November 21, 2019 | By Patrick T. McCloskey
Subject to limited exceptions, certain so-called “bad actor” disqualification rules now prevent any company with a “disqualifying event” from relying on the most basic exemptions from registration under the Securities Act of 1933, as amended (the “1933 Act”).1 Criminal convictions in connection with the purchase or sale of a security naturally trigger the disqualification, but civil orders, such as injunctions and restraining orders entered by the SEC or a state securities regulator, are also disqualifiers. Some of the disqualifying events can result from a violation that does not necessarily involve knowing misconduct or “scienter”.
The way the rules work, if a “covered person” (a director, executive officer, general partner, managing member or 20% stockholder) has a disqualifying event within the relevant “look-back” period (generally five years, but 10 years for serious events involving individuals), the company may not, absent a waiver (discussed below), rely on the exemption unless it can establish that it did not know and, in the exercise of reasonable care, could not have known, of the disqualifying event.2
The inability of a startup or other early-stage company to rely on Regulation D, Regulation A or Regulation Crowdfunding would make it extremely difficult for such company to raise sufficient capital from outside investors in a private placement. To preserve the reasonable care exception, many issuers have their respective “covered persons” complete written questionnaires certifying as to the absence of disqualifying events and sign agreements obligating them to notify the company of any future disqualifying event.
In addition to the reasonable care exception, a disqualifying event will not prevent reliance on an exemption if (i) the applicable court or regulatory agency advises in writing that disqualification should not apply to the conduct that is the subject of the enforcement order or (ii) the SEC grants a waiver. Interestingly, the SEC recently changed its policy so that it will now respond to waiver requests at the same time it responds to related settlement offers.3 Bear in mind, however, that the waiver process has been scrutinized as being inconsistent with the purpose of the disqualification rules, and legislation has been proposed (on numerous occasions, without enactment to date) to add transparency and protective procedures for waiver applications and grants.4
Notwithstanding a potential waiver as an escape hatch, the existence of a disqualifying event is likely to have an adverse impact on any entrepreneur that is the subject of an enforcement order or decree for a disqualifying act. In order to remove the taint that would otherwise disqualify an issuer, the individual bad actor could be demoted or reassigned and possibly have a portion of his or her equity repurchased so that he or she is no longer a covered person (i.e. a director, officer or 20% owner). Depending on the circumstances, an issuer could seek to cut ties with the bad actor altogether.
While true that a disqualifying event could hamper anyone’s professional prospects, the stigma associated with bad actor status could be particularly dire for entrepreneurs. In most situations a founder will be a covered person of a new venture in three different ways: director, officer and 20% stockholder. As a result, bad actor status could effectively prevent the entrepreneur from raising equity financing from outside investors to fund any new venture(s) of which he or she is a founder, at least for the duration of the applicable look-back period.
Entrepreneurs should proceed with caution when it comes to securities laws and regulations, at both the federal and state levels. There have been sweeping changes in these areas over the past few years and that trend is likely to continue. In June, the SEC issued an extremely broad concept release seeking public comment on whether significant changes to the existing federal exemptions were warranted.5
1 The exemptions to which the bad actor disqualification rules currently apply include Rules 504, 506(b) and 506(c) of Regulation D, as well as the exemptions under Regulation A and Regulation Crowdfunding.
2 Disqualifying events that occurred prior to effectiveness of the rules (generally September 23, 2013) do not disqualify the issuer, but if such event is still within the applicable look-back period it must be disclosed to prospective investors.
3 See Robert J. Anello & Richard F. Albert, SEC’s Reboot on Waiver Requests in Enforcement Settlements, New York Law Journal, Thursday, October 10, 2019.
4 See U.S. House Committee on Financial Services, Waters Introduces Legislation to Improve SEC Process for Holding Bad Actors Accountable, July 27, 2017.
5 SEC Concept Release 33-10649 (June 18, 2019).