SEC Proposes Amendments to Regulation D Rule 506 to Disqualify "Bad Actors" From Private Placement Transactions

August 1, 2011 Advisory

The U.S. Securities and Exchange Commission (the "SEC") recently proposed amendments to Regulation D to disqualify issuers from taking advantage of the Rule 506 safe harbor with respect to any offering involving felons or other bad actors. The SEC is issuing these rules pursuant to the requirements set forth in the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Rule 506 allows unregistered sales of an unlimited dollar amount of securities to an unlimited number of accredited investors, and up to 35 non-accredited investors. This safe harbor is available so long as there is no general solicitation, appropriate resale limitations are imposed, any applicable information requirements are satisfied, and the other conditions of the rule are met.

Rule 506 is by far the most widely used of the Regulation D safe harbors, accounting for more than 90% of all offerings under this regulation.


As proposed, the amendments would prohibit issuers from relying on the Rule 506 safe harbor if any "covered persons" have been subject to certain disqualifying events, including, for example, a conviction of securities fraud within the last ten years.

The proposed Rule would also include a reasonable care exception and a waiver provision, under which an issuer would not lose the benefit of the Rule 506 safe harbor.

Covered Persons
The disqualification provisions of the proposed amendments to Rule 506 would cover the following persons:

  • the issuer and any predecessor of the issuer or affiliated issuer;
  • any director, officer, general partner or managing member of the issuer;
  • any beneficial owner of 10% or more of any class of the issuer's equity securities;
  • any promoter connected with the issuer in any capacity at the time of the sale;
  • any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and
  • any general partner, director, officer or managing member of any such compensated solicitor.

Disqualifying Events
Under the proposed amendments, an issuer would be prohibited from using the Rule 506 safe harbor if any covered persons have been subject to any of the following types of disqualifying events:

  • recent felony or misdemeanor convictions relating to the purchase or sale of a security, involving false filings with the SEC, or arising out of the conduct of professionals such as brokers, dealers or investment advisors;
  • court injunctions and restraining orders relating to the purchase or sale of a security, involving false filings with the SEC, or arising out of the conduct of professionals such as brokers, dealers or investment advisors;
  • final orders of certain state regulators (such as state securities, banking and insurance regulators) and Federal regulators barring the person from associating with certain industry entities;
  • SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons that bar or limit industry registrations or activities;
  • suspension or expulsion from membership in a securities self-regulatory organization, or suspension or bar from associating with a member of a securities self-regulatory organization;
  • SEC stop orders and orders suspending a registration exemption; and
  • U.S. Postal Service false representation orders.

Reasonable Care Exception
The proposed amendments would also include a reasonable care exception. Under this exception, an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it could show that it:

  • did not know of the disqualification; and
  • in the exercise of reasonable care, could not have known of the disqualification.

To establish reasonable care, the issuer would be expected to conduct a factual inquiry, the nature and extent of which would depend on the facts and circumstances of the situation.

As proposed, issuers that would otherwise be disqualified from using the Rule 506 safe harbor would be able to seek a waiver from the SEC. Issuers seeking a waiver would be required to show good cause why it is not necessary under the circumstances to disqualify the issuer from relying on the Rule 506 safe harbor.


The SEC is considering amending related rules and regulations to make the application of bad actor disqualification uniform. Without such amendments, Rule 506 would have different bad actor disqualifications from the other more limited safe harbor rules under Regulation D.

The SEC is also considering adopting a uniform ten-year look-back period for disqualifying events. Without such amendments, there would be a ten-year look-back period for the final orders of certain state and Federal regulators and for some criminal convictions, and a five-year period for all other events.


If Rule 506 is amended as proposed, issuers will have to comply with the increased factual inquiry burdens under Rule 506 or either rely on other more restrictive safe harbors under Regulation D or take the less protective approach of arguing that its offering is exempt from registration pursuant to Section 4(2) of the Securities Act.

Although an issuer might be able to comply with the Securities Act by relying on the Section 4(2) exemption, offerings made under this exemption alone do not generally constitute an offering of a covered security. Section 4(2) offerings are therefore subject to state-level bad actor disqualifications and certain registration and review requirements.

Issuers that rely on the amended Rule 506 safe harbor will need to implement procedures to screen out "bad actors" from their offerings. As noted above, to establish reasonable care in screening, the issuer would need to conduct a factual inquiry into the background of the broad group identified as "covered persons," the nature and extent of which would depend on the facts and circumstances of the situation. At the present time, the SEC has provided no additional guidance about the standard for reasonable care.

Until it becomes clear what set of screening procedures or questionnaires will meet the SEC's definition of reasonable care, issuers will have to weigh the costs and benefits of different bad actor screening procedures. This uncertainty will likely increase the risks associated with Rule 506 offerings in the near future.