Friday, July 12, 2013

SEC'S Bad Actor Rule: When You Lie Down with Dogs Expect to Get Fleas

 By Jim Verdonik

I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals, have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at or Or you can check out my eLearning course at
or or you can purchase my books at

 On July 10, 2013 the Securities and Exchange Commission expressed faith in the old adage "If you lie down with dogs expect to get fleas" by approving its final Bad Actor Rule for Rule 506 private placements. 

 Here's a link to the page of the SEC's website that contains the Bad Actor Rule in SEC Release 33-9414:  Most of the SEC's release explains the rule and the reasons for it, but the full text of the new rule is at the end of the release.

Some people might complain that the SEC is making many people pay for a few people's bad acts.  If the SEC makes it more difficult for a business to raise capital, because a person related to the business or an intermediary did something bad at some point during the past ten years, all the investors in the business risk losing their investment.  Is this additional investor risk necessary - especially in light of the fact that the bad action doesn’t have to be related to this current business?

Any impediment to raising capital is likely to scare away some investors, because a business' ability to raise additional capital is important to many business plans.  So, investors have another thing to look for in due diligence.   Before you invest, ask about the past history of all the officers, directors, other investors and intermediaries.

 But after much debate, the SEC seems to have decided that it's more important to try to make it more difficult for the fleas to bite new investors than to worry about collateral damage to existing investors, founders and employees. 

Of course, many teachers think cancelling recess for the entire class is a useful disciplinary tool even if only two children in the class are misbehaving.  Teachers use  class-wide punishments to exert peer pressure.  This can be effective if it motivates the other twenty children in the class to police the misbehaving students.  But students usually have no choice about their classes and their teachers.  Investors can just decide not to invest.

Only time will tell whether the SEC's disciplinary strategy works so that investors get rid of bad actors or whether this policy will just reduce the amount of capital American businesses can raise.


Bad Acts

The new rule lists list eight (8) bad acts.  Because the rule takes several pages to define these bad acts in detail, we won't repeat these lengthy definitions here, except to say that all the bad acts relate to securities or financial industry related violations, but the list extends beyond fraud to other types of violations. 

Covered Person/Bad Actors

 The rule applies if any of the following persons or organizations commits a "bad act":

·         the business selling securities
·         a predecessor business
·         affiliated issuers (entities that control, are controlled by or are under common control with the issuer)
·         directors
·         executive officers, general partners or managing members of the business selling securities
·         other officers who participate in the securities offering
·         beneficial owners of 20% or more of the business' voting power
·         investment managers if the business selling securities is a pooled investment fund
·         promoters
·         investment bankers or others who are directly or indirectly paid to solicit in the offering and all of their general partners, directors, executive officers any of their other officers who participate in the offering

Penalty for Bad Acts: You Cannot Use Rule 506 as an Exemption from the Registration Requirements of Section 5 of the Securities Act of 1933

If the bad act by a covered person happens after the rule becomes effective, the business cannot use Rule 506 to sell securities. 

If the bad act happened before the new rule became effective, the company must disclose the bad act and the bad actor, if the company wants to use Rule 506.  Most companies will want to avoid this type of disclosure to investors, unless the bad actor has little or no influence over the business or the bad act involved only a technical violation.

 Why is Rule 506 Important?

This is an important rule because most securities offerings use Rule 506 as an exemption from registration.  One reason for Rule 506's popularity is that Rule 506 preempts state securities laws other than fraud and certain notice filings.  Preempting state securities laws allows securities offerings to close quickly and reduces compliance costs.  This is especially useful in multi-state private placement offerings.  If you limit sales to only accredited investors, Rule 506 allows you great flexibility in what you tell investors and how you tell them as long as you don't commit fraud.  Under new rules, you can also use advertising and other media to conduct a general solicitation in Rule 506 offerings.

What Happens If you Try to Use Rule 506 When the New Rule Prohibits It?

If you try to use Rule 506 to exempt offers and sales of securities, but the Bad Actor Rule disqualifies you from using Rule 506, you can still rely on another Federal securities exemption, but only if you have met all the terms and conditions of the other offering exemption.  

Factors that might disqualify you from using other securities exemptions include: the size of the offering, the number of investors and the wealth and sophistication of the people who purchase securities, what information you give purchasers and how you solicit purchasers.  Rule 506 is generally the most flexible alternative for each of these issues.

 But even if you qualify for another Federal securities offering exemption, you may violate state securities laws, if the Federal exemption you use does not pre-empt state securities laws like Rule 506 does.

 If you don't have a Federal exemption, or if you don't comply with state securities laws, the usual remedy is rescission.  That means that investors have the right to get their money back, plus interest.  If the business cannot pay the money back, officers and directors, investment bankers and others might have personal liability.

This creates the possibility of an unusual result.  The person who committed the bad act that disqualifies you from using the Rule 506 exemption might not have personal liability, but officers and directors of the business who did not commit any bad acts could have personal liability.

The Bad Actor rule is most likely to be used by plaintiffs' lawyers who are unable to prove that a business committed any fraud.  But if they can find one bad actor among the large group persons the Bad Actor rule covers, they can win the same damages that would be available if fraud had occurred.

Spillover Effect of New Rule

Technically, the new rule applies only to Rule 506 offerings.

But this rule will probably spill over into other types of offerings beyond Rule 506 offerings, because companies that raise capital will want to avoid any appearance of a problem even if the new rule technically doesn't apply to them. 

People on juries are not likely to conclude that it's OK to have bad actors in a Rule 504 offering, if it's not OK in a Rule 506 offering.  If a company fails to disclose bad acts and bad actors in any type of securities transaction, the company will risk that the omission will be determined to be a material omission that constitutes fraud. 

Arguably, failing to disclose bad acts by people who run the business might be a material omission before the new rule.  So, even if an officer, director, promoter or other person has done something that is not technically a bad act under this new rule, you still have to decide whether it is a material fact you have to disclose to investors.

 Bad Acts Before the New Rule Became Effective

Technically, the new  rule only covers convictions, orders, judgments and other legal events that occur after the new rule is in effect (60 days after publication in the Federal Register).  This means that bad acts that occurred before the new rule is effective would only be covered by the new rule if the conviction, order, judgment or other legal event occurs after the new rule is in effect. 

But most bad acts are likely to become disclosure issues even if everything occurs before the new rule becomes effective.  Why would investors not care about bad acts that occurred before the new rule? 

Of course, the number of people covered by the new rule includes many intermediaries.  Bad acts that aren't committed by people who are in the issuer's business might not be material.

If everything associated with the bad act happened before the new rule became effective, the company has to disclose the bad act and the bad actor to investors, if the company wants to use Rule 506.  Most companies will want to avoid this type of disclosure.

Compliance and Reasonable Care

The Rule provides that a business will still qualify to use Rule 506, if the business "establishes that it did not know, and in the exercise of reasonable care, could not have known that a disqualification existed."

This defense raises several issues:

·         How do you establish that you did not know something?  The burden seems to be on the business to prove it didn't know something.  Proving a negative can difficult.

·         If the bad actor is the business' CEO or a director, is their personal knowledge imputed to the business as a whole?  If not, how many people associated with the company have to know about the bad act for the business to be deemed to know?

·         What constitutes the "exercise of reasonable care"?  What does a business have to do to demonstrate it exercised reasonable care?

 What constitutes the exercise of reasonable care is likely to be the biggest issue that affects how businesses conduct securities offerings. 

What does "exercise reasonable care" mean?

Here's what the SEC's rule says:

"An issuer will not be able to establish that it has exercised reasonable care unless it has made, in light of the circumstances, factual inquiry into whether any disqualifications exist.  The nature and scope of the factual inquiry will vary based on the facts and circumstances concerning, among other things, the issuer and the other offering participants."

 This part of the rule makes three things clear:

·         The issuer must be able to show that it made some type of "factual inquiry" about whether any of the covered persons has committed a bad act.

·         The nature and scope of the factual inquiry can vary based on facts and circumstances.

·         Both the issuer and other offering participants are among the variables that can affect the nature and scope of the factual inquiry.

Beyond these three principles, the SEC leaves us to guess what type of factual inquiry is sufficient to constitute exercising reasonable care.

Its easy ot predict some things about the factual inquiries peolpe will make.  Both companies raising capital and investment bankers and other intermediaries will undoubtedly require covered persons to sign questionnaires that verify that they have not committed bad acts.

But will questionnaires be enough to establish that an issuer has used reasonable care?

Certainly, issuers can't rely on a form questionnaire, if they have reason to know the answers on the questionnaire are not true.

 But how do you identify who has to sign a questionnaire?  What if one or more sales agents are involved in the offering?  Or if many related shareholders own shares and might share beneficial ownership?  Do you have to verify that shareholders understand complex beneficial ownership rules?  How much digging do you have to do to create your list of covered persons?

What about agents who sell securities through other agents and pass along commissions?  How far does the verification trail lead us into intermediaries?

Do you have to search though officer personnel records?  What if an old past conviction is sitting in someone's employment file?

 What if you hire someone with a five-year gap in his or her resume?  Do you have to verify the person wasn't it prison?

Should you hire someone to do an internet research of criminal records?  For all covered people?  Or just for executive officers and directors of the issuer?

When should you look at someone to verify they are a covered person and have no bad acts? Businesses should do this with intermediaries and officers and directors before they hire them to avoid problems later.  But securities offerings can last a long time.  Facts can change. 

The SEC's release indicates that periodic updates should be sufficient in long continuous offerings, but the release does not give guidance about how often updates should occur.  If possible, you should re-check before each sale to be 100% safe.  But can you discipline yourself to do that?

Will all your covered persons be available on short notice to provide an update?

Small companies often raise capital in small increments over extended periods.  Often, they retain lawyers to prepare form documents, but they don't consult their attorneys each time they accept money.  This practice will raise due diligence issues in later investment rounds when later investors try to verify that investors in earlier rounds do not have rescission rights.


Promoters present a big challenge.  Promoter is another term for any founder of the business.  But unlike founders, promoter has a legal definition.  Promoters are people who directly or indirectly participate in initiating the organization of the business or who in connection with organizing the business receive 10% of any class of the securities of the business or 10% of the proceeds from sales of any class of securities of the business in exchange for services and/or property.  There are exclusions for underwriters and for people who contribute only property, if they don't otherwise participate in organizing the business.

That's pretty broad definition and it can be difficult to document years later who is a promoter and who isn't a promoter.  If all you have to do to be a promoter is to participate in initiating organization of the business, your name may never appear in any corporate documents and you might not even own shares of the business.  But bad acts by this person who has no formal connection to the business could disqualify the business from using Rule 506 to raise capital.
To protect your ability to raise capital, document that you made a factual inquiry about who the business' promoters are.  When you start a business, create a paper trail that indicates who participated in initiating organization of the business.

Investment Bankers and Other Intermediaries

Personnel at investment banks and other intermediaries often change.  How would an investor document in later due diligence who was a covered person at the time an investment round occurred two years earlier - especially for people associated with investment bankers and other intermediaries who often change firms?

Most businesses can check on their officers and director relatively easily.  Beneficial shareholders are often more difficult.  Intermediaries and their officers, directors and partners are even more difficult.  Presumably, intermediaries will be asked to provide blanket assurances about their own people.

But the SEC's release also talks about companies checking publicly available data bases for disciplinary actions against personnel at investment banks and other intermediaries.  Unless companies know the brokerage industry, it may be difficult for them to interpret information in these public data bases.

It might be reasonable for companies to do relatively light investigations of intermediaries and shareholders, but more intensive investigations of officers and directors who play active roles in the business.  The less influence someone has on the business and the offering, the less material their bad act would be to investor decisions to purchase securities.


 You have to hand it to the SEC.  They really know how to cut costs.  The SEC estimates that the factual inquiry to identify bad acts and bad actors will cost companies only $400 per offering.  We don't recommend you defend yourself by saying you stopped the factual inquiry into bad acts when you reached the SEC's $400 cost estimate. 

That expense estimate just pays for a standard questionnaire.  It doesn't allow much factual inquiry, especially since the factual inquiry covers beneficial ownership.  Beneficial ownership rules are complex.  Most shareholders don't understand them.  $400 doesn't allow for much in the way of explanations about beneficial ownership rules.  Since the factual inquiry also has to cover intermediaries and related persons, dozens of people may be involved.  Except in the smallest offerings by companies with few shareholders, compiling a list of covered persons probably will cost more than $400.

 On the other hand, the SEC is more realistic about the cost of disclosing bad acts.  The SEC estimates it will cost $5,200 to disclose bad acts that occurred before the rule becomes effective.  This is realistic if it's clear that something is a bad act.  But analyzing court and agency orders and other documents to determine whether something was a bad act as defined in the rule may be time intensive.

 Practical Effects of New Rule

The Bad Actor rule will impact companies that raise capital, investors and middlemen who facilitate securities offerings in several ways:

 (1)  If you are the business that is raising capital now or that may raise capital in the future, you will want to protect your businesses from having bad actor problems that would disqualify you from raising money using Rule 506 or that would require embarrassing disclosures to investors.  This requires heighted scrutiny of executive officers, directors, 20% shareholders and the people and entities that businesses use to raise capital.  You have to make factual inquiries to identify bad acts and bad actors to protect yourself.  This will require you to either change existing questionnaires or to create a new questionnaire.  Like other areas, you can't rely on a form questionnaire if you have reason to know the answers are not true.

 (2)  If you are an investment banker or other paid intermediary, companies will ask you to verify that you and people related to your organization won't create a bad actor problem.  Intermediaries should get ahead of the curve and obtain statements from people in your organization before you are asked to do so by others.  Registered intermediaries already track this type of information for their personnel.  But informal placement agents may not have systems in place.  If you use sub-agents to sell securities, do you have systems to verify that sub-agents and their coverred persons have not committed bad acts?

 (3)  Companies may ask investors to verify they won't cause bad actor problems, because of the 20% voting power test.  Because this applies to beneficial ownership, investors may be asked to verify who all their beneficial owners are and that none of the will create a bad actor problem.  This could make things complicated for families and others who utilize many trusts and other entities to make investments.

 (4)  Large investors will add Bad Actor checks to their due diligence lists.

 (5)  Companies or other investors may restrict share transfers or require investors to sign buy-back agreements or to lose rights to vote or to nominate directors if this becomes necessary to cure a bad acts problem.  Pricing buybacks will be an issue.  Should buy backs reflect market value?  Or should investors who cause bad acts problems suffer penalties by being required to sell their shares back at below market prices?

 (6)  Employees, officers and directors of issuers, middlemen and investors may be asked to sign documents to verify they will not create bad actor problems.  Employment and other agreements may provide the employment or other relationship can be terminated by the company, if the person creates a bad actor problem.  Clawback provisions in bonus and stock option grants may include penalties if a person causes a bad acts problem.

Employers' use of criminal backgrounds to screen employees is coming under increasing scrutiny.  Efforts to eliminate bad actor problems may have disparate effects on different ethnic groups, which could raise discrimination issues if companies are not careful how they implement bad actor programs. State and Federal employment related agencies may penalize your business for how it attempts to comply with this SEC rule.

 Special Rules

The SEC can grant waivers to the new rule, but don't expect the SEC to grant many waivers.

 Likewise, if a court or other regulatory authority that adjudicated the bad act says that the bad act should not disqualify use of Rule 506, the issuer can use Rule 506.

People may bargain with prosecutors and regulatory agencies when they enter into plea bargains to obtain language that preserves Rule 506 rights.

Because the rule applies to bad acts by affiliates of the issuer and the SEC broadly defines affiliates to include persons and entities that control, are controlled by or are under common control with another person or entity, the SEC created a special rule for affiliates.  An issuer can use Rue 506 if the bad act relates to an affiliated issuer, if the bad act occurred before the affiliation arose and other conditions of the rule are met.

Articles in Private Placement Series
In July 2013 the SEC made the biggest changes to private placement capital raising rules since the SEC issued Regulation D more than three decades ago.
More than 90% of private securities offerings are affected by these changes.
The SEC's recent changes are a mixed blessing for businesses selling securities.  These changes include:
  • Prohibiting using Rule 506 if someone affiliated with your business or with your capital raising efforts has violated securities or other financial industry laws. 
  • Adding new Rule 506 (c), which allows you to advertise when you raise capital in a private placement.
  • Rule 506 (c) also requires you to take reasonable steps to independently verify that all people who buy securities are "accredited investors," if you advertise your offering.
Our articles in this series about SEC Rule 506 private placements help you decide how you can use these new rules to raise the capital your business needs by balancing three competing factors:
  • Advertising effectiveness
  • Budget
  • Securities law compliance 
You have to get all three right to successfully raise capital.
Here's a list of our articles that discuss the primary issues you will face when you try to balance these three objectives in your capital raising efforts:
  • Advertising Messages   Tweeting Your Way to Securities Fraud in 140 Characters: What Do you Say in SEC Rule 506 (c) Advertising in Private Placements?  How do you decide what you say in your advertising?  How do you say it?  What current SEC and state advertising rules can you use to guide your advertising decisions?  Can you combine effective sales messages with complying with securities laws?  Or is it an either or choice?  What's the point of advertising if securities laws prevent you from selling effectively?
  • Choosing the Right Media for your Advertising. Don't Tweet when You Should Have LinkedIn: Choosing Your Advertising Media in SEC Rule 506 (c) Private Placements  How do you advertise within your budget?  How do you identify your "sweet spot" target investors and the right media to reach them?  What social media tools can you use?  How do you attract accredited investors who meet SEC criteria for making investments?
  • Building your Sales and Legal Team.  Would You Let Your Lawyer Run Your Sales Department?  How Can You Build the Right Team for Advertising in SEC Rule 506 (c) Private Placements?  How do you build teams to help you do effective advertising while still complying with SEC and state anti-fraud rules?  What role should your sales team play?  What role should your lawyer play?  How do you choose a lawyer who can help you create effective advertising that also complies with securities laws.
  • Accredited Investor Verification.  Will SEC Rule 506 (c)'s Permission to Advertise Cure Your Capital Woes or is Its Accredited Investor Verification Requirement a Poison Pill?  If you want to advertise your securities offering, you must take reasonable steps to verify that everyone you sell to is an "accredited investor."  You can't just rely on the investor checking a box that tells you it is accredited.  How much checking is "reasonable"?  How do you qualify for the "safe harbor" the SEC included in Rule 506 (c)?  What happens if you don't obtain the right type of proof that the people you sell securities to are "accredited investors?"  Why will some investors refuse to comply with your verification requests?  What can you do to reassure investors about privacy issues and make the verification process more convenient for investors?
  • Beware of SEC Integration Rules:  SEC RULE 506 (c) Integration Pitfalls: Don't Use the SEC's New Advertising and Solicitation Private Placement Rule to Saw Off the Limb You are Sitting On  Why should you look before you leap into advertising?  What integration and related pitfalls does Rule 506 (c) create for businesses that choose to advertise or engage in general solicitations?  How do you sell securities to people who are not accredited investors under another SEC private placement exemption, if your advertising doesn't attract enough accredited investors to finance your business?
·         Getting Caught : How Will the SEC Know I'm Advertising in a Rule 506 (c) Private Placement?   How will the SEC know about your advertising?  Why isn't it a defense that everyone else is breaking the rules?  How do you deal with the interim period when people are figuring out what the new rules let you do and don't let you do?
·         Bad Actors:  SEC's Bad Actor Rule: When You Lie Down with Dogs Expect to Get Fleas  To use Rule 506 (with or without advertising) you have to verify that a long list of people who are affiliated with your business or with selling your securities offering haven't violated securities or other financial industry laws.  How do you make sure the SEC's Bad Actor Prohibition for Rule 506 private placements from cut off your ability to raise capital?

If you would like to learn more about learning how to grow your business or other issues important to your success, you can reach me at or Or you can check out my eLearning course at
or or you can purchase my books at


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