Making an offering of securities under the SEC’s Regulation D Rule 506(b) or Rule 506(c) comes with many advantages. Both allow you to raise an unlimited amount of capital. Plus, the rules offer exemption from the Securities and Exchange Commission’s (SEC’s) usual registration rules. As such, Rule 506 is ideal for syndicates, entrepreneurs, and small business owners that wish to raise money quickly from multiple investors.
However, the rule carries limitations. Some of these relate to the types of investors you can sell securities to, as well as the verification requirements for these investors. Others relate to how you advertise or solicit investment. But perhaps the most important for the safety of your offering are the Bad Actor rules that Regulation D offerings must follow.
The Basics of Bad Actors Under Regulation D
Rule 506(d) states that any Bad Actor who has engaged in a disqualifying event cannot be a part of any offer made under Regulation D. These disqualifying events don’t just affect the individual in question. If you make any offering with a Bad Actor as part of your issuing team, the SEC disqualifies the offering. What’s more, the presence of Bad Actors under Regulation D may place you at risk of federal and state prosecution.
Specifically, the rule states that you can’t issue securities under Rule 506(b) or Rule 506(c) if any covered person in the issuing team has engaged in a disqualifying event on or after September 23, 2013. What’s more, Bad Actors under Regulation D that participated in a disqualifying event before this date must have the nature of their event disclosed to all investors.
What is a Covered Person?
The SEC defines a covered person as the issuer and anybody involved with the issuer’s team who has a direct interest in the securities offering. These people include the following:
- The issuer
- Any of the issuer’s predecessors
- Those affiliated with the issuer
- Promoters with direct connections to the issuer
- Any executive officer, or any other type of officer, who takes part in the offering
- The issuers managing members
- Directors and general partners that work with the issuer
- Any beneficial owner of the issuer or their business who owns at least 20% of the issuer’s total voting power
- Anybody who receives compensation for soliciting investors
- Any managing members, directors, and general partners associated with a solicitor who receives compensation
All of these are individuals who have a vested interest in the success of your securities offering. For example, a solicitor receiving compensation gets paid based on the number of investors they attract. As such, they benefit directly from the success of the offering of securities. Without the provisions for Bad Actors under Regulation D, these solicitors may use unscrupulous means to attract investors. Or, they may have negative histories that would affect an investor’s decision to buy securities.
The same applies to every concerned person in a securities transaction. Your investors need to know that everybody involved in the issuing of securities has a clean history and isn’t engaged in any fraudulent activities.
What is a Disqualifying Event for Bad Actors?
The SEC class any event that marks people as Bad Actors under Regulation D as disqualifying events. These events include:
- Some criminal convictions
- Certain disciplinary orders that the SEC issues
- Certain SEC cease-and-desist orders
- Select restraining orders and injunctions
- Final orders from federal and state regulators
- Suspension of expulsion from certain professional organizations
- False representation orders from the U.S. Postal Service
- SEC stop orders
The mentions of “some” and “certain” are worth understanding. In the event of a criminal conviction, people are not considered Bad Actors under Regulation D for all convictions. The event applies to select convictions, typically related to securities fraud and similar issues. The same applies to most of these disqualifying events, meaning it’s worth digging into the specific convictions, orders, and injunctions that trigger disqualification.
Disqualification occurs for Bad Actors under Regulation D if their conviction relates to any of the following:
- False filings with the SEC
- Fraud or similar activities relating to the buying or selling of securities
- Poor conduct by an investment professional
The conviction must have occurred within the last five years for the issuer, their affiliates, or their predecessors. This time extends to 10 years for any other covered person involved in the offering. Once these limits are reached, the criminal convictions no longer affect the covered person’s ability to take part in the offering.
SEC Disciplinary Orders
These types of disciplinary orders typically prevent a covered person from operating in a professional capacity. Usually, they occur due to the person breaching rules in either the Investment Advisers Act or the Securities Exchange Act. These orders typically relate to investment professionals, such as brokers, dealers, investment advisers, and investment companies.
Suspension or revocation of a covered person’s license is usually classified as a disqualifying event. The same applies to any orders that bar the person from association with securities or similar financial instruments. A disqualifying event may also occur if the SEC limits the covered person’s functions, activities, or operations under one of the acts mentioned above.
Again, these covered persons are not permanent Bad Actors under Regulation D. The Bad Actor status lasts for as long as the disciplinary order.
SEC Cease-And-Desist Orders
Cease-and-desist orders come directly from the SEC. They compel the covered person to stop any current or future violations of the anti-fraud rules documented in several actions. These rules include:
- Section 5 and Section 17(a)(1) of the Securities Act
- Section 10(b), Rule 10b-5, and Section 15(c)(1) of the Securities Exchange Act
- Section 206(1) in the Investment Advisers Act
Any cease-and-desist orders that are in effect at the time of the sale of securities class as disqualifying events. Furthermore, cease-and-desist orders issued within five years of the proposed sale of your securities also disqualify the sale from occurring.
Restraining Orders and Injunctions
As with the criminal convictions example, only select orders and injunctions make people Bad Actors under Regulation D. Typically, an injunction or restraining order must come directly from the court and be related to false filings, improper professional conduct, or purchasing and selling securities illegally.
A five-year look-back period applies to injunctions and restraining orders. That means that anybody who is under one of these orders is disqualified if the injunction or restraining order was issued up to five years before the proposed sale.
However, the expiration of the injunction or order before the sale means it is no longer a disqualifying event, regardless of when the event took place. For example, a covered person may have had a two-year injunction placed on them three years before your proposed offering. Because the injunction expired before the proposal, this person isn’t disqualified from the issuing of securities.
Final orders can come from state and federal authorities, with both considered under the rules for Bad Actors under Regulation D.
These orders can come from state regulators that oversee banking, credit unions, securities, insurance, and saving associations. They can also come from federal banking agencies. Furthermore, final orders issued by the National Credit Union Administration and Commodity Futures Trading Commission may be included here.
These orders must relate to one of the following:
- Barring the covered person from associating or doing business with professionals in the financial industry.
- Improper conduct, such as fraud or deceit, that led to the issuing of a final order within 10 years of the proposal for the sale of your securities.
What is a Final Order?
A final order is a written document or declaration created by one of the previously mentioned state or federal agencies. It is issued to declare the final action the relevant authority takes against the person in question. Final orders usually offer an opportunity to take part in a hearing to appeal the order. However, this is not always the case.
What Are Bars?
Bars prevent the person who received a final order from associating with certain professional entities or individuals. For example, a final order may bar a Bad Actor from working with anybody in the business of buying or selling securities. These bars have time limits attached to them, meaning they can last anywhere from a few months to an indefinite period. Some bars also have time limits that offer the covered person the chance to apply for reassociation with the professional entities they’re barred from working with after a set period. Any bar that is in effect during your offering of securities is a disqualifying event.
Suspension or Expulsion From an Organization
These disqualifying events are only relevant if they involve a Self-Regulating Organization (SRO). SROs are organizations that can enforce industry regulations but are not directly connected to the government.
The Financial Industry Regulatory Authority (FINRA) is the most obvious example when dealing with securities. FINRA is not a government entity. However, it provides resources and oversight for investors, along with several industry certifications and regulations. If a covered person is suspended or expelled from FINRA, this serves as a disqualifying event because it demonstrates that the person does not follow industry-accepted regulations.
U.S. Postal Service False Representation Orders
False representation is the term used to describe any event where a person misrepresents who they are. Mail fraud is the most direct example relating to the U.S. Postal Service. Those convicted of mail fraud typically falsely represent themselves as part of fraudulent schemes to generate income based on their false identity.
Mail fraud is a very serious crime that carries a prison sentence of up to 30 years, in addition to a maximum $1 million fine.
Covered persons are Bad Actors under Regulation D if they were issued with a false representation order at any point within the last five years.
SEC Stop Orders
A disqualifying event occurs if a covered person files a registration statement for which the SEC issues a refusal or stop order. This also applies to Registration A offering statements, as a stop order prevents the covered person from making public offerings without registering them.
These orders are disqualifying events if they apply to the issuer or any covered person who is an underwriter of the securities you issue. All stop orders created within five years of the proposed offering disqualify the covered person.
How to Ensure Bad Actor Rules Don’t Sink Your Offering
The SEC requires you to take reasonable care to ensure that no covered persons in your offering are Bad Actors under Regulation D. This means that the responsibility for rooting out Bad Actors lies with the issuer.
Start by issuing questionnaires to any covered persons involved in your offering of securities. This questionnaire should ask point-blank questions about the person’s history and all of the disqualifying events mentioned in this article. Your goal is to create a signed and dated document that confirms that you’ve asked the person about their history and that they’ve stated that they’re not a Bad Actor.
Keep all of these questionnaires in your records so you can use them as evidence if you discover that you have a Bad Actor in your offering. It’s also worth following up on the information that each covered person provides, allowing you to document any further checks you conducted beyond the questionnaire.
Unfortunately, these checks may not be enough to root out Bad Actors if the covered person makes a concerted effort to lie to you. Thankfully, the SEC provides a Reasonable Care Exemption in such cases. This only applies if you can demonstrate that you did not know about a covered person’s Bad Actor status. You must also demonstrate that you took reasonable steps to ensure you weren’t working with a Bad Actor, which is why you must maintain questionnaires and other documentation in your records.
If the SEC decides you displayed reasonable care, your offering will receive an exemption from disqualification.
Guard Your Offering Against Bad Actors
Bad Actors under Regulation D can disqualify your offering of securities before it gets off the ground. What’s more, working with a Bad Actor can cause professional issues, as investors may feel wary about any future offerings you make.
Simply put, you cannot work with Bad Actors if you want to create a Regulation D syndication. That means you need to closely examine the records of any covered persons in your offering for signs of disqualifying events. Maintain records of your investigative efforts so you can prove that you took reasonable care to prevent Bad Actors from getting involved in your offering.
If you need help with any aspect of a Regulation D offering of securities, the Moschetti Law team is here for you. Our specialists can guide you as you create your Regulation D syndication, ensuring that you meet all of the criteria for a valid offering of securities. To find out more about what we do and how we can help you, contact us today on (888) 606-0990 or via our website at http://moschettilaw.com.