Policing Reg D for "Bad Actors"

Startup founders and angels alike do not want felons and other "bad actors" participating in the startup ecosystem.

So SEC rulemaking on this point - specifically, by disqualifying a private offering from the federal exemption under Rule 506 of Regulation D if the offering involves bad actors - is something you'd hope entreprenuers and angel investors could cheer.

But the details are bedeviling.

The SEC's proposed rules - and these are the rules as proposed, not final rules - seem to place on even the youngest of companies a burden of inquiry that is more stringent than that required to meet any other condition of the Rule 506 exemption.

Disqualification does not apply, the proposed rule states, "If the issuer establishes that it did not know, and in the exercise of reasonable care could not have known, that a disqualification existed . . ."

It's the negative epistemological imperative, "could not have known," that is troubling.

What if it turns out after the fact that a bad actor had, unknown to anyone in the deal but the bad actor himself, been involved?

What if the accredited investor standard were subject to such a test? Could an issuer "have known" that a given investor's accredited investor reps were false, had it merely verified the investor's brokerage and bank accounts, checked his tax returns, and hired a private detective to ensure he wasn't living in his winter cabin as his principal residence?

On the other hand, footnote 85 in the SEC release announcing the proposed rules seems to suggest that checking for bad actors might be no more onerous then screening potential investors for accreditation by use of a questionnaire:

". . . using questionnaires similar to the current practices for establishing a reasonable basis for determining accredited investor status would seem to be appropriate . . ."

So which is it going to be? The language in the proposed rule, or the guidance of the footnote?

There shouldn't be this much uncertainty about such a practical issue.

Thankfully the Angel Capital Association has keyed on this point, in a letter from ACA Executive Director Marianne Hudson that supplements her prior letter to the SEC on the bad actor rules:

"Perhaps the Commission’s intentions would be better served by rewording the proposed safe harbor as follows: 'If the issuer establishes, after inquiry that is reasonable in the particular circumstances, that it did not know that a disqualification existed.' This regulatory language should be supplemented with an instruction that, where an issuer engages no compensated solicitor but instead sells securities directly in conformance with the exemption, the use of questionnaires (as proposed in our letter dated July 14, 2011) will ordinarily satisfy the standard."

I think that's exactly right.

Pictured: René Descartes reviews investor questionnaires with Queen Christina of Sweden.