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Covered Persons
Covered persons under 506(d) generally fall into
four broad categories:
•
The issuer itself
•
Individuals who control the issuer, for example, the
principals of a regional center or developer that will
be general partner or manager of an EB-5 fund
•
Beneficial owners - individuals or
companies that control 20 percent or
more of the issuer’s voting securities
•
Individuals and companies associated with
the offering, including company officers,
fund managers and “promoters.”
The Bad Acts
The bad acts specified under Rule 506(b) generally fall into
the following categories:
•
Convictions for crimes – either felonies or
misdemeanors – involving securities
•
Court orders or decrees that bar the covered person
from specific activities involving securities
•
Orders of state and federal banking,
insurance and commodities regulators
•
SEC orders that prohibit a covered person from
engaging in specified business activities or order a
person to stop committing fraud or illegal offerings
•
Expulsion from membership in a securities exchange
or a national securities association for failing to
follow just and equitable principles of trade
•
Making or underwriting a registered offering
that was stopped or suspended by the SEC,
or is currently the subject of investigations or
proceedings for a stop order or suspension
•
Orders of the U.S. Postal Service related to
false representations (i.e., mail fraud).
The Rule has varying “look back” periods for the bad acts.
Generally, a bad act disqualifies the covered person or must be
disclosed (if the act falls within the grandfathering period) if it
occurred within five years of the contemplated Rule 506 offering. However, criminal convictions for covered persons other
than the issuer have a look-back period of 10 years. Orders that
bar the covered person from business activities or enjoin the
covered person from committing wrongful acts will be disqualifying bad acts if the bar or injunction is effective at the time of
the contemplated Rule 506 offering.
24
“…Rule
506(d) stands for the
proposition that even wealthy
and sophisticated investors
are entitled to an assumption
that persons legally offering them
securities are not convicted felons
or persons who have been cast out
of the more regulated sectors
of the financial community
for their misdeeds.”
Phased Due Diligence Review
Companies planning an EB-5 offering should begin the due
diligence process early, and for regional centers and developers
that regularly raise EB-5 funds, bad actor due diligence should
be an ongoing process, integrated into the general background
checks performed when engaging team members and strategic
partners for projects.
This article lays out a phased approach to Rule 506(d) due
diligence – it is just one manner by which bad actor checks
might be accomplished. Rather than leaping to the minute
criteria of the Rule, one could begin with broad categories of
potential bad acts. While this approach will result in “false
positives” – people who have committed misdeeds that don’t ultimately disqualify them –it should rule out bad acts for the vast
majority of covered persons, eliminating the need to investigate
further. When a potential problem is found, the investigator
can more closely examine the conduct and determine if it falls
within the bad acts.
Identification of Covered Persons. The first step in any
inquiry will be to identify the covered persons. Managers, general partners, directors and executive officers, officers preparing
offering materials or communicating with investors, financial
advisors and brokers are all easily identified and classified as
covered persons. The issuer should work with securities counsel
to determine if covered persons exist in any of the Rule’s more
technically defined categories.
Phase One Review. A phase one review would generally
include a questionnaire with checklist of bad acts and room for
explanation. Because it is not reasonable to assume that bad
actors always tell the truth, questionnaires are not sufficient.
However, they can flag problems for both the covered person
and the issuer that warrant a deeper analysis. A brief questionnaire with a few broad questions, rather than simply cutting and
pasting the entire text of Rule 506(d) and adding checkboxes,
would be the goal during phase one. For example, “Have you
ever been the subject of an order issued by any state or federal
agen