The SEC and Small Capital Formation: Strengthening the Bad Actor Provisions (Part 3)

The recently formed Advisory Committee on Small and Emerging Companies has recently recommended that the SEC relax the general solicitation requirement for offerings under Rule 506.  We have been discussing the connection between any relaxation and the SEC's proposal to extend bad actor disqualifications to offerings under Rule 506.

While expansion of the use of general solicitations can benefit legitimate companies raising capital, extension of the bad actor provisions to Rule 506 seeks to ensure that this expanded authority will not be used by recidivists. 

To the extent that these reforms can be read in conjunction, it suggests that considerable thought needs to be given to the appropriate type of bad actor provisions.  These provisions generally disqualify issuers, brokers, promoters, and certain large shareholders from relying on the relevant exemption (only Regulation A and Rule 505 contain bad actor provisions) to the extent having engaged in the specified disqualifying conduct. 

Several observations about this approach deserve comment.  First, the Commission has proposed an extension of the bad actor provisions to Rule 506.  The SEC has asked for comments on whether the bad actor provisions should be extended to Rule 504, the seed capital rule.  The answer is that they should for the reasons specified here:   Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.  Under certain circumstances, Rule 504 allows for the use of general solicitations.  Extending the bad actor provisions to the rule would effecitvely prohibit recidivists from using general solicitations while preserving the right for legitimate companies.

Second, the category of bad actors should be expanded.  Violations of the registration requirements sometimes involve active participation by transfer agents and lawyers.  This occurs because exempt securities typically contain a legend on the certificate restricting resale.  Often, fraudulent offerings involve the improper removal of the restriction.  The legend is lifted by the transfer agent typically after receiving an opinion of counsel.

Transfer agents and lawyers should, therefore, be included in the type of persons who can render an exemption inapplicable.  For both, however, this should only occur where they are found, in effect, to be active and knowing participants in a registration violation.  This is discussed in greater detail here:  Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.

Strong bad actor provisions will help insure that any relaxation in the ban on general solicitations is accompanied by requirements designed to prevent improper use of this authority.  In short, bad actor provisions target bad actors without interfering with the ability of legitimate companies to raise capital. 

J Robert Brown Jr.