The Sec Rule 506’s Bad Actor Rule: A Condition or an Invalidator of Rule 506 Exemption Status?

Abstract

Federal securities regulation in the United States has one principle goal: to ensure that investors are able to make informed decisions regarding potential investments. To achieve this, federal regulations oblige firms to be forthright with shareholders and potential investors through disclosing material facts, projects, performance metrics, and the like. However, both the states and the federal government regulate securities and, in some cases, there is a clear dividing line between what falls under federal jurisdiction and what is left to the states. In other cases, determining this line is far from clear, resulting in a murky and complex overlap of federal and state regulations. For example, a state could aim to protect state investors by bringing a fraud action against an issuer on the offering’s merits, yet that same offering would be federally compliant and unobjectionable. Because state and federal regulations may have different objectives, investor protection versus disclosure respectively, the tension between them can raise federalism concerns when an offering abides federal regulations yet is deficient under state laws with concurrent jurisdiction. To simplify overlapping state and federal securities regulations, in 1996 Congress passed the National Securities Markets Improvement Act (“NSMIA”) to preempt states from regulating “covered” securities, leaving covered securities solely under substantive federal regulation. While various types of securities are covered, the Security and Exchange Commission (“SEC”)’s Rule 506 of Regulation D (“Rule 506”) is a prevalent regulation for offerings to qualify as a covered security. Rule 506 covers private offerings that are only available to sophisticated buyers and/or limited in its solicitation methods. Rule 506 provides a “safe harbor” that exempts the private offering from both federal and state registration if its prescribed conditions are met. In response to the economic havoc wrought by the 2008 Great Recession, the SEC introduced several major changes to Rule 506, including the addition of a rule that disqualifies “bad actors” convicted of fraud-related crimes (“Bad Actor Rule”) from relying on Rule 506 for an exempted status. Recent judicial decisions have required an issuer to prove that it is in substantive compliance with Rule 506’s conditions before the offering is actually exempt from state laws. However, if an issuer must prove compliance before being exempted from state securities law, may state securities regulators rebut an issuer’s claimed Rule 506 exemption with evidence that the issuer is non-compliant with the Bad Actor Rule? In other words, may state regulators who have evidence that an issuer has violated the Bad Actor Rule use that evidence to disqualify that issuer from relying on Rule 506 because a condition of Rule 506 is that the issuer must be a “good actor,” in a manner of speaking? Setting aside the merits of this argument for a moment, this Article applies standard statutory interpretation maxims to argue that the text of Rule 506 and the Bad Actor Rule do not support the argument that the Bad Actor Rule is a condition under Rule 506. However, this Article goes on to argue that, as a matter of policy, states ought to have authority to challenge an issuer’s claimed good character. Therefore, the Article will make several appropriate recommendations.