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Beware the Bad Actor


It is fairly obvious to most of us what bad acting looks like – we know it when we see it. However, "bad acting" has significant ramifications under Federal securities laws. In 2013, the Securities and Exchange Commission (the "SEC") adopted bad actor disqualification provisions which apply to securities offerings conducted under Rule 506 of Regulation D of the Securities Act of 1933, as amended (the "1933 Act"). This bad actor provision was adopted to implement certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Most private companies think that the Federal securities laws do not impact them because they are not publicly traded and are not planning on going public. However, this is not the case. Every time a company issues a share of its stock, state and Federal securities laws come into play. There must an exemption from registration for the issuance of a share of stock. Typically, Regulation D is the most frequently relied upon safe harbor for inter-state offers and sales of securities. Thus, whether a company realizes it or not, Regulation D may be at play in its issuances of its securities.

Under the 1933 Act, every security that is issued must be registered unless there is an exemption from registration. Regulation D is a safe harbor that allows companies to issue their securities and raise capital without registering these securities under the 1933 Act. When the SEC amended Rule 506, it provided that an issuer can no longer rely on Rule 506 (b) or (c) if the issuer or its officers, directors, certain shareholders and promoters have certain disqualifying events in their respective backgrounds.

These disqualifying events, or "bad acts," include criminal convictions, court injunctions and restraining orders, final orders of state and federal regulators, SEC disciplinary orders, SEC cease-and-desist orders, SEC stop orders, suspension from a self-regulatory organization, and US Postal Service false representation orders, all of which relate to securities and the securities industry. As of September 23, 2013, if an issuer or covered person has a disqualifying event, the issuer cannot rely on Rule 506 as a safe harbor for an offering of its securities. If the disqualifying event happened before September 23, 2013, the issuer may rely on Rule 506 but will have disclose the disqualifying event in its offering materials. Obviously, removing a company's ability to rely on the safe harbor provided by Rule 506 of Regulation D may be especially detrimental if a company is required to unwind the transaction.

A company may be interested at some point in being acquired by a public company or it may be acquired by a company that does ultimately becomes publicly traded. At that time, the bad actor provisions will rear its head as the acquiring company conducts its due diligence of the private company and its past and present officers, directors, and 20% shareholders.

Since the adoption of the bad actor rules, self-regulatory organizations such as FINRA (Financial Industry Regulatory Authority), which process all corporate actions for publicly traded companies, such as name changes, stock dividends and stock splits, have aggressively begun investigating the backgrounds of the persons affiliated with trading companies before it will process and implement any proposed corporate action. This includes reviewing the shareholders' list for the company as well as requesting list of beneficial owners of the issuer's securities. The beneficial owners are those persons holding their securities in brokerage accounts. If FINRA determines that there is a bad actor in the company, including any companies that it acquired or merged with, then it may refuse to process the corporate action. As a result, a company is not able to change its name or request a new trading symbol or a myriad of other corporate actions. To avoid this consequence, many companies have been forced to rescind the merger or the purchase of a company because one of the entities involved has a bad actor lurking in its corporate past. In some instances, FINRA has allowed the bad actor to resign from the issuer, which may work a hardship on someone losing a lucrative employment opportunity.

As matter of good corporate practice for any company, starting with its incorporation and moving forward, it would behoove its board of directors to institute a policy of having director nominees as well as officer candidates complete officer and director questionnaires which ask about potential disqualifying acts in that person's background. These questionnaires should be reviewed and follow-up questions asked if necessary. These questionnaires should be updated annually.

In addition, shareholders who will own at 20% of a company's stock are subject to the bad actor provisions. Therefore, before accepting an investment that will result in some person or entity owning more than 10% of a company's stock, the board of directors should also conduct a review of that proposed acquisition of stock and have a similar questionnaire completed before the stock purchase is completed.

If a company cannot rely on Rule 506 of Regulation D because of bad actor disqualification, then the company should make sure that there is another rule or exemption upon which it can rely. If there is not an applicable rule or exemption, the company is subject to federal and/or state regulatory action which may include rescission of all investments received under the non-exempt transaction as well as fines, disgorgement, penalties and an injunction against future involvement in securities and public companies.

In this age of technology, as a matter of simple due diligence, it is prudent for a company to check online databases such as the SEC's website ( to see if a person's name appears in that database. If it does, then the company is then on notice that there may be an issue with that person and can investigate accordingly.

Failure to identify potential bad actors which results in a merger or company sale being rescinded would likely subject the directors and/or officers to potential liability in shareholder lawsuits or in shareholder derivative litigation. So while a company may not think that it need to be concerned with federal securities laws because it is not publicly traded, think again. It may sneak up on a company when it least expects it. And it is not going away in this information age.

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