Optima Law Group Blog

Opportunities and Landmines: Changes In Rule 506 and Reg D (Part 2)

On September 23, 2013 (the “Effective Date”), all companies that rely on a Rule 506 exemption for their securities offerings were affected by the SEC’s new ‘bad actor disqualification.’ The ‘bad actor disqualification’ affects all securities offerings that rely on Rule 506, even those made by companies that choose not to engage in general solicitation under the new Rule 506(c). Your company’s securities offering is at risk of losing its Rule 506 exemption if a “covered person” engages in a “disqualifying event” on or after the Effective Date, and you must give written disclosure to your company’s investors for those that occurred prior to the Effective Date.

“Covered persons” include:

  • the issuer, including its predecessors and affiliated issuers;

  • directors, general partners, and managing members of the issuer;

  • executive officers of the issuer, and other officers of the issuers that participate in the offering;

  • 20 percent beneficial owners of the issuer, calculated on the basis of total voting power

  • promoters connected to the issuer;

  • for pooled investment fund issuers, the fund’s investment manager and its principals; and

  • persons compensated for soliciting investors, including their directors, general partners and managing members.

“Disqualifying events” include:

  • Certain criminal convictions;

  • Certain court injunctions and restraining orders;

  • Final orders of certain state and federal regulators;

  • Certain SEC disciplinary orders;

  • Certain SEC cease-and-desist orders;

  • SEC stop orders and orders suspending the Regulation A exemption;

  • Suspension or expulsion from membership in a self-regulatory organization (SRO), such as FINRA, or from association with an SRO member; and

  • U.S. Postal Service false representation orders.

If a covered person engages in a disqualifying event and no exception or other exemption from registration is available, your company’s investors will have the right to rescind their investments for one year and get their money back.

With these dire consequences in mind, we advise you to do your due diligence by distributing questionnaires and creating written procedures for assessing potential bad actors. Your company is now required to take preemptive action to avoid disqualification, and you need to be prepared to make representations as to the compliance of your company and all covered persons. For these reasons, you should always work with qualified counsel when initiating or altering your Rule 506 offering. 

Opportunities and Landmines: Changes In Rule 506 and Reg D

On September 23, 2013, major changes to the SEC’s Rule 506 went into effect that create new opportunities and impose new burdens on companies (issuers), especially start-ups, looking to raise capital to grow their ventures. Companies that rely on Rule 506 as an exemption for their securities offerings MUST be alerted to these recent changes and remain vigilant in order to stay compliant.

On the opportunity side, in the past, companies were barred from public soliciting and/or advertising (i.e., general solicitation). Now, companies can potentially advertise the sale of their stock under the new Rule 506(c). Your company can engage in general solicitation—for example, advertising on television or the Internet—if the following strict requirements are met:

  1. The offering can only be made to accredited investors;

  2. Your company must take reasonable steps to verify that all purchasers of the securities are accredited investors;

  3. Your company must comply with new Form D filing requirements; and

  4. Advertising materials with proper legends must be submitted to the SEC in advance of the solicitation.

While it is an exciting time for companies raising capital, the SEC rules on this subject are still developing. Our recommendation is to proceed cautiously and allow time for further development of the rules. The SEC has not yet clarified what constitute “reasonable steps to verify that all purchasers of the securities are accredited investors,” and the opportunity for general solicitation is tempered by restrictions that could burdensome for your company. 

Next time, I will be continuing this series and highlighting another recent, major development that affects each and every company’s offering that relies on a Rule 506 exemption.