Richard W. Jones

Mr. Jones is an attorney with the Atlanta,Georgia law firm of Jones & Haley,P.C. Mr. Jones concentrates his practice on securities law matters,such as public offerings,IPO's,private placements,SEC compliance,broker/dealer and investment adviser regulation and hedge funds. For further information go to www.corplaw.net

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SEC Applies “Bad Boy” Rules to Regulation D Offerings

           Last year the US Securities and Exchange Commission proposed a new rule that would disqualify “bad actors” from using Rule 506 of Regulation D.  This is not a new concept,Rule 262 of Regulation A already has a “bad boy” disqualification,and many states also prohibit “bad boys” from using their exemptions.  However,the SEC was not reacting to activities in the marketplace by proposing the new rules.  They were reacting to Section 926 of the Dodd-Frank Act,which requires the SEC to adopt rules to disqualify certain persons from  making  use of the safe harbor provisions of Rule 506.

            Under the new proposal,the exemption provided by Rule 506 cannot be used if certain acts have been committed by certain “bad boys”.  In the Rule,these “bad boys” are referred to as “covered persons”.  The following are considered “covered persons” under the Rule:

            1.         The issuer and any predecessor of the issuer or affiliated issuers;

            2.         Any director,officer,general partner or managing member of the issuer;

            3.         Any beneficial owner of 10% or more of any class of the issuer’s equity securities;

            4.         Any promoter connected with the issuer in any capacity at the time of the sale;

            5.         Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities in the offering;and

            6.         Any director,officer,general partner or managing member of any such compensated solicitor.

            The disqualifying events under the Rule,are the following:

            1.         Criminal convictions occurring within the past 5 years for issues and the past 10 years for other covered persons;

            2.         Court injunctions and restraining orders if issued within the past 5 years;

            3.         Final Orders of certain state regulators (such as state securities,banking and insurance regulators and federal regulators) in effect at the time of the proposed offering or if the final order is related to a securities violation or fraudulent conduct then the period extends to  ten years after the order is entered;

            4.         Commission disciplinary orders relating to brokers,dealers,municipal securities dealers,investment advisors and investment companies and their associated persons,if in effect at the time of the proposed 506 offering;

            5.         Suspension or expulsion from membership in,or suspension or bar from associating with a member of a securities regulatory organization if the suspension or order is still in effect at the time of the proposed 506 offering;

            6.         Commission Stop Orders entered within 5 years of the proposed offering and Orders suspending a Regulation A offering or if an investigation is being conducted into conduct that could result in a Stop Order,the 506 offering exemption would be prohibited;and

            7.         The entry of a US Postal Service false representation Orders within the past 5 years.

Accordingly,under the Rule,any securities offering that is associated with a “covered person” as defined above would be disqualified from the use of the exemption provided by Rule 506 if those “covered persons”  had committed any of the acts described above.  This limitation could create great hardship for issuers where a person peripherally associated with the offering has been involved with one of the disqualifying events listed.  A good example of this is the limitation on 10% shareholders.  Under the Rule,any shareholder that owns 10% of any class of securities would disqualify an issuer from the use of Rule 506 if he has been involved in a disqualifying event.  This could be especially troublesome for small issuers and start ups,where many of the owners involved in the startup process will generally own more than 10% of the company.

            Fortunately,in order to prevent hardship,the SEC has the authority to grant waivers “upon the showing of good cause and without prejudice to any other action”.  By using this power,the SEC has the authority under the Rule to waive any applicable disqualification under the proper circumstances.  The problem with this power is whether the process would be lengthy and expensive,thereby limiting its usefulness.

            In addition,the Commission has proposed a “Reasonable Care Exception” to the Rule,which would avoid the impact of the Rule for an offering where the issuer establishes that it did not know,and,in the exercise  of reasonable care,could not have known that a disqualification existed, because of the presence or attendance of a concerned person.

            It is important to note that the new Rule does not apply to investment advisors or the directors,officers,general partners or managing members of such investment advisors.

            All in all the new Rule creates some serious limitations on the ability of issuers to rely on one of the Commission’s most useful exemption from registration—i.e.  Rule 506–and it creates traps for the issuer,who could have the exemption declared unavailable after the fact,thereby subjecting  the issuer to liability for the sale of unregistered securities in violation of the Securities Act of 1933.  Accordingly,if the proposed Rule passes,future issuers will be required to be much more diligent in their knowledge of the rules and their knowledge of the background of the people associated with the offering.

            Fortunately,the new “bad boy” rules only apply to Rule 506 offerings.   This creates a planning opportunity for those  issuers who may have a “bad boy” associated with a proposed private placement. It will be necessary for these issuers to do their research in order to find  other exemptions at the state and federal level in order to conduct the securities offering and avoid  registration.

            The proposed Rule is still pending and it could be enacted in an alternative format,so future issuers should be alert to the final form of the rule that is enacted.

            Richard W. Jones is an Atlanta business lawyer and an Atlanta securities lawyer  with the Atlanta,Georgia law firm of Jones &Haley,P.C.  He has over 30 years experience representing clients in securities and corporate matters.  Please see our website at corplaw.net          .

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