to guesswork. Whether a given event disqualifies, requires disclosure, or does neither depends on the type of event, the person’s role, and the exact date. Have counsel make that call rather than assuming an old matter is either fatal or irrelevant.

Navigating the Look-Back Periods

Rule 506(d) does not treat every disqualifying event as permanent. The rule imposes a look-back period, generally running from five to ten years depending on the person’s role and the type of event. Do not guess on these timelines. The date math is technical, and getting it wrong means you either kill a clean offering or rely on an exemption you no longer have.

The Five and Ten-Year Baselines

The two common baselines are five years and ten years, and which one applies depends on who the covered person is.

Criminal convictions generally look back five years for the issuer and its predecessors and affiliated issuers, and ten years for other covered persons like directors, general partners, managing members, promoters, and 20% owners.

The measuring point matters as much as the length. The look-back is calculated against the date of the sale of securities, not the date you started drafting the offering or the date you formed the entity. That means the same conviction can be inside the window on one closing date and outside it on another.

Do not assume an old offense has simply aged out. A conviction from six or seven years ago might feel ancient, but if the person is a promoter subject to the ten-year window, it still counts. Verify the exact statutory period against the facts before you conclude anyone is clear.

Foreign Infractions

Rule 506(d) is generally triggered by U.S.-based court judgments and regulatory actions – SEC orders, FINRA expulsions, state securities and banking orders, CFTC orders, and criminal convictions in U.S. courts. A foreign conviction or a foreign regulator’s order usually does not, by itself, trip the specific list of disqualifying events in the rule.

That is a narrow point, not a free pass. If you are bringing in offshore entities or foreign promoters, the underlying facts still matter. The federal anti-fraud provisions apply regardless of where someone got into trouble, and a foreign record can point to a real problem you do not want in your deal.

So the practical answer is the same as everywhere else in this rule: collect the facts, then have counsel decide whether a given event actually falls inside Rule 506(d) or not.

The Operational Fix: Establishing the “Reasonable Care” Exception

The rule includes a safe harbor. If a disqualifying event exists but you did not know about it, and you can show you conducted a reasonable factual inquiry into your covered persons, you do not lose the exemption.

In practice, the industry solves this by having every covered person sign a Bad Actor Questionnaire before the deal launches. That questionnaire is your evidence that you looked.

Why “Knowing Them for Years” Is Not a Legal Defense

The reasonable care exception is not satisfied by trust. It is satisfied by an affirmative inquiry that you can document.

The rule expects you to take steps to uncover bad actor issues, not to assume they do not exist because the person seems fine. A handshake is not an inquiry.

“I’ve known my co-GP for fifteen years” does not help you if the SEC audits the offering. The examiner is not going to care about your friendship. The question will be what you actually did to check, and whether you have a record of it.

That is the practical point. The reasonable care defense is a paper defense. If you cannot show the paper, you do not have the defense.

Deploying the Bad Actor Questionnaire

Treat the Bad Actor Questionnaire as a mandatory pre-deal checklist item. It typically sits alongside the rest of the Reg D private offering legal package, next to the PPM and subscription documents.

Send it to every covered person. That means your co-GPs, your managing members, your participating officers, any 20% beneficial owners, and any promoters or compensated solicitors.

Do this before you file Form D and before you circulate the PPM. The inquiry needs to happen before the offering, not after a problem surfaces.

What If Someone Lies on the Form?

The questionnaire also protects you against a covered person who hides something. If someone lies on the form, and you had no reasonable cause to believe they were lying, you have generally established your reasonable care defense.

That is the whole design. You are not being asked to guarantee that no covered person has a disqualifying event. You are being asked to show you made a genuine inquiry and had no reason to doubt the answers.

Documented correctly, a scary strict-liability rule becomes a routine administrative step you handle at the front of every deal.