What are we gonna do to screen for you…
Sorry, as a child of the 80s I couldn’t resist, but my bad version of the classic “Cops” theme does reflect a serious question: how are issuers and intermediaries going to comply with the new “Bad Actor” disqualification provisions of Rule 506, Regulation A, and Regulation Crowdfunding offerings? The short answer is to use CrowdCheck’s BadActor Report℠. Why CrowdCheck is the answer will require some explanation.
The first obvious question is, what are those disqualification provisions? Well, the full text of the rule is here, and a condensed analysis is here (page 7), but the really condensed analysis is this: companies or covered persons (generally officers, directors, 20% voting equity holders, promoters, and the intermediary) that have committed certain enumerated bad acts (more on that in a second) cannot take advantage of the exemptions from registration found in Rule 506, Regulation A, or Regulation Crowdfunding when seeking investment. Meaning, if they proceed with an offering that they thought complied with an exemption, but they were actually not able to rely on that exemption due to a prior bad act, the offering is really an unregistered offering of securities. This result can lead to liability for both issuers and intermediaries.
What are those bad acts I mentioned a second ago? Well, the regulation lays it out in detail (seriously, read it to get the full picture), but the gist is that the following types of “bad acts” will trigger the prohibition:
- Criminal convictions within the past 10 years (five years for the issuing company) arising in connection with the purchase or sale of a security, making a false filing to the SEC, or arising out of actions as an intermediary, advisor, or solicitor.
- Court orders within the past five years enjoining a person or entity from practices in connection with a securities transaction, making false filing to the SEC, or acting as an intermediary, advisor, or solicitor.
- Final orders from federal and state financial regulators barring a person from engaging in the business or associating with an entity that engages in the business regulated by the regulator. This also includes previous orders within the last 10 years relating to fraudulent or deceptive conduct.
- Any SEC disciplinary order that, at the time of sale of securities, suspends or limits the activities of the person.
- Any SEC cease-and-desist order within the past five years regarding a violation of federal securities law.
- Any suspension or expulsion from a securities self-regulatory organization (e.g. FINRA) for any act or omission inconsistent with just and equitable principals of trade. It is unclear whether a suspension results in a permanent ban or only applies for the duration of the suspension.
- Any order to stop or suspend a registration statement or Regulation A offering statement in the past five years.
- Any USPS false representation order within the past five years or temporary restraining order at the time of the sale of securities.
Ok, you still with me? What is interesting about this list is both how broad it is (Postal Service?), and how narrow it is (a fraud conviction is not necessarily disqualifying; it has to be fraud in connection with securities). Of course, there are also some escape clauses:
- If the violation occurred before the rule went into effect (September 23rd, 2013) it only has to be disclosed;
- A bad actor can petition the SEC for relief from disqualification;
- If a court order or other sanction explicitly says it shouldn’t count for bad actor purposes it won’t; and most importantly
- If the issuer has a reasonable basis for belief that none of the covered persons are bad actors the issuer can rely on the exemption, even if it turns out there are bad actors in the mix.
But how do you establish a reasonable basis? You must make a "factual inquiry". Well, what is a factual inquiry? The SEC is customarily vague about what would count, and ultimately if you get sued it will be a question for the court. What we do know is that you need to take the scope of the prohibition. This means that just doing a standard criminal background check probably won’t cut it, since it isn’t just criminal acts that can be disqualifying, you will need to look at all of the enumerated categories.
Likewise, you need to consider how well you know the covered person when evaluating what you need to do to have a reasonable basis. Obviously, the better you know the covered person and their history, the less you may need to do, but if you are talking about someone who you don’t know all that well just relying on your gut or an unverified questionnaire probably won’t be enough. After all, the standard questionnaire asking, in effect, “Are you bad? A fraud? A liar?” may not be held as reasonable since, well, liars lie. The good news is you don’t need perfect knowledge, just a reasonable basis, so you don’t need to pay for a private investigator, force the person to take a lie detector test, or interrogate him, but you do need to get sufficient information to make a reasonable assumption.
So, now that we have gone through all that the big question is: How do you get to the reasonable basis you need to comply with the rules? The CrowdCheck BadActor Report℠. The BadActor Report℠ uses a proprietary suite of background checks, specifically designed by experienced professionals with the “Bad Actor” rules in mind, to provide you with actionable information and a report of the factual inquiry that constitutes a reasonable basis for belief regarding the status of your covered persons. It is available as a stand-alone product and as part of our other services, and is suitable for all raises where “Bad Actor rule” compliance is required. If you are interested or want to learn more, contact us and we can get started.