United States: SEC Gets Tough On Bad Actors

Last Updated: September 20 2013
Article by Valérie Demont and Brian S. Korn

New Securities and Exchange Commission (SEC) Rule 506(d), which is set to take effect September 23, 2013, disqualifies securities offerings from reliance on the private placement exemption of Rule 506 of the Securities Act of 1933, as amended (the Securities Act), if certain felons and other "bad actors" are involved in the offering.

The rule was mandated by Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, and applies to both traditional Rule 506(b) private placements (sales to accredited investors and to up to 35 non-accredited investors without any general solicitation) and to new Rule 506(c) private placements (sales to accredited investors only, but using general solicitation).

Because Rule 506 is the most frequently used private placement exemption from SEC registration, these new rules are expected to cause significant added due diligence on securities market participants and likely embarrassing revelations, and certain persons being de facto barred from significant capital markets involvement.

Disqualification will not arise as a result of triggering events that occur before the effective date of the rule (unless the adjudication occurs after the effective date); however, matters that existed before the effective date of the rule and would otherwise be disqualifying are subject to a mandatory disclosure requirement to investors.

What Is a Bad Actor/Bad Actress? (Hollywood Jokes Aside)

Persons covered by the rule are an issuer, placement agent and other compensated solicitor, and each of their respective directors, executive officers, any officer involved in the private placement, and holders of 20 percent of the voting securities of such entities. The disqualification also covers the investment managers (including sub-advisors), general partners or managing members of a fund, and their principals and officers.

The disqualifying bad acts and relevant look-back periods are set forth in the following table:

Bad Act Look-Back Period
Criminal convictions in connection with the sale of securities or making false statements to the SEC Issuers – 5 years

All others (including issuer executive officers and directors) – 10 years
Court orders, judgments or decrees in connection with the purchase or sale of securities or in connection with the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor 5 years
Final orders of certain regulators, including state securities commissions, state banking authorities, state insurance commissions, federal banking agencies or the National Credit Union Association, which bar the person from:
  • association with an entity regulated by such commission
  • engaging in the business of securities, insurance or banking, or
  • engaging in saving association or credit union activities
Longer of duration of final order or 10 years from final order based on violation of fraudulent, manipulative or deceptive conduct, if applicable
CFTC orders (bar or final orders) relating to violations of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct Longer of duration of final order or 10 years from final order
SEC disciplinary orders under Sections 15(b) or 15B(c) of the Securities Exchange Act of 1934, as amended (the Securities Exchange Act), or 201(e) or (f) of the Investment Advisers Act of 1940, as amended, that:

  • suspends or revokes such person's registration as a broker, dealer, municipal securities dealer or investment adviser
  • limits such person's activities function or operations, or
  • bars person from association with any entity or from participating in an offering of penny stock
Duration of order
SEC orders prohibiting future violations of any scienter-based anti-fraud provision, including Sections 5 and 17(a) of the Securities Act, and Sections 10(b) of the Securities Exchange Act 5 years from date of order
Suspension or expulsion from membership in or bar from association with a member of a national securities exchange or registered national securities association (currently FINRA is the only registered national securities association) Duration of suspension or expulsion
Regulation A bad-actor stop-orders 5 years
U.S. Postal Service false representation orders Longer of 5 years or duration of order

Exceptions to the Bad-Actor Disqualification from Rule 506 Private Placements

In the following situations, an issuer will not be disqualified from the use of Rule 506 Private Placements:

  • Adjudications that predate enactment of the rules (September 23, 2013) – but disclosure is required if the timing of the bad act would have caused disqualification (i.e., within the applicable look-back period)
  • SEC can grant waiver
  • Court or agency can opt out of bad-actor disqualification when sentencing
  • Issuer's knowledge exception – if the issuer can establish it did not know of disqualifying bad-actor violations and could not have known with the exercise of reasonable care.

What Are the Consequences of Discovering a Bad Actor Following a Rule 506 Private Placement?

Even though the detection of an unknown bad actor is going to be rare, each issuer, advisor and placement agent will need to be prepared to represent that it is in compliance with the bad-actor disqualification requirement and potentially indemnify other parties to a transaction in the event a bad actor is later discovered. If a disqualifying bad actor is discovered and none of the exceptions are available, and no other Securities Act registration exemption is available (e.g., Rule 144A, Regulation S, Section 3(a)(9)), the private placement exemption will be lost, causing the issuer to have engaged in an unregistered public offering in violation of Section 5 of the Securities Act, which gives investors the right to rescind their investment for one year.

FINRA Catches Bad-Actor Fever and Modifies New Private Placement Forms to Inquire About Bad Actors

FINRA (not to be left out and probably curious what skeletons are lurking in issuer and private-fund sponsor closets) recently modified its newly required private placement filing form under Rules 5122 and 51231 to ask the following question:

"Has the issuer, any officer, director or executive management of the issuer, sponsor, general partner, manager, advisor, or any of the issuer's affiliates been the subject of SEC, FINRA, or state disciplinary actions or proceedings or criminal complaints within the last 10 years?" (See FINRA Regulatory Notice 13-26, http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p325359.pdf).

This new question expands the bad-actor disqualification inquiry of issuers and others using broker-dealer placement agents and solicitors to inquire about disciplinary actions and proceedings and criminal complaints, not just final orders, adjudications and convictions. It also expands the look-back period from Rule 506(d) disqualification to ten years from five in most cases. It also expands the scope of the inquiry as it appears the question is not limited to financial or securities-related wrongdoing. On the other hand, FINRA is merely gathering data and is not disqualifying respondents who answer in the affirmative. At least not yet ...

On the positive side, this question need not be answered if the transaction is exempt from filing under Rules 5122 and 5123, which generally includes all private placements of broker non-affiliate securities sold only to non-individuals and employees.

What Should Issuers and Other Capital Markets Participants Do ASAP?

  • All corporate issuers and funds that rely on the Rule 506 private placement safe harbor for their offerings of securities and covered persons involved in such private placements need to immediately assess their potential compliance with the bad-actor disqualification requirement. Frequent private placement participants (including investment funds) should develop a bad actor assessment policy or have written procedures in place to manifest the firm's compliance with the rule.

    • In the final version of the rules, the SEC limited the scope of bad actors to any executive officers and, with respect to other officers, only to those participating in the offering. This significantly reduces the work of the investment banking compliance community, which had been concerned that the previous formulation of "any officer" would require the polling of personal data of thousands of bank employees who have officer titles (e.g., vice president, director, managing director), most of whom would not be working on or even be aware of the private placement. Broker-dealers should consider amending written supervisory procedures and monthly checklists to hasten "up-the-ladder" reporting of bad acts.
  • Compliance officers, lawyers and advisors should create a list of all potentially affected persons and distribute questionnaires to such persons immediately. These questionnaires should be circulated for updating at least annually. In particular, issuers should include bad-actor qualifications in their directors' and officers' questionnaires annually and at the time of each 506 securities offering. Such questionnaires should also be addressed to their 20 percent voting security holders as well.
  • Covered persons will also need to review their hiring policies to identify potential bad-actor job applicants.
  • Covered persons should also review their insurance coverage in light of these new rules.
  • Covered persons will need to be prepared to make representations as to their compliance with the bad-actor disqualification requirement, as well as the compliance of their directors, executive officers, officers participating in the offering and their 20 percent security holders or general partners. They also should be prepared to indemnify other parties to the transaction in the event a bad actor is discovered which disqualifies a previous Rule 506 private placement.
  • The rules will likely result in embarrassing revelations for some who had managed to keep their bad acts secret from their employers, or firms that kept an officer's or director's bad acts secret from clients, investors and regulators. Given the dire consequences of disclosure or disqualification firms face with this rule, some bad actors could be fired or effectively barred from hiring, posing business and ethical dilemmas. Short of receiving an SEC exemption, firms that rely on, or are active participants in, Rule 506 private placements will have the choice of demoting, terminating or shifting bad actors' responsibilities within the firm so that they do not participate in the offering.

Pepper Points

  • As a practical matter, any registered representative of a FINRA-regulated broker-dealer who has committed any disqualifying act would most likely have such act already disclosed on their Central Registration Depository (CRD). CRD records can be obtained from the FINRA BrokerCheck Web site, http://brokercheck.finra.org. The SEC did address the ex post facto argument by disqualifying only those bad actors who commit future bad acts or are adjudicated after the effective dates; many expect that the disclosure of past disqualifying acts will effectively punish the bad actor for past transgressions in the same manner as if the SEC had set an outright ban.
  • The SEC confirmed in the adopting release that its much-anticipated crowdfunding and Reg A+ rulemaking will have their own bad-actor disqualifications, despite not being required by the JOBS Act or Dodd-Frank.
  • The list of disqualifying acts in the bad-actor disqualification is limited to "financial" or securities-related bad acts. Violent non-financial bad acts and felonies (e.g., murder, rape, arson) do not exclude someone from participating in a Rule 506 private placement, it turns out. This means that our worst criminals are not affected by the bad-actor disqualification. Only Congress can decide to address this gap.


1 Pepper Hamilton has written extensively about Rules 5122 and 5123:

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Valérie Demont
Brian S. Korn
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