Bad actor checks under Regulation D

Regulation D has unlocked a path for small businesses seeking to raise capital without undergoing the process of registering with the SEC. While the exemption lowers the barriers to capital raising for SMBs, there are a number of rules designed to safeguard investors despite relaxing the registration requirements.

One of those core rules is a prohibition on Bad Actors from leveraging Regulation D to raise capital. If a Bad Actor is found to have participated in a Reg D capital raise,  the ramifications extend beyond the individual involved; they have the potential to render the entire offering ineligible according to SEC regulations. Furthermore, having Bad Actors associated with your offering under Regulation D can expose you to federal and state legal liabilities.

The rule mandates that no securities may be issued under Rule 506(b) or Rule 506(c) if any member of the issuing team, considered a “covered person”, has been involved in a disqualifying event since September 23, 2013. 

What Constitutes a Disqualifying Event?

The SEC categorizes any event that identifies individuals as Bad Actors under Regulation D as a disqualifying occurrence. These events include:

1. Specific criminal convictions connected to the purchase or sale of securities, making a false filing, or the conduct of a broker-dealer

2. Particular disciplinary orders issued by the SEC

3. Select SEC cease-and-desist orders

4. Restraining orders and injunctions connected to the purchase or sale of securities, making a false filing, or the conduct of a broker-dealer

5. Conclusive orders from federal and state regulators

6. Suspension or expulsion from specific professional organizations

7. Orders for false representation

For a detailed list, view the SEC’s guide to bad actor compliance.

Guarding against Bad Actors

Bad actor checks are essentially background investigations carried out on individuals or entities associated with a securities offering to ensure they have not been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations that would disqualify them from participating in Regulation D offerings.

Bad actor checks can be performed manually or through service providers. Manual checks involve conducting background investigations through various sources, including the Financial Industry Regulatory Authority (FINRA) database called BrokerCheck and the National Futures Association (NFA) database known as BASIC. Alternatively, service providers such as CrowdCheck and platforms like Mainshares offer streamlined solutions for these checks. 

Why Are Bad Actor Checks Needed?

Bad actor checks serve a pivotal role in the world of securities regulations:

• Preventing Fraud: One of the primary purposes of these checks is to prevent individuals or entities with a history of fraudulent activities from exploiting Regulation D exemptions to perpetrate fraud and sell securities.

• Instilling Investor Confidence: By prohibiting the participation of bad actors in securities offerings, these checks instill confidence among investors, assuring them that they are engaging with ethical and trustworthy entities.

• SEC's Goals: These checks align with the Securities and Exchange Commission’s (SEC) overarching goals of safeguarding investor interests and reducing securities law violations, ensuring the integrity of the securities market.

In the context of the bad actor provisions for Regulation D, a "covered person" refers to an individual or entity that could potentially be disqualified from participating in specific securities offerings. These provisions are designed to protect investors by preventing individuals or entities with a history of securities law violations or other disqualifying events from participating in private placements and other exempt offerings.

Covered persons include:

• Issuers using the Regulation D exemption (e.g., entrepreneurs raising capital for a small business venture)

• Directors, officers, partners, managers, trustees, and others with similar status or function

• Persons compensated for soliciting investors (e.g., a broker-dealer assisting with capital raising)

• Affiliates and predecessors of the above person

Typically, the issuer and legal counsel will conduct checks before offering securities. Broker-dealers, such as our affiliate Main Street Securities, may also run checks on issuers and their related parties.

Failing a Bad Actor Check

If a covered person fails a bad actor check, the consequences include:

• Disqualified issuers cannot rely on the Regulation D exemption

• Must disclose bad actor involvement to investors

• Could face SEC enforcement action or civil lawsuits

• May request a waiver through the Office of Small Business Policy

When a covered person fails a bad actor check, it means that the disqualified entity or individual cannot benefit from the streamlined and cost-effective capital-raising methods that Regulation D offers. This bad actor disqualification measure serves as a deterrent to those with a history of securities fraud or other disqualifying violations, reinforcing the SEC's commitment to maintaining the integrity of the financial markets and safeguarding the interests of investors and small businesses alike.  

How Do You Avoid a “Bad Actor” disqualification?

While there isn't a single comprehensive database that provides a definitive check for the presence of Bad Actors in your offering, taking the path of "reasonable care" through a "factual inquiry" into each person subject to disqualification is the key to ensuring that you can proceed with selling securities under the SEC's registration exemptions, even if a Bad Actor is unexpectedly involved.

So, how can you demonstrate that you've exercised "reasonable care"? Leverage a service like Crowdcheck or a platform like Mainshares.

It's not necessary to wait until you're actively planning an offering; consider checking potential officers and directors before they join your team to proactively avoid complications down the road. Avoiding a Bad Actor disqualification under Regulation D involves careful compliance and due diligence. Here are some steps to help prevent such disqualifications:

Reasonable Care Exception

The SEC has introduced a provision known as the "reasonable care" exception, which allows issuers to bypass the prohibition on using Rule 506 of Regulation D, Regulation CF, and Regulation A if they can demonstrate that they neither knew nor could have reasonably known about the presence or participation of a disqualified covered person. The SEC acknowledges that this exception is necessary because there is no central repository that consolidates information from all federal and state courts and regulatory authorities, making it challenging to ascertain whether covered persons have a disqualifying event in their history.

Information posted on this page is not intended to be, and should not be construed as tax, legal, investment or accounting advice. You should consult your own tax, legal, investment and accounting advisors before engaging in any transaction.