Willful Blindness: The Rule 506 Securities Law Exemption and The New “Bad Actor” Rules

Entrepreneurs create jobs, but they generally don’t do it out of thin air. Usually, they need investors. These investors are generally very wealthy people who are 1) inherently private and 2) usually very busy doing wealthy person stuff. So imagine learning, after going through all the work of finding an investor, that the Congress and the Securities and Exchange Commission (SEC) want to make it harder to raise money, including in some cases requiring investors to respond to a checklist of private and probing questions to find out if they are or have been at any time within the last 10 years a “bad actor.”

If you haven’t had the chance to read the SEC’s proposed rules on “bad actors” disqualifying companies from using the Rule 506 securities law safe harbor exemption, you ought to. The proposed rules, if adopted, will fundamentally change Rule 506 offerings and the startup financing legal landscape.

How, you might ask? By imposing on startups the “did-not-know-and-in-the-exercise-of-reasonable-care-after-factual-inquiry-could-not-have known” standard when it comes to investigating “covered persons” (including prospective 10% or greater investors). Covered persons who are bad actors might disqualify a startup from using Rule 506 by virtue of their prior bad acts (including in some cases misdemeanors committed as long ago as 10 years before the sale of the securities).

“Willful blindness” is a legal concept that is bandied about in scandal from time to time. Remember Watergate? Or last week’s scandal for that matter? It all comes down to the fundamental question of what did the President or CEO know and when did he know it? The opposing question is, of course, how is a President or CEO supposed to know everything about everyone involved in her or his company?

One of the beauties of Rule 506 right now, of course, is that it is easy for startups to use. There is no due diligence requirement currently built into Rule 506. To use rule 506, there are a few requirements, for sure, but the primary requirement–that the company had a reasonable belief that each of the investors was accredited, does not affirmatively require investigation or diligence, like the new “bad actor” rules would.

What Is the Rule 506 Exemption?

Rule 506 is the securities law “safe harbor” exemption that startups most commonly use to raise capital. Under Rule 506 you can raise as much money as your heart desires as long as your investors are accredited (meaning, generally, that they have a net worth of over $1 million (not including primary residence) or at least $200,000 in income for the last 2 years (or $300,000 with spouse) and the expectation of the same during the year of investment) and you follow some rules which are generally pretty easy to follow. This is a big deal. The Rule 506 offering safe harbor exemption is a key piece of the legal framework that has allowed the angel and venture capital industry to thrive. Without it, officers and directors of companies would be exposed to great personal risk when their companies sold securities to raise funds.

Here are some of the key aspects of Rule 506:

  • Safe Harbor – Rule 506 is a “safe harbor.” Meaning, if you meet the requirements of the rule, you can be assured that you fit within the exemption from registration allowed by Section 4(2) of the Securities Act of 1933, as amended. If you don’t meet the requirements of the rule, you will not have this assurance, and you will be at greater personal risk as an officer and director of a company.
  • Accredited Investors Only – A startup can solicit an unlimited number of investors, and sell to an unlimited number of investors, as long as all investors are accredited. If you sell to any non-accredited investors, then Rule 506 has voluminous specific information requirements.
  • Unlimited Dollar Amount – A startup can raise an unlimited amount of capital.
  • No General Solicitation – A startup cannot use general solicitation or advertising to market the securities.
  • Restricted Securities – The securities sold must have resale restrictions and be “restricted securities.”

What You Should Know Can Hurt You

What the SEC is proposing in its new rules is nothing less than the most strenuous legal standard possible be applied to the last type of business you need to be burdening in a climate of high unemployment–startups! The Rule 506 exemption will still be available, even if a bad actor is in the mix:

“If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed…”

Instruction…An issuer will not be able to establish that it has exercised reasonable care unless it has made factual inquiry into whether any disqualifications exist. The nature and scope of the requisite inquiry will vary based on the circumstances of the issuer and other offering participants.”

What this means is that startups are going to have to go through a new, cumbersome two (2) step inquiry as part of fund-raising. First, they are going to have to identify the universe of “covered persons” (including prospective 10% or greater investors). Next, they are going to have to determine if any of the “covered persons” have engaged, within a defined time period, in a “disqualifying act.” If you discover that you have a “covered person” that is a bad actor that would disqualify your offering, you must not let person be a “covered person” with respect to your company, because if you do you will not be able to rely on the Rule 506 safe harbor securities law exemption. This is new to Rule 506 offerings and this process will not be an easy or brief or abbreviated process.

Contrast this proposed rule with the existing rule on whether you can take money from an investor. In that circumstance, you just need a reasonable basis to belief that the investor is accredited. There is no affirmative factual inquiry required.

What’s Wrong With The New Rules?

  • They fundamentally change Rule 506 offerings – The ease of Rule 506 offerings has been a key component of the startup ecosystem for years. No longer will Rule 506 offerings be so easy. Rule 506 offerings will be fundamentally changed if these rules become law. This is extremely unfortunate.
  • They are onerous – The SEC’s proposed rules are onerous. They are long. They are complex. Simpler is not always but is frequently better. The SEC would do well to substantially shorten these rules and make them less cumbersome.
  • They will slow down the process of raising money – The process of conducting factual inquiries will take time. These aren’t processes that can be completed in a very abbreviated period of time.
  • They will make the process of raising money more expensive – Companies are going to have to undertake due diligence investigations. This will cost money.
  • They will slow down job creation – Startups create jobs. The faster startups can raise capital, the faster they can hire workers.

Why Are Congress And The SEC Doing This?

Perhaps it is what Howard Lindzon says–“entrepreneur envy.”

“…entrepreneurs are chasing dreams with little bits of angel and venture money. Companies with massive opportunity and now loads of cash are going public and dominating their verticals or mindshare. That’s not a bubble.

We the entrepreneurs believe at some level that we have the next Facebook, Linked In, Google, Pandora and our passion, fear, hunger and envy drives us. First let me tell you how humbling it is to have a board meeting with the investors in Zynga and WordPress – to name a couple- and explain our growth.”

I Wish Congress Would Just Repeal This New Rule

As the founder of a startup, just finding investors is hard enough. The thought of the law making it even harder to raise money probably makes you feel like you just drank a tall glass of turpentine and will probably keep you up at night thinking of alternatives. It might be so easy to turn a blind eye and say that you didn’t know, but that would mean you didn’t exercise reasonable care. And finding out about it later and doing nothing (willful blindness) won’t make the situation any better. It would probably make it worse. The past mistakes of “covered persons” shouldn’t hold you back from realizing your dream of starting an honest and lucrative business. The SEC needs to cut back these rules and make them more reasonable and less cumbersome (for example, the proposed coverage of 10% shareholders should be increased substantially). They should harmonize them with the current operating environment for Rule 506 offerings–with no specific factual inquiry required.

For more information check out:




This entry was posted in Federal Law & Regulation and tagged , , . Bookmark the permalink.
  • http://www.wac6.typepad.com William Carleton

    Joe, the new design likes great!

    Good post and I share your concern that 506 could be rendered much harder to use if the SEC is not careful about implementing the bad actor disqualifications. It could even be ruined if what you worry about comes to pass.

    But keeping “bad actors” out of 506 offerings is a good idea. It’s one of the mandates of Dodd-Frank and, as you well know, it’s one of the reforms that were part of the Angel Investor Amendment that saved 506 from (then Senate Banking Committee Chair, now MPAA lobbyist) Christopher Dodd’s initial, indiscriminate attack on startups and angel financing.

    So I support the bad actor exclusion. I think the focus should be persuading the SEC to implement the rules so it is as easy to comply with as startups today comply with the accredited investor standard. Ideally, a questionnaire filled out by the appropriate persons should do it. And if it takes everyone some time to learn what the “bad actor” definitions are, I think that’s okay. The integrity of Rule 506 is really important!

    • Anonymous

      Bill, yeah, we just disagree. I think Congress should spend more time repealing law than making law. And I think the regulatory agencies should spend more time repealing regulations than imposing new ones. So, I would favor repealing the two sections of Dodd-Frank which made life harder on startups. I just don’t see the justification for making like more difficult on a segment that is actually one of the few bright spots in this economy.

  • http://twitter.com/asherbearman Asher Bearman

    First, this is a really great article Joe, nicely done.  I think you make some valid points here but agree with Bill that, overall, the concept of a bad actor rule is a good thing for companies and startups.  It should, if properly implemented, increase the integrity of the startup ecosystem and facilitate investments by giving reasonable comfort.  That said, I agree with you that the scope of these rules is broad and perhaps more than the appropriate level of protection. 

    • Anonymous

      Thanks for your comment Asher. I think the we have too much law.

  • Pingback: 5 Rules of the Road For Private Company Financings | Startup Company Law Blog | Davis Wright Tremaine LLP()

  • Pingback: SEC “Bad Actor” Rules: Hard On Startups And Early Stage Companies | Startup Company Law Blog | Davis Wright Tremaine LLP()