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Burke Costanza & Carberry LLP your smart choice for lawyers in Northwest Indiana. Our full-service law firm has offices in Merrillville and Valparaiso Indiana as well as one in Chicago Illinois. At BCC, our lawyers pride themselves on being able to provide a wide range of legal services to our clients, who benefit from the depth and experience we provide from top to bottom.

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Burke Costanza & Carberry LLP is a well-rounded firm with strong roots in Northwest Indiana that is focused primarily on our lawyers providing clients with the highest quality legal service in a broad range of practice areas.

Business & Personal Services Blog

Proposed Rule 506 Changes

Jon A. Schmaltz

Co-authored by Michael Bolde, summer associate, and Jon Schmaltz, partner

In many circumstances, companies can raise an unlimited amount of capital by issuing securities exempt from registration with the U.S. Securities and Exchange Commission under Rule 506 of Regulation D.  In these transactions, securities can be issued to an unlimited number of accredited investors and up to 35 non-accredited investors.  Non-accredited investors must be given written disclosures regarding the company and the securities being issued, and the issuer must comply with the anti-fraud requirements of the Securities Act of 1933 and the Securities Exchange Act of 1934.  Recently, the SEC has published a proposed rule restricting the issuance of securities to certain felons and other “bad actors” as a result of requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act.

Currently, Rule 506 has no rules for disqualification for securities offerings involving felons and other bad actors; however, this is changing due to the requirements of Section 926 of the Dodd-Frank Act, which requires the SEC to adopt and implement felon and other bad actor disqualification provisions for Rule 506.  According to the Act, these disqualification provisions need to be “substantially similar” to Rule 262, the disqualification provision of Regulation A and must also cover matters enumerated in Section 926.

The proposed rule will surely bring some changes; however, it will not impose any new reporting requirements.  In addition, the cost of compliance with the new Rule 506 is expected to be lower for smaller entities than for larger entities, largely due to the differences in organizational structure and the number of individuals involved in the securities offerings.

As a result of the addition of felon and other bad actor provisions to the current Rule 506, there is no question that the burden, with respect to the array of now potentially disqualifying events, will increase to issuers intending to issue securities under Rule 506.  To combat these concerns, the SEC has proposed a “reasonable care exception,” surprisingly not mentioned in Section 926 or in the current Rule 262, to offset some of the newfound concerns.

The reasonable care exception is just that – an exception from disqualification for those offerings where the issuer is able to establish that they did not know or, of course within the gambit of reasonable care, could not have known that a disqualification existed because of the involvement of another, unbeknownst to the issuer, disqualified person.  To fall within this exception, a securities issuer would need to engage in a factual inquiry, the breadth of which would depend on the facts and circumstances in regards to the risk that disqualified, bad actors, could be present, the presence of other screening and compliance mechanisms, and the cost and burden of the inquiry.  Naturally, the burden of establishing such reasonable care would be on the issuer, and it remains to be seen what an issuer will need to do, and of course, how much it will cost the issuer to comply with and demonstrate that the requisite amount of reasonable care was exhibited by the issuer.

Issuers under the proposed changes to Rule 506 will also be able to seek waivers from disqualification from the SEC.  In fact, the SEC has proposed to carry over the current waiver provisions of Rule 262 to the new disqualification provisions in Rule 506.  Waivers are important to securities issuers in Rule 262 and will certainly be important in the new Rule 506 since the SEC, just like in Rule 262 of Regulation A, may grant a waiver when it deems an issuer has shown good cause that it is not necessary under the circumstances that the registration exemption be denied.

Moving on to the transition period that will undoubtedly occur once Rule 506’s changes become final, many might be wondering what will happen to securities already issued or to those that are in the process of being issued.   The SEC has stated that the disqualification provisions would apply to offerings issued after, not before, the effective date of the new provisions.  Basically, if the transaction was completed before the effective date of the new Rule 506, then the new Rule 506 will not apply to the offering; however, whether the offering has been “completed” is the critical subject of concern.  Those securities transactions that are underway, but not yet finished, are incomplete and will resultingly fall within the purview of the updated and revised Rule 506, including the felon and other bad actor disqualification provisions.  It is important to note, that once a transaction falls under the new disqualification provisions of the new Rule 506, it also becomes subject to the relevant look-back periods, regardless of whether the events occurred before enactment of Section 926 of the Dodd-Frank Act.

It is certain that those offering securities under the new Rule 506 will face new challenges due to the felon and other bad actor provisions; however, Rule 506 will look and feel a lot like Rule 262 of Regulation A.  Furthermore, the inclusion of a “reasonable care exception” by the SEC will further ensure that these disqualification provisions do not become insurmountable to those who seek to engage in future offerings using Rule 506 of Regulation D.

Co-authored by Michael Bolde, summer associate, and Jon Schmaltz, partner