SEC Proposes to Disqualify Felons and Other “Bad Actors” from Rule 506 Offerings

Investment Management Update

Date: June 06, 2011


In accordance with Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission (SEC) recently proposed amendments to Rules 501 and 506 of Regulation D and Form D under the Securities Act of 19331 ("Securities Act"). The proposed rules would disqualify certain securities offerings involving felons and bad actors from reliance on the safe harbor exemption.

The rules, which would impact hedge funds, private equity funds and private placements, would impose a new burden of inquiry with respect to potential disqualifying events.


Rule 506 permits an unlimited dollar amount of securities to be sold without registration to an unlimited number of accredited investors and up to 35 non-accredited investors as long as there is no general solicitation, appropriate resale limitations are imposed, any applicable information requirements are satisfied and the other conditions of the rule are met.2

Rule 506 in its current form does not impose any bad actor disqualification requirements and since the securities are "covered securities" under Section 18(b)(4)(D) of the Securities Act, no state-level bad actor disqualification rules apply.

Requirements of the Proposed Rule
Covered Persons

The proposed rules would include the following as "covered persons":

  • The issuer, including its predecessors and affiliated issuers
  • Any director, officer, general partner or managing member of the issuer
  • Any beneficial owner of 10 percent or more of any class of the issuer's equity securities
  • Any promoter connected with the issuer at the time of the sale
  • Any person who has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering
  • Any director, officer, general partner or managing member of compensated solicitors
Disqualifying Events

Under the proposed rules, a "disqualifying event" would include the following:

Under the proposed rule, an offering would be unable to rely on the Rule 506 exemption if the issuer or any other person covered by the rule had a "disqualifying event."

Reasonable Care Exception

The proposed rules provide an exception from disqualification when the issuer can show it did not know, and in the exercise of reasonable care, could not have known, that a disqualification existed.


The proposed rules provide for waivers from disqualification under Rule 506 upon showing good cause if the SEC determines that it is not necessary that the exemption be denied.

Events Pre-Dating Affiliation

Under the proposed rules, past disqualifying events will be taken into account under the new disqualification rules. Events relating to any affiliated issuer that occurred before the affiliation arose will not be considered disqualifying if the affiliated entity is not in control of the issuer or not under common control with the issuer by a third party that was in control of the affiliated entity at the time of such events.

Submitting Comments

Comments on the proposed rules should be submitted to the SEC on or before July 14, 2011 by using the SEC's internet comment form, using the Federal Rulemaking Portal, sending an email3 or mailing written comments.4


115 U.S.C. 77a et seq.

2Offerings under Rule 506 are subject to all the terms and conditions of Rules 501 and 502, including limitations on the manner of offering, limitations on resale and, if securities are sold to any non-accredited investors, specified information requirements. Non-accredited investors must also satisfy the investor sophistication requirements of Rule 506(b)(2)(ii). In addition, offerings under Rule 506 must comply with notice of sale requirements of Rule 503.

3Send emails to with "File Number S7-21-11" in the subject line.

4Send written comments in triplicate to Elizabeth M. Murphy, Secretary; Securities and Exchange Commission; 100 F Street, NE; Washington, DC 20549-1090.