A threat to early-stage offerings:
The “Bad Actor” disqualification
Several of the exemptions that allow start-ups and small companies to sell securities to raise money without registering the offering with the Securities and Exchange Commission are conditioned on no “Bad Actors” participating in the offering. The exemptions include Regulation A, Rule 506 of Regulation D, and the proposed crowdfunding rules. If you allow a Bad Actor to participate, you are disqualified from relying on these exemptions from registration. Going forward with a deal that involves a Bad Actor will likely result in a violation of the registration requirements of the Securities Act—creating legal liabilities for you and your company. Securities intermediaries face “Bad Actor” requirements as well. Not only are intermediaries themselves required to not be Bad Actors, but the proposed Crowdfunding rules require that intermediaries to run background checks to check for Bad Actors.
The acts that would make a person a Bad Actor include eight classes of disqualifying events that include civil and criminal judgments, administrative orders from state and federal agencies, and orders from self-regulatory organizations. The people who are subject to this disqualification include the issuing company itself along with the company’s officers, directors, major shareholders, and people that the company is paying to solicit or promote the offering.
How do you avoid a “Bad Actor” disqualification?
There is no single database that can be checked to see if you have a Bad Actor participating in your offering. However, if you take “reasonable care” through a "factual inquiry" into every person subject to the disqualification, you won’t be prevented from selling securities in reliance the SEC's exemptions from registration, even if it turned out that a Bad Actor was involved.
So, how to show you used “reasonable care”? Use CrowdCheck.
CrowdCheck's experienced professionals will check each covered person against the available sources of information that would reveal a disqualifying event, and report back with an easy-to-understand report that shows what we’ve found and whether the event triggers disqualification.
Using CrowdCheck means one less thing you need to worry about when you are seeking investors.
There is no need to wait until you are planning an offering. Check out potential officers and directors before you bring them onboard and avoid problems later.
The Bad Actor Disqualification
A securities offering is disqualified from relying on certain exemptions from the registration requirements of the Securities Act if the issuer or any other specified people are considered Bad Actors. The disqualification applies to securities offerings that attempt to rely on Rule 506 of Regulation D, Regulation Crowdfunding, or Regulation A.
Persons Covered Under the Bad Actor Disqualification
Under the rules put into effect by the SEC, the following people and entities are considered "covered persons" and are disqualified from offering securities under Rule 506 of Regulation D, Regulation Crowdfunding, or Regulation A:
- The issuer and any predecessor of the issuer or affiliated issuer;
- Any director, general partner or managing member of the issuer;
- Any executive officer and officers participating in the offering;
- Any 20 percent beneficial owner of the issuer;
- Any promoter—that is, any person or entity that directly or indirectly takes initiative in founding the issuer, or in connection with the founding of the issuer, receives 10% or more of any class of the issuer's securities, or 10% of the proceeds from the sale of any class of the issuer's securities;
- Any investment manager or principal of pooled investment funds offering securities;
- Any person that has been or will be compensated for solicitation of purchasers in connection with sales of securities in the offering ("compensated solicitor"); and
- Any director, officer, general partner or managing member of any such compensated solicitor.
The above description applies to offerings under Rule 506. The rules for Regulation Crowdfunding and Regulation A differ slightly. All officers, regardless of whether they are executive officers, are included under Crowdfunding, and both Crowdfunding and Regulation A are not available to pooled investment funds.
The Bad Actor rules also apply to broker-dealers and other intermediaries.
The disqualifying events cover eight classes of court and administrative orders that relate to a person's or entity's history of financial and securities fraud. The different events require different look-back periods from the date of the start of the securities offering. The disqualifying events include:
- Criminal Convictions — Any felony or misdemeanor in connection with the purchase or sale of a security, involving the making of any false filing with the Commission, or 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.
- Court Injunctions and Restraining Orders — Any order, judgment or decree of any court of competent jurisdiction that restrains or enjoins a covered person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of a security, involving the making of any false filing with the Commission, or 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.
- Final Orders of Certain Regulators — Any final order of a state securities commission, state banking regulator, state insurance commission, federal banking regulator, the U.S. Commodity Futures Trading Commission, or the National Credit Union Administration that bars the covered person from association with any entity regulated by such commission, authority, agency, or officer; engaging in the business of securities, insurance or banking; engaging in savings association or credit union activities; or that constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct.
- Commission Disciplinary Orders — Any order of the Securities and Exchange Commission entered pursuant to Section 15(b) or 15B(c) of the Securities Exchange Act of 1934, or Section 203(e) or (f) of the Investment Advisers Act of 1940 that suspends or revokes the covered person's registration as a broker, dealer, municipal securities dealer or investment adviser; places limitations on the activities, functions or operations of the covered person; or bars the covered person from being associated with any entity or participating in the offering of any penny stock.
- Certain Commission Cease-and-Desist Orders — Any order of the Securities and Exchange Commission that orders the covered person to cease and desist from committing or causing a violation of or future violation of any scienter-based anti-fraud provision of the federal securities laws; or Section 5 of the Securities Act.
- Suspension of Expulsion from SRO Membership or Association with an SRO Member — Any suspension or expulsion from membership in, or suspension or bar 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 principals of trade.
- Stop Orders and Orders Suspending the Regulation A Exemption — Any participation in any registration statement or Regulation A offering statements filed with the Securities and Exchange Commission that was the subject of a refusal order, stop order, or order suspending the Regulation A exemption.
- United States Postal Service False Representation Orders — Any United States Postal Service false representation order, or any 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.
Reasonable Care Exception
The SEC has provided a “reasonable care” exception from the prohibition on use of Rule 506 of Regulation D, Regulation Crowdfunding, and Regulation A if the issuer can establish that it did not know and, in the exercise of reasonable care, could not have known, that a disqualification existed because of the presence or participation of a disqualified covered person. The SEC notes that the reasonable care exception is necessary because there is no central repository that aggregates information from all the federal and state courts and regulatory authorities that would be relevant in determining whether covered persons have a disqualifying event in their past.
In order to qualify for the reasonable care exception, the issuer must make a factual inquiry into whether any disqualifications existed. The SEC notes that the nature and the scope of the factual inquiry would vary based on the circumstances of the issuer and the other offering participants. Obtaining a CrowdCheck Bad Actor Report would constitute such a factual inquiry.
For Rule 506 of Regulation D, the issuer or covered person would not be disqualified from offering securities as a result of a disqualifying event that occurred before the effective date of the rule, September 23, 2013. Proposed Regulation Crowdfunding includes a similar transition provision. The disqualification rules for Regulation A are in effect. If the disqualifying event occured before the effective date, an issuer must disclose in the offering materials the existence of events that would have triggered disqualification. Failure to disclose such events could itself result in a finding of securities fraud.
Obligation to Make Background and Regulatory Checks
Under Regulation Crowdfunding, an intermediary is required to deny access to its platform if the intermediary has a reasonable basis for believing that an issuer or its covered persons is subject to a Bad Actor disqualification. To satisfy this requirement, the intermediary must conduct a background and securities enforcement regulatory check on the issuer and its covered persons. The SEC does not provide guidance on the content of the required background and securities enforcement regulatory history checks beyond what is necessary to establish a reasonable basis for believing that no disqualifying events are present.