Bad Actors Under Rule 504 of Regulation D
Regulation D provides an exemption from registration under the Securities Act of 1933 for the offer and sale of securities. As you may know, the Securities and Exchange Commission made significant changes to Regulation D that took effect in 2017. Among the more important changes were:
- Abolition of Rule 505 (effective May 22, 2017);
- Raising the maximum amount that can be raised under Rule 504 from $1 million to $5 million (effective January 20, 2017); and
- Applying the “bad actor” rule to Rule 504 transactions (effective January 20, 2017).
Regulation D Background
Normally, a company conducting an offering of securities (an “Issuer”) must comply with all of requirements of the Securities Act of 1933, including extensive disclosure requirements. However, Regulation D is an exception allowing for the offering and sale of securities intended to encourage small businesses and startup companies or sales to accredited investors who are more capable of protecting themselves in private placements.
However, Regulation D still requires disclosure of significant information and various filings. For example, Issuers under Rule 504 and 506 must file a notice with the SEC on Form D within 15 days after the first sale of securities in the offering.
There are also significant limitations on who can buy securities being offered or sold under Regulation D. For example, with some exceptions, the securities are to be sold only to “accredited investors” under Rule 506(c), and while a limited number of unaccredited investors are allowed under Rule 504 and Rule 506(b), these exemptions place limitations on general solicitations and advertising.
In addition, under Rule 506, so-called “bad actors” are prohibited from offering and selling securities under Regulation D. Those prohibitions now apply to offerings and sales under Rule 504.
The “Bad Actor” Disqualification Under Rule 506
The “bad actor” disqualification provisions disqualify persons and entities from using Regulation D if the issuer or “covered persons” has experienced a “disqualifying event.” The most common “disqualifying event” is being convicted criminally of certain acts, including but not limited to convictions related to securities fraud. Other “disqualifying events” include, without limitation, a “covered person” being served with and/or having imposed:
- Court injunctions and restraining orders related to securities;
- Certain final orders of certain state and federal regulators;
- SEC disciplinary orders;
- SEC cease-and-desist orders;
- Suspension or expulsion from membership to certain securities-related organizations;
- Certain SEC stop orders; and
- U.S. Postal Service false representation orders.
A “covered person” includes:
- The issuer and its predecessors and affiliates;
- Directors, officers, general partners, or managing members of the issuer;
- Beneficial owners of 20% or more of the issuer’s outstanding voting securities;
- Promoters connected with the issuer; and
- Persons compensated for soliciting investors.
Issuers of securities under Rule 504 and Rule 506 must conduct a factual inquiry to determine whether any persons involved in the offering or sale has had a disqualifying event. The existence of such an event for any person so affiliated will generally disqualify the offering as being exempt under Regulation D. Some disqualifying events are only disqualifying if they occur during the so-called “look-back period,” which is defined in the regulations. A court injunction, for example, has a “look-back” period of five years.
Bad Actor Disqualification Under Rule 504 Will Only Apply to post-January 20, 2017 Events
In issuing the revisions to Regulation D, the SEC declined to connect “bad actor” disqualification events under Rule 506 to the new provisions of Rule 504. Thus, disqualification events that occurred before January 20, 2017, the effective date of the Rule 504 amendment, will not be disqualification events for Rule 504. However, such events will still be disqualifying under Rule 506 and such events must be disclosed in writing to each Rule 504 purchaser.
Contact San Diego Corporate Law
For further information on Regulation D, accredited investors, and private placements and other private securities offerings, contact Michael J. Leonard, Esq., of San Diego Corporate Law by email or by calling (858) 483-9200.