Scherzer Blog

Remedying Rule 506 “bad actor” disqualification through reasonable care

The SEC’s Rule 506 “bad actor” amendments went into effect September 23, 2013. As we reported previously, these amendments add Rule 506(d) to implement Regulation 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Under the rule, securities offerings involving certain “felons and other ‘bad actors'” are disqualified from the Rule 506 exemption unless the disqualification is waived or remedied through a “reasonable care” exception. (See Securities Act Release No. 9414, 78 Fed. Reg. 44,729; July 24, 2013).

The rule’s long list of disqualifying events – and an even longer list of covered persons – is raising consternation as issuers and practitioners come to grips with the challenges of compliance. A disqualification due to the presence of “bad actors” can be catastrophic, resulting in the loss of the exemption altogether, spilling into regulatory actions, litigation, and reputational issues. And any impediment to raising capital is likely to scare away investors.

The rule provides an exception from disqualification if the issuer is able to demonstrate that it did not know and, in the exercise of reasonable care, could not have known that a covered person with a disqualifying event participated in the offering. The SEC has not prescribed specific steps to establish reasonable care; however, it has indicated that the concept includes a factual inquiry in view of the particular facts and circumstances and other offering participants. Despite the procedural ambiguity, the message is clear that is not enough to show that the issuer was unaware of the disqualifying event – the issuer must establish that in exercising “reasonable care,” could not have known that a disqualification existed.

In anticipation of this ruling, SI has been including “disqualifying event” searches in many of its reports for over two years. Now that the ruling has gone into effect, SI also offers a specialized factual inquiry service to help our clients evidence “reasonable care” under the highest standards. For information, please contact Dave Lazar at 440-423-1157 or e-mail dlazar@scherzer.co or Jessica Staheli at 818-227-2598 or e-mail jstaheli@scherzer.co.

|Dodd-Frank|

Issuers should ensure that investors are not criminals

The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited investor status of purchasers. Rule 506(c) sets forth a principles-based method of verification which requires an objective determination by the issuer or its representatives that the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction. But perhaps a question whether the investor is a felon should be added to the list.

A case decided in 2011 by California’s Court of Appeal, Second District, suggests that indeed it may be prudent for issuers to ensure that investors are not criminals. The plaintiff in this case intended to purchase units in a limited liability company, but was rejected after the mezzanine lender would not accept the plaintiff as a member due to his status as a former felon. The plaintiff subsequently sued the lender, alleging a violation of the Unruh Civil Rights Act. After a dismissal by a trial court, the case was appealed, resulting in a conclusion that (1) status as a felon is not a personal characteristic similar to those enumerated in the statute; (2) criminal convictions raised legitimate questions about the honesty and trustworthiness of the plaintiff, and the lender had legitimate business reasons justifying its decision; and (3) the potential consequences of allowing the plaintiff’s claim would improperly involve the courts in second-guessing a lending institution‘s expertise in determining loan and investment criteria. As lenders are absolved from potential liability under the Act, issuers who unwittingly accept convicted felons as investors may be jeopardizing their funding.

|Employment Decisions, Fraud, Legislation|

California passes two new data privacy laws

Effective January 1, 2014, California will have two new data privacy laws: AB 370, which mandates disclosure of “do not track” and other tracking practices in online privacy policies, and SB 46, which amends the state’s data security breach notification law.

AB 370 adds to the California Online Privacy Protection Act (“CalOPPA”) a requirement for companies that collect personally identifiable information online to include disclosures regarding (1) how they respond to a web browser’s “do not track” (DNT) signal, and (2) if third-parties can collect personal information across a network of sites. The law does not require websites to honor browser DNT signals or block third-party tracking; it simply tries to increase transparency about the site’s practices.

SB 46 adds a new category of data triggering California’s breach notification requirements, to wit: “a user name or e-mail address, in combination with a password or security question and answer that would permit access to an online account.” The new law requires notification of unauthorized access to user credential information even if that information is encrypted.

|Educational Series, Legislation, Privacy|

Grace period for E-Verify compliance ends November 5, 2013

Now that E-Verify services are back online, employers must create an E-Verify case for each employee hired during the shutdown (October 1-17, 2013) no later than November 5, 2013. When prompted by the E-Verify system to explain why the case was initiated late (a violation of the three-day E-Verify rule), employers should select “other” from the drop-down menu and enter into the text field “federal government shutdown.” See the USCIS E-Verify instructions page for handling specific situations.

|Educational Series, Employment Decisions|

Tenant screening laws update: passing background check costs to the applicants

The states of Washington and Oregon recently enacted laws in connection with tenant screening. Among the provisions in both Washington’s RCW §59.18.257 and Oregon’s OAS §90.295, is that the entire cost of the background check can be charged to the applicant, if the screening is performed by a consumer reporting agency (“CRA”). However, if the landlord conducts the background check, it may not charge in excess of the customary fees of the CRAs in its geographical area.

Notably, California’s Civil Code §1950.6(b) provides that a landlord cannot charge (or pass-through) to the applicant more than $30 for a background check. This application screening fee may be adjusted annually by the landlord or its agent commensurate with an increase in the Consumer Price Index. (The current adjusted amount is $41.50.)

|Business Transactions, Legislation|

New regulation in the UK mandates licensing of private investigators

Presented to the Parliament by the Secretary of State for the Home Department by Command of Her Majesty on July 31, 2013, the new regulation, which will take effect next year, makes operating as an unlicensed private investigator in the United Kingdom a criminal offense. Licenses will be granted by the Security Industry Authority only when an applicant has successfully completed training and achieved a government-recognized qualification, including an understanding of relevant laws and standards, and the skills required to conduct activities ethically; has confirmed his/her identify; and has passed a criminal background check.

|Legislation|

Illinois amends its password protection law to exclude financial services firms

In August 2013, Illinois passed an amendment to its existing password protection law that lifts restrictions for financial services firms, enabling them to monitor their employees’ business-related social media communications. Effective January 1, 2014, the law will no longer apply when an employer requests access to a “professional account” to “monitor or retain employee communications as required under the state’s insurance or federal law or by a self-regulatory organization. The amendment also permits Illinois employers to seek access to a professional account when the employer has “a duty to screen applicants or employees prior to hiring.”

|Judgment|

New Jersey enacts law for social media password protection

Continuing a nationwide momentum of restricting employers’ access to personal social media content of applicants and employees, in August 2013, New Jersey passed Act 2878 joining eleven other states (Maryland, Illinois, California, Michigan, Utah, New Mexico, Arkansas, Colorado, Washington, Oregon, and Nevada) with similar laws. Dozens more states and the U.S. Congress are considering comparable legislation. New Jersey’s new law, which becomes effective December 1, 2013, prohibits employers from asking or requiring that applicants or employees “provide or disclose any user name or password, or in any way provide the employer access to a personal account through an electronic communications device.”

|Legislation, Social Media|

EEOC fails to prove disparate impact in another case involving background checks

In August 2013, a Maryland federal judge dismissed without a trial a putative suit filed by the Equal Employment Opportunity Commission (the “EEOC”) against event-promoter Freeman for alleged discriminatory background screening practices. Calling the EEOC’s expert report “an egregious example of scientific dishonesty,” the court granted a summary judgment to Freeman based on its findings that the EEOC’s expert testimony was unreliable, and would not support a claim of disparate impact. According to the court’s opinion, the EEOC failed to establish an element of its case when it made no effort to analyze Freeman’s multi-step screening policies to identify the specific practices that caused the alleged disparate impact. The court went on to say: “By bringing actions of this nature, the EEOC has placed many employers in the ‘Hobson’s choice’ of ignoring criminal history and credit backgrounds, thus exposing themselves to potential liability for criminal and fraudulent acts committed by employees, or, on the other hand, incurring the wrath of the EEOC for having utilized information deemed fundamental by most employers.”

The EEOC most likely will appeal the decision, as it has done in another high-profile background check case in Ohio, where in January 2013 the court similarly ruled that the EEOC failed to prove disparate impact. Although these rulings represent a victory for the employer, the EEOC has not reversed its position, and is expected to continue its attempts to severely limit, if not eliminate, the use of criminal and credit checks by private employers.

|Employment Decisions, Judgment|

California passes bill that would require policy disclosures for “do not track”

On August 28, 2013, the California State Senate and Assembly passed AB 370, to amend the California Online Privacy Protection Act (CalOPPA) that would require operators of commercial websites or “online services” accessible to California residents to disclose how the site responds to “do not track” (DNT) browser settings, which in turn will trigger enforceability by federal and state authorities. The amendment is expected to be signed by Governor Jerry Brown.

|Legislation|