Bad actors! Bad actors everywhere!

Well, maybe.  The SEC doesn’t like bad actors in securities offerings.  Since finalizing its Disqualification of Felon and Other “Bad Actors” from Rule 506 Offerings, the SEC has copied and pasted (with a few differences) the same disqualification terms into its proposed rules for securities crowdfunding and proposed amendments to Regulation A.

As a reminder, the disqualification works like this: an offering is disqualified from relying on Rule 506, Section 4(a)(6), or Regulation A if the issuer or any other covered person in the offering has a relevant criminal conviction, regulatory or court order, or other enumerated event.  Great, you say, liars get caught and now they have to pay.  However, as we have noted before, securities fraud is a broad concept and it does not necessarily take malicious intent to end up with a record of violation of securities law.

While the disqualification currently only applies to relevant bad acts done on or after September 23, 2013, an issuer must still disclose the existence of any bad actors in the offering.  Going forward with a securities offering when the issuer is disqualified, or not disclosing the involvement of a bad actor, have serious consequences of their own.  The likely result for making an offering that is totally disqualified will be liability for violating Section 5 of the Securities Act, and the possible outcome for failing to disclose a bad actor is liability under the securities anti-fraud rules for omitting important information.

Companies planning to issue securities under an exemption from registration should be aware of the sheer number of entities and people who have to be taken into account.  According to the SEC, “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.

For context, let’s use the situation of a real estate development.  In a typical real estate deal offering securities under Rule 506, investors will purchase interests in a fund that will purchase an interest in the development or make loans to the development.  In this situation, the covered persons could include the fund, the fund manager, the broker-dealer facilitating the offering, the developer (and there may be may than one developer), and every director, general partner, 20 percent owner, managing member, executive officer and officer participating in the offering of each entity.  That is a lot of people that could throw a wrench into your securities offering.

Fortunately, the issuer will not be disqualified or face liability for not disclosing bad actors 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. In order to demonstrate the “exercise of reasonable care” the SEC requires that the issuer make a “factual inquiry” into whether any disqualification exists.

Here are CrowdCheck, we are in the business of factual inquiries, be it due diligence on your securities offering or verifying that there are no covered persons with disqualifying events. Our Checks are robust and will help you discover past events that could affect your offering and provide assurance that you have exercised the “reasonable care” required by the bad actor rules.

Join CrowdCheck

More Blogs