The “bad boy” provisions have been added as a new paragraph (d) to Rule 506. These provisions disqualify an offering from utilizing the Rule 506 exemption from registration if certain persons related to the issuer or the offering have engaged in specified “bad acts.” The disqualification provisions apply to offerings under Rule 506(b) and Rule 506(c).
The disqualification provisions apply to the following categories of persons (who are deemed “covered persons”):
- The company issuing or selling the securities (the “issuer,”) any predecessor of the issuer, and any affiliated issuer.
- Directors of the issuer.
- Executive officers of the issuer, as well as other officers of the issuer who participate in the offering. The release indicates that “participation” in the offering refers to more than incidental involvement, and could include involvement in due diligence, preparation of disclosure documents, and communications with prospective investors or other participants in the offering process.
- General partners and managing members of the issuer.
- Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power.
- Promoters connected with the issuer in any capacity at the time of the sale. (The term “promoter” is defined in Rule 405 to mean anyone who, alone or together with others, directly or indirectly takes initiative in founding the business, or who in connection with the founding of the business receives 10% or more of a class of issuer securities or 10% or more of the proceeds from the sale of a class of issuer securities.)
- Any person being paid (directly or indirectly) for soliciting purchasers in the offering (as well as such person’s general partners and managing members, and the directors, executive officers, other officers participating in the offering, general partners, and managing members of the solicitor or its general partner or managing member).
- Investment managers of issuers that are pooled investment funds (as well as such investment manager’s general partners and managing members, and the directors, executive officers, other officers participating in the offering, general partners, and managing members of such investment manager or its general partner or managing member).
Disqualifying Events. Rule 506 is unavailable if any covered person has engaged in any of the following disqualifying events (of course the SEC, the court or other regulatory body issuing order can determine that disqualification is not necessary on a case-by-case basis). In addition, even if there is a disqualifying event, an offering will not lose the Rule 506 exemption if the issuer can establish that it did not know, and in the exercise of reasonable care based on factual inquiry could not have known, that a disqualification existed.
The following are the actual disqualification provisions.
- Criminal Convictions Related to the Securities Industry. An offering is disqualified if any covered person was convicted of a misdemeanor or felony (i) in connection with the purchase or sale of a security, (ii) involving the making of a false filing with the SEC, or (iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities. A conviction is disqualifying only if it occurred within five years before the Rule 506 sale in the case of the issuer, its predecessor, or an affiliated issuer, and ten years before the Rule 506 sale in the case of all other covered persons.
- Court Injunctions and Restraining Orders Related to the Sales of Securities. An offering is disqualified if any covered person is subject to a court order entered into within five years before the Rule 506 sale that restrains such person from engaging in any conduct or practice (i) in connection with the purchase or sale of a security, (ii) involving the making of a false filing with the SEC, or (iii) arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities. A court order is not a disqualifying event if either it was entered into more than five years before the offering (even if it remains in effect at the time of the offering) or if the court order is no longer in effect at the time of the offering (even if entered into within the five-year period).
- Final Orders of Regulators. An offering is disqualified if any covered person is subject to a final order (including a settlement order) of a state securities regulator, federal or state banking regulator, state insurance regulator, or the CFTC that (i) at the time of the Rule 506 sale bars the person from associating with an entity regulated by such regulator; engaging in the business of securities, insurance, or banking; or engaging in savings association or credit union activities; or (ii) is based on a violation of a law or regulation that prohibits fraudulent, manipulative or deceptive conduct and was entered into within ten years before the Rule 506 sale. Bars are disqualifying for as long as they are in effect, regardless of how long ago they were ordered. By contrast, final orders covered in clause (ii) cease to be disqualifying ten years after their entry.
- SEC Disciplinary Orders. An offering is disqualified if any covered person is subject to an SEC order under specified provisions of the securities laws that, at the time of the Rule 506 sale, (i) suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer, or investment adviser; (ii) places limitations on the activities, functions, or operations of such person; or (iii) bars such person from being associated with any entity or from participating in an offering of penny stock. Disqualification continues for as long as some act is prohibited or required to be performed pursuant to the order. As a result, there is no cut-off date if the order involves a permanent prohibition. However, if the order calls for performing a specific act (such as paying a penalty), the order is no longer disqualifying once the required act has been fully performed.
- SEC Cease-and-Desist Orders. An offering is disqualified if any covered person is subject to an SEC order entered into within five years before the Rule 506 sale that orders the person to cease and desist from committing or causing violations or future violations of (i) any scienter-based anti-fraud provision of the federal securities laws, or (ii) Section 5 of the Securities Act.
- Suspension or Expulsion from SRO Membership or Association with an SRO Member. An offering is disqualified if any covered person is suspended or expelled from membership in, or suspended or barred from association with, a stock exchange or other self-regulatory organization for conduct inconsistent with just and equitable principles of trade.
- SEC Stop Orders. An offering is disqualified if any covered person was an issuer or underwriter of an offering which, within five years of the Rule 506 sale, was subject to an SEC stop order or order suspending Regulation A exemption, or is, at the time of the sale, the subject of an investigation or proceeding to determine whether such an order should be issued.
- US Postal Service False Representation Orders. An offering is disqualified if any covered person is subject to a US Postal Service false representation order entered into within five years before the Rule 506 sale, or is, at the time of the sale, subject to an injunction or temporary restraining order with respect to conduct alleged to constitute a scheme for obtaining money or property through the mail by means of false representation.
Transition Matters. Disqualifying events that occurred before the effective date of the Rule 506 amendments will not make Rule 506 unavailable. However, a description of any such events must be provided to each purchaser a reasonable time before the Rule 506 sale. In addition, disqualifying events relating to an affiliated issuer will not disqualify the offering if they occurred before the affiliate relationship existed.