The Jobs Act of 2012 was structured to help small businesses grow, raise capital, and create jobs. In lieu of this measure, Congress is pushing the Securities and Exchange Commission to make significant changes to former regulations and to strike a delicate balance between the changing investment landscape and continuing its safeguard of the investment community.
Rule 506 is nothing new – the rule allows issuers to raise an unlimited amount of money, without registration, as long as there is no general solicitation. If the issuer complies with the rules, they are able to take advantage of these measures.
The more recent Dodd-Frank Act of 2011 directed the Securities and Exchange Commission to impose “bad boy disqualification” on Rule 506 private placements, disqualifying felons, and other “bad actors” from taking advantage of the benefits of the rule. While the proposed rules initially were published, the SEC has just now scheduled the final rules into its 2013 agenda.
Furthermore, the JOBS Act has instructed the SEC to lift the ban on general solicitation, though many commentators say the commission needs to safeguard the investment community and formally impose the bad boy disqualification before it lifts the ban on general solicitation.
The SEC Wednesday approved a measure to lift the ban that prohibited hedge funds from appealing to the mass public, to take effect in October of this year. In light of this movement, odds are that changes to Rule 506 are on deck with cutting the ban on general solicitation. If this happens, bad boy disqualifiers have broad coverage with a far-reaching impact.
The final rules are likely to look much like the proposed rules, which state that an issuer may not take advantage of Rule 506 if there are “bad boys” associated with the offering. This means that if individuals or entities relative to the issuer have a history that includes a past violation of securities law or similar infraction, Rule 506 is out of the question.
The bad boys disqualification is a wide net that reaches far beyond executive officers or directors of the issuers – the lineup also encompasses lower-level employees, individuals not working on the actual offering, and even portfolio companies or sister entities:
• 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.
So what constitutes a “bad boy”? More than you might think. The proposed rule applies to any felony or misdemeanor in connection with the purchase or sale of any security; any false filing with the Commission; or arising out of conduct of the business of an underwriter, broker, or dealer.
You’re not a bad boy without a “bad acts” – and according to the rule, these aren’t limited to securities-related criminal convictions; and in many cases, the rule can dig ten years into the past. Disqualification can also stem from:
• 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.
With these rules in mind, it’s important for an issuer to conduct thorough due diligence of its associates, as the proposed rule would disqualify the use of Rule 506 even for bad acts committed before the rule’s adoption, even if the offering is currently pending or if there has already been a sale.
Disqualifiers, however, can apply for a waiver from the SEC and may still be allowed to use Rule 506 if they can prove “good cause” and lack of prejudice to any other SEC action. And the proposal is crafted to protect issuers who can demonstrate that they exercised “reasonable care” to discover the disqualifying facts but were unable to do so.
The impending final rules are long overdue, and with the loosening of solicitation bans, the SEC faces increased pressure to move the ball forward. A word of advice to issuers who haven’t conducted thorough due diligence is to do so now to avoid speed bumps or full-on road blocks that could halt any offerings.
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