Remedying Rule 506 “bad actor” disqualification through reasonable care

The SEC’s Rule 506 “bad actor” amendments went into effect September 23, 2013. As we reported previously, these amendments add Rule 506(d) to implement Regulation 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the rule, securities offerings involving certain “felons and other ‘bad actors'” are disqualified from the Rule 506 exemption unless the disqualification is waived or remedied through a “reasonable care” exception. (See Securities Act Release No. 9414, 78 Fed. Reg. 44,729; July 24, 2013).

The rule’s long list of disqualifying events – and an even longer list of covered persons – is raising consternation as issuers and practitioners come to grips with the challenges of compliance. A disqualification due to the presence of “bad actors” can be catastrophic, resulting in the loss of the exemption altogether, spilling into regulatory actions, litigation, and reputational issues. And any impediment to raising capital is likely to scare away investors.

The rule provides an exception from disqualification if the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The SEC has not prescribed specific steps to establish reasonable care; however, it has indicated that the concept includes a factual inquiry in view of the particular facts and circumstances and other offering participants. Despite the procedural ambiguity, the message is clear that is not enough to show that the issuer was unaware of the disqualifying event – the issuer must establish that in exercising “reasonable care,” could not have known that a disqualification existed.

In anticipation of this ruling, SI has been including “disqualifying event” searches in many of its reports for over two years. Now that the ruling has gone into effect, SI also offers a specialized factual inquiry service to help our clients evidence “reasonable care” under the highest standards. For information, please contact Dave Lazar at 440-423-1157 or e-mail dlazar@scherzer.co or Jessica Staheli at 818-227-2598 or e-mail jstaheli@scherzer.co.