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October 2013 Issue

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Article 1 : PRIVATE SALES OF SECURITIES CAN NOW BE PUBLIC

By Edward T. Swanson*

 

Introduction

Securities law relating to private placements is about to go “through the looking glass.” “Private” placements that are exempt from registration soon will permit public solicitations of purchases under specified circumstances.

Rule 506 under the Securities Act of 1933, which exempts from registration certain private sales of securities, has been amended effective September 23, 2013. Upon effectiveness, issuers will be permitted to make general solicitations, including newspaper and internet advertisements, in connection with s ales of securities pursuant to Rule 506, provided only accredited investors are permitted to participate in the offering and the certain requirements are satisfied. Most importantly, the issuer must take “reasonable steps” to insure that all purchasers are accredited investors. Traditional private placements still can be made pursuant to Rule 506(b), although issuers may want to re-examine the procedures they employ to confirm accredited investor status in such offerings.

Background

Historically, a business could raise money from the sales of its securities without the substantial cost and time of a registration statement by privately raising money. This was permitted by Section 4(2) (now 4(a)(2)) of the Securities Act of 1933 (Act), which exempted non-public offerings by an issuer from the registration requirement of the Securities Act. The problem was deciding what was a private sale of securities and what involved a “general solicitation” and therefore was not a private sale of securities. Because this was a difficult problem with serious legal (and consequently financial) consequences, the Securities and Exchange Commission (SEC) adopted Regulation D in 1982. One of the Rules contained in Regulation D is Rule 506, which provides a “safe harbor” for non-public offerings of any amount which met certain requirements, including the requirement that not more than 35 non-accredited investors (as defined in Rule 501 of Regulation D) purchase securities. However, even if all investors were accredited, the offering still could not involve a general solicitation, such as public advertisements or contacting strangers even though they might be accredited investors.

Since startup and early stage businesses often have exhausted the funds of friends and family and still need more capital for survival and/or growth, this restriction has been a great hindrance to such businesses in their quest for needed capital. Registered broker-dealers for the most part did not want to be involved with most startup and early stage businesses in need of funds, so these businesses were forced to seek “finders” and other non-regulated persons who frequently charged substantial fees up front and might or might not deliver investors. In short, there was a serious problem in that many young businesses did not have meaningful legal access to substantial investor funds otherwise potentially available. Despite this limitation, the SEC estimates that $173 billion was raised by operating companies in 2012 pursuant to Rule 506 offerings and an additional $725 billion by pooled investment funds such as venture capital funds, private equity funds, and hedge funds. Obviously, Rule 506 is an important exemption for issuers seeking capital in the U.S.

When the JOBS Act (officially, the Jumpstart Our Business Startups Act) was adopted by Congress in April of 2012, a provision of that act required the SEC to amend Rule 506 to permit general solicitation or general advertisings for offerings made solely to accredited investors. This change is extremely significant, because it transforms an exemption that applied only to private sales of securities into a second exemption that permits unregistered offers and sales of securities through general solicitations, including newspaper ads and web advertisements, provided that only accredited investors are permitted to purchase the securities and certain conditions are satisfied. The JOBS Act specified that that amendment was to be adopted no later than 90 days after the enactment of the JOBS Act, but it ended up taking the SEC about a year longer than that to comply. Nevertheless, in July of 2013, the SEC adopted amendments to Rule 506 to permit certain general solicitations without the need to register the offering. (As previously mentioned, the registration process is quite costly and time-consuming, and as a result a registered offering is financially impossible for most startup and early stage businesses.) The amendments will take effect on September 23, 2013.

Overview of Existing Rule 506

Rule 506, prior to the Amendment, provides that offers and sales of securities by an issuer that satisfy the conditions of paragraph (b) of Rule 506 “shall be deemed to be transactions not involving any public offering with the meaning of Section 4(2) [now 4(a)(2)] of the Act.” There are three conditions set forth in paragraph (b): (1) the transaction must satisfy the terms and conditions of Rule 501 and Rule 502; (2) there can be no more than 35 non-accredited investors (there can be an unlimited number of accredited investors if the other conditions are satisfied); and (3) each purchaser who is not an accredited investor “either alone or with his purchaser representative(s) has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.”

Definition of Accredited Investors (Rule 501)

Rule 501 provides definitions of certain terms used in Regulation D. The most important is the definition of “accredited investor.” Rule 501(a)(1) begins as follows: “Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person….” There are eight categories specified, as follows (the order has been modified to put the most commonly used categories first):

(i) Any natural person whose individual net worth, or joint net worth with the person’s spouse, exceeds $1 million. In calculating the amount, the person’s primary residence may not be included as an asset, but indebtedness secured by the primary residence, up to the fair market value of the residence at the time of the calculation, may be excluded as a liability.

(ii) Any natural person who had an individual income in excess of $200,000 in each of the most two recent years or whose joint income with the person’s spouse exceeded $300,000 in each of the two most recent years, and who reasonably expect to reach the same income level in the current year.

(iii) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer.

(iv) Any corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million.

(v) Any trust, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5 million, provided the purchase is directed by a sophisticated person as described in Rule 506(b)(2)(ii).

(vi) Any entity in which all of the equity owners are accredited investors.

(vii) Any private business development company as defined in Section 202(a)(22) of the Investment Advisers Act of 1940.

(viii) Any bank as defined in section 3(a)(2) of the Act, or any savings and loan association or other institution as defined in section 3(a)(5)(A) of the Act whether acting in its individual or fiduciary capacity; any broker or dealer registered pursuant to section 15 of the Securities Exchange Act of 1934; any insurance company as defined in section 2(13) of the Act; any investment company registered under the Investment Company Act of 1940 or a business development company as defined in section 2(a)(48) of that Act; any Small Business Investment Company licensed by the U.S. Small Business Administration under section 301(c) or (d) of the Small Business Investment Act of 1958; any plan established and maintained by a state, its political subdivisions, or any agency or instrumentality of a state or its political subdivisions, for the benefit of its employees, if such plan has total assets in excess of $5,000,000; any employee benefit plan within the meaning of the Employee Retirement Income Security Act of 1974 if the investment decision is made by a plan fiduciary, as defined in section 3(21) of such act, which is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors

General Conditions for Existing Rule 506 (Rule 502)

Rule 502 provides certain general conditions for the availability of both the existing and the amended Rule 506, except as noted below. The conditions are as follows:

(i) Integration. All sales that are part of the same Regulation D offering must meet all of the terms and conditions of Regulation D. Offers and sales that are made more than six months before the start of a Regulation D offering or more than six months after the conclusion of a Regulation D offering will not be considered part of that Regulation D offering if there are no offers or sales by or for the issuer of the same or similar securities other than offers or sales of securities under an employee benefit plan.

(ii) Information Requirements. This provision specifies the information that must be provided to non-accredited investors. The issuer is not required to furnish the specified information to purchasers who are accredited investors.

(iii) Manner of Offering. Regulation D offerings pursuant to the existing Rule 506 cannot involve any general solicitation or general advertising.

(iv) Limitations on Resale. Generally, securities acquired in a transaction under Regulation D have the status of securities acquired in a transaction under Section 4(2) (now 4(a)(2)) of the Act and cannot be resold without registration under the Act or an exemption therefrom. The issuer must exercise reasonable care to assure that he purchasers of the securities are not underwriters within the meaning of Section 2(11) of the Act.


Overview of the Amendment: Rule 506(c)

Effective September 23 of this year, a new paragraph (c) will be added to Rule 506. Paragraph (c) provides an exemption from registration without any limitation on general solicitations or general advertising provided the following conditions are met:

(i) The terms and conditions of Rule 501 (definitions), Rule 502(a) (integration of offerings), and Rule 502(d) (restrictions on resales of subject securities) must be satisfied.

(ii) All purchasers are accredited investors.

(iii) The issuer takes reasonable steps to verify that purchasers in an offering subject to Rule 506(c) are accredited investors.

Verification of Accredited Investor Status: General

The tricky part of Rule 506(c) is taking “reasonable steps to verify that purchasers…are accredited investors.” As noted by the SEC in Adoptive Release 33-9415 (Adoptive Release): “This requirement is separate from and independent of the requirement that sales be limited to accredited investors, and must be satisfied even if all purchasers happen to be accredited investors.” In other words, if the issuer has not taken “reasonable steps” to confirm that a purchaser is accredited, then the exemption from registration will not be available, even though the purchaser is in fact accredited. According to the SEC in the Adoptive Release, checking a box in a questionnaire or signing a form, absent other information about the purchaser, does not constitute reasonable steps to verify accredited investor status.

The issuer has the burden of demonstrating that it has taken reasonable steps to verify that the purchasers are accredited investors. To assist issuers in determining what steps are reasonable, the SEC provides guidance in Rule 506(c) and in the Adoptive Release regarding what might constitute “reasonable steps.”

According to the Adoptive Release, whether the steps taken by the issuer are reasonable “will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction.” The Adoptive Release states that the factors that issuers should consider include:

· the nature of the purchaser and the type of accredited investor that the purchaser claims to be;

· the amount and type of information the issuer has about the purchaser; and

· the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as the minimum investment amount.

According to the SEC in the Adoptive Release, the more that the facts and circumstances considered suggest that a purchaser qualifies as an accredited investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa. For example, if the minimum investment amount from an investor is quite high and the investor is able to purchase that minimum amount, fewer or even no additional steps may be required to verify accredited investor status other than to confirm that the investment is not being financed by a third party.

The SEC also states in the Adoptive Release that the nature of the purchaser should be taken into account in determining the reasonableness of the steps taken to verify accredited investor status.

Verification of Accredited Investor Status: Nature and Terms of the Offering

According to the Adoptive Release, the nature of the offering – such as the means through which the issuer publicly solicits purchasers – may be relevant in determining what steps to verify accredited investor status are reasonable. The SEC provides the following example:

An issuer that solicits new investors through a website accessible to the general public, through a widely disseminated email or social media solicitation, or through print media, such as a newspaper, will likely be obligated to take greater measures to verify accredited investor status than an issuer that solicits new investors from a database of pre-screened accredited investors created and maintained by a reasonably reliable third party.

Indeed, the SEC anticipates, and seems to encourage, that third-party services will develop that screen accredited investors and then confirm to issuers (presumably for a fee) that the named investors are in fact accredited. Investors might be more comfortable providing the detailed information regarding their financial status to one third party whom they trust than to numerous companies in which they are considering an investment. Not only does Rule 506(c) expand the universe of potential investors for startup and early stage companies, but it probably will create a new industry!

Verification of Accredited Investor Status: Natural Persons

The SEC believes that the verification of natural persons as accredited investors “may pose greater practical difficulties as compared to other categories of accredited investors, particularly for natural persons claiming to be accredited investors based on the net worth test.” For this reason, Rule 506(c) provides certain non-exclusive, non-mandatory methods that will constitute “reasonable steps” to verify that the person is an accredited investor:

“(A) In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;

“(B) In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:

(1) With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and

(2) With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies; or

“(C) Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:

(1) A registered broker-dealer;

(2) An investment adviser registered with the Securities and Exchange Commission;

(3) A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or

(4) A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.

“(D) In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to [September 23, 2013] and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.”

If the person qualifies as an accredited investor based on joint income or joint net worth with the person’s spouse, the documentation specified above and written representations should come from both the person and the spouse.

Again, it is important to emphasize that the four methods of verification included in Rule 506(c) for natural persons are neither required nor exclusive. However, if one or more of the four methods identified above are utilized, then the issuer is deemed to have taken reasonable steps, unless the issuer knows that the person is in fact not an accredited investor. If the issuer uses some other method, the burden will be on the issuer to demonstrate the reasonableness of such method. This creates a substantial pressure on issuers to utilize only the methods identified in Rule 506(c) for natural persons.

Since the first two identified methods require the disclosure of personal and presumably confidential tax and/or financial information, such methods are not likely to be popular with potential investors. The fourth method, since it only applies to persons who purchased securities from the issuer as accredited investors prior to September 23, 2013 and who continue to hold such securities, is not likely to be applicable in many instances, and consequently has limited usefulness. This leaves the third method as arguably the only practical method “approved” by the SEC for verifying that individuals are accredited investors: a written conformation from a registered broker-dealer, registered investment adviser, licensed attorney in good standing, or certified public accountant in good standing, that such party has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that the purchaser is an accredited investor.

What “reasonable” steps must the broker, investment adviser, attorney or CPA take before confirming that a person is an accredited investor? Neither Rule 506(c) nor the Adoptive Release says. However, since both discuss at great length what would constitute “reasonable steps” for the issuer to make such determination, it is only logical to assume that the broker, investment adviser, attorney or CPA should obtain the same financial and/or tax information from the person that methods one or two specify, and do so not more than three months prior to providing the confirmation.

Of course, if the natural person is an executive officer of a company that is registered under the Securities Exchange Act of 1934, the proxy statement or Annual Report on Form 10-K for the registrant may disclose a compensation for the person in excess of $200,000, the Adoptive Release acknowledges that this alone might constitute “reasonable steps” for verification of that person’s status as an accredited investor. In the same vein, if the person in question is employed by an employer whose average compensation for employees of that person’s level of seniority are publicly available, such information also might constitute “reasonable steps” according to the Adoptive Release.

The Adoptive Release also declares that pay stubs for the two most recent years and the current year for an individual could, in and of itself, constitute “reasonable steps.”

Verification of Accredited Investor Status: Entities

No guidance is provided in Rule 506(c) regarding what steps will be reasonable in determining the accredited investor status of an entity such as a corporation, limited liability company, partnership or trust. However, some guidance is provided by the Adoptive Release.

If an entity claims to be an accredited investor based on its status, such as a broker or dealer registered pursuant to Section 15 of the Securities Exchange Act of 1934, an investment company registered under the Investment Company Act of 1940, or a business development company as defined in Section 2(a)(48) of the Investment Company Act of 1940, then verification of such status should be performed. In the case of a broker-dealer, the issuer could use the FINRA BrokerCheck website.

Many entities are deemed accredited investors based on both the nature of the entity and its total assets. An IRC Section 501(c)(3) organization with $5 million in assets must make its Form 990 series return as filed with the IRS available for public inspection, so a review of such form would suffice for such an organization. No other guidance is provided regarding what “reasonable steps” might be to verify the accredited investor status of entities required to have a specified amount of assets. However, the SEC’s statements regarding individuals and entities such as broker-dealers provides guidance. One can assume that the issuer first should verify that the nature of the entity is correct, such as a copy of the articles of incorporation for a corporation. Next the issuer should verify that the entity has the assets required. An audited balance sheet presumably would be a “reasonable step,” but what if the entity does not have audited financial statements? Perhaps obtaining certification from a CPA, if possible, or from the attorney of the entity, would suffice. However, neither the rule nor the Adoptive Release answers this.

What if the Verification is Wrong?

What happens if a purchaser represents that he, she or it is an accredited investor, and the issuer after taking reasonable steps believes that the purchaser is an accredited investor, but it turns out that the purchaser lied and in fact isn’t an accredited investor? The issuer should be okay, and the availability of the exemption should not be lost. According to the Adoptive Release, the SEC believes that “the issuer will not lose the ability to rely on Rule 506(c) for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that the purchaser was an accredited investor at the time of sale.” The SEC has take a similar view regarding Regulation S.

Rule 506 Remains Available for Private Offerings

An issuer still can elect to undertake a truly private offering pursuant to Rule 506(b). In such event, the issuer complies with Rule 506(b) and avoids any general solicitation or general advertising. See below, however, regarding the potential impact of new Rule 506(c) on offerings pursuant to Rule 506(b).

Form D Check Box for Rule 506(c) Offerings

Form D is the notice of offerings pursuant to Regulation D that issuers are required to file with the SEC. This form has been amended to provide separate check boxes for offerings pursuant to Rule 506(b) (truly private offerings) and for offerings pursuant to Rule 506(c) (public offerings to accredited investors). An issuer may not check both boxes, since a general solicitation permitted by Rule 506(c) precludes by definition a private offering pursuant to Rule 5-6(b).

Rule 506(c) Offerings by Private Funds

Venture capital funds, private equity funds, hedge funds, and other private funds generally rely on Sections 3(c)(1) and 3(c)(7) to avoid substantially all of the regulatory provisions of the Investment Company Act. Section 3(c)(1) excludes from the definition of “investment company” any issuer whose outstanding securities (excluding short-term paper) are beneficially owned by 100 persons or less, if the issuer is not making and does not propose to make a public offering of its securities. Section 3(c)(7) excludes from the definition any issuer whose outstanding securities are owned only by qualified purchasers and which is not making and does not propose to make a public offering of its securities.

As noted by the SEC in the Adoptive Release, the JOBS Act does not make any specific reference to private funds. However, Section 201(b) of the JOBS Act provides that offers and sales exempt under Rule 506, as to be amended, shall not be deemed to be public offerings under the “Federal securities laws” as a result of general advertising or general solicitation.” Since the Investment Company Act is part of the Federal securities laws, the SEC believes that “the effect of Section 201(b) is to permit offers and sales of securities under Rule 506(c) by private funds relying on the exclusions from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.” However, the SEC declared in the Adoptive Release that it will “monitor and study the development of private fund advertising and undertake a review to determine whether any further action is necessary.”

Impact on State Securities Law Regulation

Section 102(a) of the National Securities Markets Improvements Act of 1996 (NSMIA) preempts state registration and review requirements for transactions involving “covered securities,” which include securities offered or sold in transactions that are exempt from registration under the Act by virtue of Section 4(a)(2) (formerly 4(2)). States can require a simple notice filing, such as a copy of Form D, and the transactions remain subject to state anti-fraud regulation, but the states cannot adopt substantive requirements for such transactions. Prior to the adoption of NSMIA, a number of states had their own individual requirements for private offerings, which made the sale of securities in a private offering more difficult. NSMIA eliminated this impediment for offerings exempt under Section 4(a)(2).

Since the original Rule 506 had been adopted solely under Section 4(a)(2), offerings pursuant to Rule 506 were not subject to state registration or review requirements. In contrast, Rule 505 had not been adopted solely under Section 4(a)(2), and consequently there are few offerings pursuant to that rule.

Section 201(a) of the JOBS Act states that Rule 506, as amended, will continue to be treated as a regulation issued under Section 4(a)(2). Consequently, offers and sales pursuant to Rule 506(c) will not be subject to state registration and review requirements.

Potential Impact of Rule 506(c) on Private Offerings Under Rule 506(b)

Whether all purchasers in a “traditional” private placement are accredited investors can be extremely important to the issuer. First, private placements pursuant to Rule 506(b) can include not more than 35 persons who are not accredited investors. Perhaps more importantly, if even one purchaser is not an accredited investor, the issuer must comply with the specific information requirements of Rule 501(b).

The definition of accredited investor in Rule 501 includes persons who come within one of the identified categories and persons “who the issuer reasonably believes comes within any of” the categories. One might argue that “reasonable belief” is extremely similar to, if not even substantially the same as, “reasonable steps.” If so, then issuers who undertake traditional private placements should seriously consider taking the same steps to verify accredited investor status that are enumerated in Rule 506(c) and the Adoptive Release. For many issuers, this may significantly increase the examination of purchasers who claim to be accredited investors. The days of checking a box regarding income or net worth are over.

Addition of “Bad Boy” Restrictions to Rule 506

At the same time that the SEC added Rule 506(c) to permit public solicitations for certain offerings pursuant to Rule 506, it added Rule 506(d) to disqualify certain felons and other “bad actors” from utilizing Rule 506, whether or not a general solicitation is involved. This amendment, like the former, takes effect on September 23, 2013. A separate article discusses this amendment.

Article 2 : AVAILABILITY OF RULE 506 FOR UNREGISTERED SALES OF SECURITIES

WILL BE TAKEN AWAY FROM “BAD ACTORS”

Introduction

The JOBS Act instructed the Securities and Exchange Commission (SEC) to expand its “bad actor” provisions of Regulation A and add them to Regulation D. As a result, commencing September 23, 2013, a new paragraph (d) of Rule 506 will disqualify securities offerings involving certain “bad actors” from reliance on Rule 506 of Regulation D.

As the SEC pointed out in Release 33-9414 adopting this amendment to Rule 506, Rule 506 accounts for an estimated 90% to 95% of all Regulations D offerings. Philosophically, it would seem to make a great deal of sense that investors be protected from private sales of securities by criminals. The issue is where to draw the line. One might argue that the line has been drawn too broadly. For example, a 20% owner of the issuer might well have no role in either the sale of the securities or the conduct of the issuer, yet a disqualifying event by that 20% owner would extend to the issuer. On the other hand, one might also argue that it is “better to be safe than sorry” when dealing with securities transactions that are not subject to any regulatory scrutiny prior to their commencement. Unfortunately, history has proven time and again that unscrupulous persons will utilize the unregistered sale of securities to take advantage of investors.

Covered Persons

No exemption under Rule 506 will be available for private or public offerings if a disqualifying event, as set forth in the new paragraph (d), exists with respect to any of the following: (i) the issuer, (ii) any predecessor to the issuer, (iii) any affiliated issuer, (iv) any director, executive officer, other officer participating in the subject offering, general partner or managing member of the issuer, (v) any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities (calculated on the basis of voting power), (vi) any promoter connected with the issuer in any capacity at the time of such sale, (vii) any investment manager of an issuer that is a pooled investment fund, (viii) any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities, (ix) any general partner or managing member of any such investment manager or solicitor, or (x) any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

Disqualifying Events

Disqualifying events include (i) certain criminal convictions, (ii) certain court injunctions and restraining orders, (iii) certain final orders of certain regulators, (iv) certain SEC disciplinary orders, (v) certain SEC cease-and-desist orders, (vi) the suspension or expulsion from SRO membership of association with an SRO member, (vii) stop orders and orders suspending the Regulation A exemption, and (viii) U.S. Postal Service false representation orders. Specifically, no exemption if any of the “covered persons”:

(i) Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors and affiliated issuers), of any felony or misdemeanor:

(A) In connection with the purchase or sale of any security;

(B) Involving the making of any false filing with the Commission; or

(C) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(ii) Is subject to any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:

(A) In connection with the purchase or sale of any security;

(B) Involving the making of any false filing with the Commission; or

(C) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(iii) Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that:

(A) At the time of such sale, bars the person from:

(1) Association with an entity regulated by such commission, authority, agency, or officer;

(2) Engaging in the business of securities, insurance or banking; or

(3) Engaging in savings association or credit union activities; or

(B) Constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale;

(iv) Is subject to an order of the Commission entered pursuant to section 15(b) or 15B(c) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(b) or 78o-4(c)) or section 203(e) or (f) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the time of such sale:

(A) Suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;

(B) Places limitations on the activities, functions or operations of such person; or

(C) Bars such person from being associated with any entity or from participating in the offering of any penny stock;

(v) Is subject to any order of the Commission entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:

(A) Any scienter-based anti-fraud provision of the federal securities laws, including without limitation section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1)), section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b)) and 17 CFR 240.10b-5, section 15(c)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(c)(1)) and section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; or

(B) Section 5 of the Securities Act of 1933 (15 U.S.C. 77e).

(vi) Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;

(vii) Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or

(viii) Is subject to a United States Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Limitations on the Disqualification Provisions

The disqualification imposed by Rule 5-6(d) will apply only to events that take place after the effectiveness of the amendment on September 23. If, for example, an executive officer of the issuer is convicted of a felony in connection with the sale of a security on September 20, 2013, this event would not disqualify the issuer from making an offering of securities pursuant to Rule 506 after September 23. However, a new paragraph (e) also is added to Rule 506 that requires the disclosure, in writing and a reasonable time prior to sale, of “bad actor” events that would have disqualified the issuer but for their occurrence prior to September 23, 2013.

An issuer also can avoid disqualification upon a showing of good cause to the SEC that it is not necessary under the circumstances to prevent the use of Rule 506 by the issuer. Similarly, if the court or regulatory authority that entered the relevant order, judgment or decree advises in writing, prior to the sale, that disqualification should not be imposed as a result of such order, judgment or decree, then Rule 506(d) will not apply.

There also is an “exemption” from the disqualification imposed by Rule 506 for situations where the issuer did not know, and in the “exercise of reasonable care, could not have known,” that a disqualification under Rule 506(d)(1) existed. The issuer must have made a factual inquiry into whether any disqualifications existed. The nature and scope of the factual inquiry will depend on the specific facts and circumstances.

Inapplicability of Disqualification to Other Regulation D Offerings

The amendment applies only to Rule 506, and not to Rules 504 or 505. Consequently, a disqualifying event under Rule 506(d) would not prevent an issuer from making a private offering pursuant to Rule 505, provided the issuer complies with the requirements of that rule. Rule 505 requires a truly private offering, and the maximum offering price for the securities being offered cannot exceed $5 million, reduced by the aggregate offering price of all securities sold during the offering and within the twelve months prior thereto in reliance on an exemption provided by Section 3(d) of the Act or in violation of Section 5(a) of the Act. Disclosure of the event presumably would need to be required as a material fact, but the offering itself would not be prohibited. Consequently, the adoption of the “bad actor” disqualification with respect to Rule 506 may result in an increased popularity of Rule 505.

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Article 2 : AVAILABILITY OF RULE 506 FOR UNREGISTERED SALES OF SECURITIES WILL BE TAKEN AWAY FROM "BAD ACTORS"

Introduction

The JOBS Act instructed the Securities and Exchange Commission (SEC) to expand its “bad actor” provisions of Regulation A and add them to Regulation D. As a result, commencing September 23, 2013, a new paragraph (d) of Rule 506 will disqualify securities offerings involving certain “bad actors” from reliance on Rule 506 of Regulation D.

As the SEC pointed out in Release 33-9414 adopting this amendment to Rule 506, Rule 506 accounts for an estimated 90% to 95% of all Regulations D offerings. Philosophically, it would seem to make a great deal of sense that investors be protected from private sales of securities by criminals. The issue is where to draw the line. One might argue that the line has been drawn too broadly. For example, a 20% owner of the issuer might well have no role in either the sale of the securities or the conduct of the issuer, yet a disqualifying event by that 20% owner would extend to the issuer. On the other hand, one might also argue that it is “better to be safe than sorry” when dealing with securities transactions that are not subject to any regulatory scrutiny prior to their commencement. Unfortunately, history has proven time and again that unscrupulous persons will utilize the unregistered sale of securities to take advantage of investors.

Covered Persons

No exemption under Rule 506 will be available for private or public offerings if a disqualifying event, as set forth in the new paragraph (d), exists with respect to any of the following: (i) the issuer, (ii) any predecessor to the issuer, (iii) any affiliated issuer, (iv) any director, executive officer, other officer participating in the subject offering, general partner or managing member of the issuer, (v) any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities (calculated on the basis of voting power), (vi) any promoter connected with the issuer in any capacity at the time of such sale, (vii) any investment manager of an issuer that is a pooled investment fund, (viii) any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with such sale of securities, (ix) any general partner or managing member of any such investment manager or solicitor, or (x) any director, executive officer or other officer participating in the offering of any such investment manager or solicitor or general partner or managing member of such investment manager or solicitor.

Disqualifying Events

Disqualifying events include (i) certain criminal convictions, (ii) certain court injunctions and restraining orders, (iii) certain final orders of certain regulators, (iv) certain SEC disciplinary orders, (v) certain SEC cease-and-desist orders, (vi) the suspension or expulsion from SRO membership of association with an SRO member, (vii) stop orders and orders suspending the Regulation A exemption, and (viii) U.S. Postal Service false representation orders. Specifically, no exemption if any of the “covered persons”:

(ii) Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors and affiliated issuers), of any felony or misdemeanor:

(D) In connection with the purchase or sale of any security;

(E) Involving the making of any false filing with the Commission; or

(F) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(ii) Is subject to any order, judgment or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice:

(D) In connection with the purchase or sale of any security;

(E) Involving the making of any false filing with the Commission; or

(F) Arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser or paid solicitor of purchasers of securities;

(iii) Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency; the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that:

(A) At the time of such sale, bars the person from:

(1) Association with an entity regulated by such commission, authority, agency, or officer;

(2) Engaging in the business of securities, insurance or banking; or

(3) Engaging in savings association or credit union activities; or

(B) Constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale;

(iv) Is subject to an order of the Commission entered pursuant to section 15(b) or 15B(c) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(b) or 78o-4(c)) or section 203(e) or (f) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(e) or (f)) that, at the time of such sale:

(A) Suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer or investment adviser;

(B) Places limitations on the activities, functions or operations of such person; or

(C) Bars such person from being associated with any entity or from participating in the offering of any penny stock;

(v) Is subject to any order of the Commission entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of:

(A) Any scienter-based anti-fraud provision of the federal securities laws, including without limitation section 17(a)(1) of the Securities Act of 1933 (15 U.S.C. 77q(a)(1)), section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. 78j(b)) and 17 CFR 240.10b-5, section 15(c)(1) of the Securities Exchange Act of 1934 (15 U.S.C. 78o(c)(1)) and section 206(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-6(1)), or any other rule or regulation thereunder; or

(B) Section 5 of the Securities Act of 1933 (15 U.S.C. 77e).

(vi) Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade;

(vii) Has filed (as a registrant or issuer), or was or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the Commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption, or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or

(viii) Is subject to a United States Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations.

Limitations on the Disqualification Provisions

The disqualification imposed by Rule 5-6(d) will apply only to events that take place after the effectiveness of the amendment on September 23. If, for example, an executive officer of the issuer is convicted of a felony in connection with the sale of a security on September 20, 2013, this event would not disqualify the issuer from making an offering of securities pursuant to Rule 506 after September 23. However, a new paragraph (e) also is added to Rule 506 that requires the disclosure, in writing and a reasonable time prior to sale, of “bad actor” events that would have disqualified the issuer but for their occurrence prior to September 23, 2013.

An issuer also can avoid disqualification upon a showing of good cause to the SEC that it is not necessary under the circumstances to prevent the use of Rule 506 by the issuer. Similarly, if the court or regulatory authority that entered the relevant order, judgment or decree advises in writing, prior to the sale, that disqualification should not be imposed as a result of such order, judgment or decree, then Rule 506(d) will not apply.

There also is an “exemption” from the disqualification imposed by Rule 506 for situations where the issuer did not know, and in the “exercise of reasonable care, could not have known,” that a disqualification under Rule 506(d)(1) existed. The issuer must have made a factual inquiry into whether any disqualifications existed. The nature and scope of the factual inquiry will depend on the specific facts and circumstances.

Inapplicability of Disqualification to Other Regulation D Offerings

The amendment applies only to Rule 506, and not to Rules 504 or 505. Consequently, a disqualifying event under Rule 506(d) would not prevent an issuer from making a private offering pursuant to Rule 505, provided the issuer complies with the requirements of that rule. Rule 505 requires a truly private offering, and the maximum offering price for the securities being offered cannot exceed $5 million, reduced by the aggregate offering price of all securities sold during the offering and within the twelve months prior thereto in reliance on an exemption provided by Section 3(d) of the Act or in violation of Section 5(a) of the Act. Disclosure of the event presumably would need to be required as a material fact, but the offering itself would not be prohibited. Consequently, the adoption of the “bad actor” disqualification with respect to Rule 506 may result in an increased popularity of Rule 505.

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* © July 2013 by Edward T. Swanson. Mr. Swanson is a former staff attorney with the Securities and Exchange Commission and a former president of the CCBA. His practice focuses primarily on corporate and securities law matters. He can be reached at etswanson@att.net.

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