Per SEC rules, no company may raise capital if any officer, director, promoter or beneficial owner of 20% or more of its equity is a “Bad Actor”.
So what is a “Bad Actor” in regulatory-speak?
On July 10, 2013, the SEC adopted bad actor disqualification provisions for Rule 506 (b & c) of Regulation D under the Securities Act of 1933, to implement Section 926 of the Dodd-Frank Act. This rule prohibits a company from raising capital if the issuer or any associated person has, among other things, been convicted of, or is subject to judicial or regulatory sanctions for, certain violations of law.
Read the SEC Rule Notification https://www.sec.gov/info/smallbus/secg/bad-actor-small-entity-compliance-guide.htm
Overview of the Bad Actor Rule
The “Bad Actor” rule is codified as new paragraphs (d) and (e) to Rule 506. Rule 506(d)(1) provides that the exemptions in Rule 506(b) and Rule 506(c) are not available if the issuer or any associated person is statutorily disqualified. This includes all of the following:
1. issuer = the company selling securities, any predecessor of the issuer (prior entity), and any affiliated issuer
2. associated persons =
· Directors, general partners, and managing members of the issuer;
· Executive officers of the issuer, and other officers participating in the offering;
· 20 percent beneficial owners of the issuer;
· Investment managers and principals of pooled investment funds; and
· Any person compensated for soliciting investors.
Events that trigger disqualification under the rule include:
1. Criminal convictions relating to securities transactions, false filings with the SEC, or certain securities-related businesses;
2. Court injunctions and restraining orders relating to securities transactions, false SEC filings, securities-related business activities, or obtaining money or property through the mail by means of false representations;
3. Final orders of certain financial regulators that bar the covered person from associating with a regulated entity or engaging in certain financial business activities, or that are based on a violation of antifraud rules, or any postal service false representation order;
4. SEC orders revoking the registration of a regulated person, limiting the activities of such a person, or imposing industry, collateral or penny stock bars;
5. SEC cease-and-desist orders with respect to the scienter-based antifraud rules or violations of Section 5;
6. Suspension or expulsion from a self-regulatory organization; and
7. In the case of any registrant, issuer or underwriter named in any registration statement or Regulation A offering statement filed with the SEC, the issuance of a suspension or stop order with respect to such registration statement or offering statement, or any ongoing investigation relating to the same.
The look-back period is five years, except in the case of criminal convictions (for persons other than the issuer, its predecessors, and affiliated issuers) and certain regulatory orders based on antifraud violations, for which the look-back is ten years, and for certain SEC or SRO suspensions, revocations, bars, expulsions, and related orders, which result in disqualification so long as they remain in effect.
Q. Wow, do we really have to do this?
Yes, it’s the rule. If you are going to raise capital then you are going to do bad actor checks.
Q. Can we just do one check on the issuer?
No, you have to check not only the company (issuer), but also each and every person individually (officers, directors, 20%+ equity holders – but not regular employees or managers, nor minor shareholders or investors)
Q. How do we do these? Does the SEC have a central database we can check?
It’s frustrating that there is a rule requiring this, but no central database to check (a la OFAC, FinCEN, etc). The only way to do this is by subscribing to various legal databases (e.g. LexisNexis, WestLaw, etc) and manually researching each person. It’s labor intensive and there are no automated solutions. The best way to get this done is to rely on FundAmerica or your securities attorney to do this for you – though honestly, due to scale, the FundAmerica fee of $45 per check is likely the best you’ll find.
Q. Is this the same as “AML”?
No. You always have to perform “Anti-Money Laundering” checks on everyone in the chain of funding. This means each investor, as well as the issuer and associated persons. Whereas bad actor searches look for violations of law and regulatory infractions, AML searches look for money-laundering, terrorist watchlists, financial crimes and IRS tax-id fraud. Both different. Both required.
Q. I had a bankruptcy, am I a bad actor?
That’s a civil matter, not necessarily regulatory. So bankruptcies, while they may or may not be a material item requiring disclosure in an offering, they are not something that makes you a bad actor.
Q. I made some mistakes in my youth and have a felony conviction on my record, am I a bad actor?
Is it related to securities? Chances are that it’s irrelevant to the bad actor designation and you should be fine but you need to check to be sure.
Q. I’m involved in a nasty lawsuit with…(some party)…, am I a bad actor?
Civil matters are not included in the bad actor designation, so the answer is probably no. Though lawsuits may or may not be a material item that requires disclosure on your offering documents (your securities attorney will make that call).
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