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USLAW
SPRING 2025 USLAW MAGAZINE
California Issuers Beware DFPI Settlements for Unintentional Securities
Violations may constitute "Bad Acts’" under Regulation D K. Bradley Rogerson
Since 2013, the federal exemption from securities registration provided under Regulation D has disqualified an issuer from utilizing the exemption if the issuer or certain "covered persons" become subject to one of several "bad acts" outlined in Rule 506(d) of Regulation D.1 For many companies, including real estate companies, funds and investment sponsors that rely on Regulation D to raise capital for their investing activities, becoming subject to a disqualification event under Rule 506(d) could prove catastrophic for their businesses. Many of the "bad acts" enumerated in Rule 506(d) relate to orders and actions taken by the Securities and Exchange Commission under federal law. One such "bad act," however, is the entry of a final order by a state securities commission that is based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct.2 Issuers may think there is no risk of disqualification based upon such a provision because they would never intentionally or knowingly defraud, manipulate or deceive their investors. At the federal level, this view may be justified because the anti-fraud provisions of Rule 10b-5 prohibiting the use of material misstatements or omissions in securities offerings require an element of scienter (i.e., an intentional or knowing violation of the law). Issuers of securities in California, however, should be aware that the California Department of Financial Protection and Innovation ("Department" or "DFPI") is not required to find intentional fraud or a
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knowing violation of the law to allege violations of California's version of Rule 10b-5 -- California Corporations Code Section 25401 ("Section 25401"). As a result, a California issuer can be cited for violating a California statute that "prohibits fraudulent, manipulative or deceptive conduct" for acts that are done unintentionally and with no knowledge that they represent a violation of California securities laws. Unfortunately, this can, and does, occur even when an issuer finds itself subject to a routine DFPI examination that is not commenced due to investor losses or complaints. DFPI examiners often find what many practitioners would describe as technical violations or violations based upon unforeseen DFPI interpretations that are clearly not intentional but that are, nonetheless, characterized by the DFPI as violations for "fraud" under Section 25401. The provisions of Regulation D expressly provide the DFPI with the authority to exempt their orders from the disqualifying provisions of Rule 506(d); however, the DFPI has recently expressed a blanket policy against including language exempting Section 25401 allegations from Rule 506(d) in its settlement agreements or otherwise. Issuers that rely on Regulation D for their operations and that become subject to DFPI review should therefore be mindful of the potential adverse effects of becoming subject to any order, including settlement orders, that are based upon any Section 25401 allegations. Such orders, whether or not based based upon intentional Section 25401
allegations, on their face, are orders based upon a California law prohibiting fraudulent and manipulative or deceptive conduct and could be deemed a "bad act" disqualifying any future use of Regulation D entirely. PRIVATE PLACEMENT EXEMPTION IN CALIFORNIA Regulation D is a safe harbor providing the conditions upon which an issuer of securities can offer and sell securities in a “private offering” exempt from federal registration under Section 4(a)(2) of the Securities Act of 1933 (Federal Act).3 Unlike other common federal exemptions, by complying with Rule 506 of Regulation D, a company can offer securities in any amount to an unlimited number of “accredited investors” who can be residents of any state without registering the offering with the SEC. For these reasons, Rule 506 of Regulation D is the most commonly utilized federal exemption from federal registration. Its availability is critical to companies that regulatory utilize the exemption to raise capital without incurring the prohibitively high costs of SEC registration. Securities offered and sold under Regulation D are also “covered securities” subject to the preemptive provisions of Section 18 of the Federal Act.4 Consequently, state securities agencies are prohibited from imposing conditions for exempting Regulation D offerings from state qualification other than requiring a filing notice and payment of a filing fee. In California, this exemption is set forth in Corporations Code Section 25102.1(d),