Financing Through Exempt Private Capital Raise Transactions Under Regulation D of the Securities and Exchange Commission. Part II.
Regulation D Transactional Exemptions – The Anti-Fraud and “Bad Boy” Provisions
The most common registration exemption are the rules under Regulation D (Reg. D) of the Securities and Exchange Commission (SEC) as offers not involving any public offering under section 4(a)(2) of the Securities Act of 1933 (the Securities Act), to wit, Rules 506(b) and Rule 506(c). Those “safe harbor” rules do not replace section 4(a)(2) of the Securities Act as an alternate transactional exemption from registration of the securities, yet they do provide objective standards for issuers’ compliance with the exemption’s requirements, and, therefore, a higher comfort level to issuers in achieving compliance.
Notwithstanding an issuer’s technical compliance with the standards under Reg D, every offer and sale of securities within the United States must also comport with the anti-fraud provisions of the U.S. securities laws and those of the states into which such securities are offered. The federal anti-fraud statutes are described below.
Anti-Fraud Provisions
As noted, an issuer’s undertaking of an exempt offering under Rules 506(b) and 506(c), requires the issuer’s additional compliance with applicable federal statutes and the standards promulgated by the SEC under those statutes, collectively referred to as “antifraud laws.”
Under Section 17 (a) of the Securities Act, it is unlawful for any person in the offer and sale of any securities by the use of any means or instruments of transportation or communication in interstate commerce (e.g,, telephone) or by the use of the mails, directly or indirectly, (i) to employ any device, scheme or artifice to defraud, (ii) to obtain money or property by means of any untrue statement of a material fact or any omission to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or (iii) to engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser.
Furthermore, under Section 17(b) of the Securities Act, use of commerce for purposes of offering for sale, it is unlawful for any person, by the use of any means or instruments of transportation or communication in interstate commerce (e.g., telephone) or by the use of the mails, to publish, give publicity to, or circulate any notice, circular, advertisement, newspaper, article, letter, investment service, or communication which, though not purporting to offer a security for sale, describes such security for a consideration received or to be received, directly or indirectly, from an issuer, underwriter, or dealer, without fully disclosing the receipt, whether past or prospective, of such consideration and the amount thereof.
Additional anti-fraud provisions are provided under the federal Securities and Exchange Act of 1934 under Section 10(b) and SEC Rule 10b-5 promulgated thereunder, prohibiting, respectively, (i) employment of manipulative or deceptive devices or contrivances in connection with the purchase and sale of any security or (ii) utilization of the instrumentalities of interstate commerce (e.g., the U.S. Mail, telephone) or the employment of any device, scheme or artifice, or the making of any untrue statement of a material fact or omission of a material fact in order to make the statements made, in light of the circumstance in which they were made, not misleading, in either case, in connection with the purchase and sale of any security.
Most state securities laws have essentially analogous anti-fraud statutes to the federal antifraud statutes. Accordingly, notwithstanding the information disclosure threshold that may be facially satisfied under either Rule 506(b) or Rule 506(c), an issuer’s compliance with the federal and applicable state anti-fraud laws is essential, including, prudently in connection with the offering and sale of securities to accredited investors not otherwise requiring disclosure documentation to be delivered to them under Rule 506(c).
Bad Boy Provisions
In considering whether an exempt securities issuance under Reg D may be appropriate for a particular issuer or in light of particular prevailing circumstances, prospective exempt transactions require being additionally scrutinized in light of the so-called “bad actor” disqualification provisions found at Section 4(d)(5) of the Securities Act and Rule 506(d)(1) of Reg D. The bad actor prohibitions disqualify an issuer for the transactional exemption where the issuer, or any predecessor or affiliate, or any director, executive officer or other officer participating in the offering (or any general partner or managing member), or any 20% or greater voting equity holder, or, generally, any compensated or other person involved in the offering, has been convicted in the last 10 years before such sale of any crime in connection with the purchase or sale of any security, involving the making of any false filing with the SEC or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment advisor or paid solicitor of purchasers of securities, or a judgement or decree of any court within five years before such sale or any similar such conduct, or a final order of a state securities commissioner or agency thereof.
There are further elements of the bad boy provisions foreclosing the availability of private exempt offerings under Reg D not specifically enumerated here that need examination in evaluating a prospective transaction. Understanding that promoters of prospective issuers, their management teams and persons engaged in facilitating their offers and sales to whom the bad boy provisions would apply would be disqualified from utilization of Regulation D for a private offering of the securities makes essential preliminary due diligence of the prospective client, including through obtaining such persons’ comprehensive officer, director, significant shareholder representation assertions in advance to evaluate whether such transaction would be disqualified by application of the bad boy provisions, thereby prohibiting such transactions.