May 23, 2011
The SEC's "Bad Actor" Quandary
On Wednesday, May 25, the SEC is meeting to consider whether to propose amendments to Regulation D that would disqualify “bad actors” from using the Rule 506 exemption from the registration requirements of the Securities Act. This isn’t surprising news; section 926 of the Dodd-Frank Act requires the SEC to issue these rules.
Disqualifications like this aren’t new. Rule 262 of Regulation A disqualifies certain wrongdoers from using the Regulation A exemption and the Rule 505 exemption in Regulation D incorporates those Rule 262 bad actor disqualifications. But there’s a hitch in extending those disqualifications to Rule 506 that I don’t think either Congress or the SEC has thought through.
The two rules that already incorporate bad actor restrictions were adopted pursuant to the SEC’s rulemaking authority in section 3(b) of the Securities Act. Section 3(b) authorizes the SEC to exempt offerings if the offering amount does not exceed $5 million, “subject to such terms and conditions as may be prescribed” by the SEC. If an offering falls within the “bad actor” rules, it doesn’t meet the terms and conditions prescribed by the SEC and no exemption is available. End of story.
The analysis isn’t that simple for Rule 506. Rule 506 is a “safe harbor” for the statutory exemption in section 4(2) of the Securities Act, which exempts “transactions by an issuer not involving any public offering.” Rule 506 doesn’t create a new exemption, but merely assures issuers that “[o]ffers and sales of securities by an issuer that satisfy the conditions in . . . [Rule 506] . . . shall be deemed to be transactions not involving any public offering within the meaning of section 4(2) of the Act.” In other words, if you meet the conditions specified in Rule 506, you have met the conditions of section 4(2) and have the section 4(2) exemption. But Rule 506 is just a safe harbor; a company that doesn't meet all the conditions of Rule 506 is still free to argue that its offering falls within the outer bounds of section 4(2).
The problem for the SEC is that neither section 4(2) nor the case law interpreting section 4(2) say anything about disqualifying bad actors. Why does that matter? Consider what happens after the SEC amends Rule 506 to disqualify bad actors.
Assume that Acme Corporation, which is now ineligible to use Rule 506 because of a prior securities conviction, sells securities in an offering meeting every other requirement of Rule 506. Because of the bad actor disqualification, the Rule 506 safe harbor isn’t available. But Section 4(2) has never had a bad actor disqualification, and Dodd-Frank didn’t amend section 4(2) in any way. Acme still may use the section 4(2) exemption.
The case law interpreting the section 4(2) exemption is notoriously uncertain, but the SEC has been telling us for years that anyone who complies with Rule 506, bad actor or not, comes within the uncertain boundaries of section 4(2). Unless the SEC was wrong all those years, Acme’s compliance with all the other requirements of Rule 506 should qualify it for the section 4(2) exemption. To show otherwise, the SEC will have to argue, in essence, that its own interpretation of section 4(2) is incorrect.
Of course, Congress could have avoided this quandary by extending the bad actor restriction to section 4(2) itself, but Congress didn’t do that. Now, the SEC has to live with the consequences.