Rule 506 B of Regulation D is considered a “safe harbor” exemption under Section 4(a)(2) of the Securities Act of 1933. Section 4(a)(2) of the Securities Act exempts from registration transactions by an issuer not involving any public offering. It provides objective standards that a company can rely on to meet the Section 4(a)(2) exemption requirements. Companies conducting an offering under Rule 506(b) can raise an unlimited amount of money and sell securities to an unlimited number of accredited investors. An offering under Rule 506(b), however, is subject to the following requirements:
- no general solicitation or advertising to market the securities
- securities may not be sold to more than 35 non-accredited investors (all non-accredited investors, either alone or with a purchaser representative, must meet the legal standard of having sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment)
If non-accredited investors are participating in the offering, the company conducting the offering:
- must give any non-accredited investors disclosure documents that generally contain the same type of information as provided in Regulation A offerings (the company is not required to provide specified disclosure documents to accredited investors, but, if it does provide information to accredited investors, it must also make this information available to the non-accredited investors as well)
- must give any non-accredited investors financial statement information specified in Rule 506 and
- should be available to answer questions from prospective purchasers who are non-accredited investors
Rule 506 C permits issuers to broadly solicit and generally advertise an offering, provided that:
- all purchasers in the offering are accredited investors
- the issuer takes reasonable steps to verify purchasers’ accredited investor status and
- certain other conditions in Regulation D are satisfied
Purchasers in Rule 506(b) or Rule 506(c) offerings receive “restricted securities.” A company must file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering. Although the Securities Act provides a federal preemption from state registration and qualification under Rule 506(b), the states still have the authority to require notice filings and collect state fees.
BAD BOY DISQUALIFICATIONS
Rule 506(b), Rule 506(c), and Regulation A (Reg A) offerings are subject to “bad actor” disqualification provisions described under Regulation D.
Rule 506 and Reg A registration exemptions cannot be used if covered persons have committed certain acts. The following “bad boys” are referred to as these “covered persons” under Rule 506 or Reg A:
1. The issuer and any predecessor of the issuer or affiliated issuers;
2. Any director, officer, general partner, or managing member of the issuer;
3. Any beneficial owner of 10% or more of any class of the issuer’s equity securities;
4. Any promoter connected with the issuer in any capacity at the time of the sale;
5. Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with the sale of securities in the offering; and
6. Any director, officer, general partner, or managing member of any such compensated solicitor.
The disqualifying events under the Rule are the following:
1. Criminal convictions occurring within the past 5 years for issues and the past 10 years for other covered persons;
2. Court injunctions and restraining orders if issued within the past 5 years;
3. Final Orders of certain state regulators (such as state securities, banking, and insurance regulators, and federal regulators) in effect at the time of the proposed offering or if the final order is related to a securities violation or fraudulent conduct, then the period extends to ten years after the order is entered;
4. Commission disciplinary orders relating to broker-dealers, municipal securities dealers, investment advisors, and investment companies and their associated persons, if in effect at the time of the proposed 506 offering;
5. Suspension or expulsion from membership in, or suspension or bar from associating with a member of a securities regulatory organization if the suspension or order is still in effect at the time of the proposed 506 offering;
6. Commission Stop Orders entered within 5 years of the proposed offering and Orders suspending a Regulation A offering, or if an investigation is being conducted into conduct that could result in a Stop Order, the 506 offering exemption would be prohibited; and
7. The entry of a US Postal Service false representation orders within the past 5 years.
Accordingly, under the Rule, any securities offering that is associated with a “covered person”, as defined above, would be disqualified from the use Rule 506 if those “covered persons” had committed any of the “disqualifying events”. This limitation could create significant hardship for issuers where a person peripherally associated with the offering has been involved with one of the disqualifying events listed. An excellent example of this is the limitation on 10% shareholders. Under the Rule, any shareholder that owns 10% of any class of securities could disqualify an issuer from the use of Rule 506 if he has been involved in a disqualifying event. This could be especially troublesome for small issuers and startups, where many of the owners involved in the startup process will generally own more than 10% of the company.
Fortunately, to prevent hardship, the SEC has the authority to grant waivers “upon the showing of good cause and without prejudice to any other action.”
Fortunately, the new “bad boy” rules only apply to Rule 506 and Reg A offerings. This creates a planning opportunity for those issuers who may have a “bad boy” associated with a proposed investment opportunity. It will be necessary for these issuers to consult with their securities attorney to identify whether registration or an alternative exemption is available for the issuer to avoid registration.
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