Why Rule 506?
Congress singled out Rule 506 offerings as an activity where
felons and wrongdoers must be identified and banned because
these offerings represent approximately one trillion dollars per
year of largely unregulated financial transactions. Rule 506 is
also the fundraising tool of choice for private issuers and funds,
including hedge funds and private equity funds (in addition
to EB-5 funding vehicles). The collapse of the private funds
managed by Bernard L. Madoff, which prosecutors estimated to
involve a $65 billion fraud, revealed that even ostensibly sophisticated investors could fail to identify fictitious investments on a
scale large enough to damage the national economy and destroy
the personal finances of many. While the “bad actor” rules
themselves would have done nothing to stop the Madoff fraud,
new Rule 506(d) stands for the proposition that even wealthy
and sophisticated investors are entitled to an assumption that
persons legally offering them securities are not convicted felons
or persons who have been cast out of the more regulated sectors
of the financial community for their misdeeds.
Rule 506 is a safe harbor under the Securities Act that allows
issuers to sell an unlimited amount of securities to an unlimited
number of “accredited investors” – investors who theoretically
have the sophistication or financial resources to invest wisely
and withstand losses – without registering the securities with
the SEC. Absence of registration means that the company selling securities to raise capital, known as the “issuer,” can avoid
the time, expense and management distraction of clearing a
prospectus with the SEC, an intimidating process most often
associated with a company “going public” in an IPO. In addition, an issuer that raises funds under Rule 506 – even tens or
hundreds of millions of dollars –can also often remain private
and avoid the reporting and compliance burdens of becoming
a public company.
The emphasized words in the preceding sentence create a
“due diligence” defense that not only shields from liability but
affirms the exempt, legal nature of the offering. Those words
also create an obligation for well-advised issuers to conduct a
reasonable investigation to discover if any covered person is a
bad actor. The Rule instructs that the nature of the inquiry will
vary based on the specifics of the issuer and the offering.1
In the view of many practitioners, a reasonable inquiry under
Rule 506(d) should at a minimum identify all covered persons,
ask if they have committed any of the bad acts, and include a
background check that includes all publicly available records
that would report the convictions, orders, judgments and other
actions that comprise the bad acts. Such a background check
should also follow up with greater scrutiny any “red flags”
indicating possible bad acts that appear in threshold research.
In determining when an investigation goes beyond the
reasonable, it is useful to keep in mind that neither Congress
nor the SEC intended to regulate Rule 506 out of existence.
Therefore, reasonable Rule 506(d) due diligence should not
add prohibitive costs to an offering unless the investigation
uncovers wrongdoing or other problems that require broadened investigation and remediation beyond the investigation’s
original purpose.
Grandfathering
A bad actor whose conduct occurred prior to September 23,
2013, when the rules became effective, will not be disqualified;
rather, the issuer must notify investors of the bad acts before
they buy. The notice requirement for “grandfathered” bad acts
is subject to the identical due diligence standard that a