Michigan Equity Crowdfunding: The Bad Actor Rule

Michigan’s equity crowdfunding law, technically referred to as the “Michigan Invests Locally Exemption,” represents a fundamental shift in how businesses can raise capital. The power of turning to the crowd, instead of banks, is an opportunity Michigan businesses have never possessed before.

But, equity crowdfunding in Michigan comes with a number of regulations. One of those regulations is called the “bad actor” rule.

The Bad Actor Rule

The Michigan equity crowdfunding exemption is found at MCL 450.2202a. Subsection 5 states that the exemption does not apply if a number of people affiliated with the issuer or offering are subject to disqualification pursuant to 17 CFR 230.262.

17 CFR 230.262, or Rule 262, is a Securities and Exchange Commission rule that disqualifies certain “bad actors” from using exemptions to the traditional disclosure process involved with the sale of securities. The bad actor disqualification applies to the issuer itself, and its directors, officers, or general partners of the issuer, 10% owner (or more) of the issuer, promoters, and the underwriter and its directors, officers, or partners.

In general, the bad actor rule states that if an individual identified above has been convicted of a felony or misdemeanor in connection with the sale or purchase of a security, a false statement to the SEC, or arising out of the conduct of an underwriter, broker, or investment advisor, the exemptions from the general disclosure and reporting requirements are not available. In other words, issuers with a “bad actor” cannot utilize Michigan’s equity crowdfunding laws.

Preparing an Equity Crowdfunding Campaign

Similar to the list of requirements in making and submitting the disclosure statement, or using a website to facilitate the raising of money online, the bad actor rule is another regulation businesses must be aware of before investing time, money, and effort into a crowdfunding campaign.

To be prepared, you must have a complete understanding of your business partners, including their background with any misconduct in connection with the sale of securities. This requires business owners to conduct a level of due diligence on the individuals involved in the company and its large investors.

A Deeper Look at the Bad Actor Disqualification Under Rule 262

Rule 262 under Regulation A, 17 C.F.R. § 230.262, was crafted by the SEC to prevent individuals with a history of misconduct in the securities markets from accessing exemptions that bypass the full registration and disclosure process. Michigan incorporated this federal standard by reference into the MILE statute, ensuring that bad actor principles apply with equal force to intrastate crowdfunding offerings.

The disqualifying events under Rule 262 include:

• Criminal convictions. A conviction for any felony or misdemeanor in connection with the purchase or sale of any security, making false filings with the SEC, or arising out of the conduct of a broker, dealer, municipal securities dealer, investment advisor, or paid solicitor of purchasers of securities within ten years (five years for issuers and their predecessors and affiliated issuers).
• Court injunctions and orders. Being subject to a final order of a state securities regulator, state banking regulator, state insurance regulator, or federal banking agency that either bars the person from associating with a regulated entity or is based on fraudulent, manipulative, or deceptive conduct.
• SEC disciplinary orders. Being subject to an SEC disciplinary order issued under Section 15(b) or 15B(c) of the Securities Exchange Act, or an order or judgment of the SEC suspending or revoking registration as a broker-dealer, municipal securities dealer, or investment advisor.
• SEC cease-and-desist orders. Being subject to an SEC order under Section 8A of the Securities Act or Section 21C of the Exchange Act finding a violation of securities law.
• Suspension or expulsion from SRO membership. Being suspended or expelled from membership in a self-regulatory organization (such as FINRA) in connection with a securities-related conduct violation.
• U.S. Postal Service stop orders. Being subject to a final order of the U.S. Postal Service based on fraud in connection with the offer, purchase, or sale of a security.

Who Is Covered by the Bad Actor Rule?

The bad actor rule does not apply only to the company itself. It extends to a broad category of affiliated individuals and entities:

• The issuing company and any predecessors or affiliated issuers;
• Any director, executive officer, general partner, or managing member of the issuer;
• Any beneficial owner of 20% or more of the issuer’s outstanding voting equity securities;
• Any promoter connected with the issuer in any capacity;
• Any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers; and
• Any general partner, director, officer, or managing member of any such solicitor.

For a startup company with multiple founders, angel investors holding significant equity stakes, and advisors who may receive compensation in connection with the offering, the scope of this review can be extensive. Each person in a covered category must be vetted before the company can rely on the MILE exemption.

Conducting Pre-Campaign Due Diligence

Michigan companies planning an equity crowdfunding campaign under the MILE exemption must conduct thorough pre-campaign due diligence on every covered individual. This diligence includes:

• Reviewing criminal history records at both the state and federal level;
• Checking SEC Enforcement Actions and EDGAR for any enforcement actions, cease-and-desist orders, or consent judgments;
• Checking FINRA BrokerCheck for any disciplinary history;
• Reviewing state securities regulator databases for any enforcement actions; and
• Obtaining representations and warranties from each covered individual in the subscription agreement or a separate certification.

If a bad actor disqualification is discovered, the company is not necessarily barred from conducting an equity crowdfunding offering. Rule 262 provides a waiver process: the SEC (or in the case of the MILE exemption, the relevant state regulator) may waive the disqualification upon a showing of good cause. A company seeking a waiver must file an application that describes the relevant disqualifying event, explains why the disqualification should not apply, and demonstrates that investors will be adequately protected.

Consult a Michigan Equity Crowdfunding Lawyer

The MILE statute and its regulatory framework are complex, and the consequences of non-compliance — including rescission rights for investors and potential civil and criminal liability — are significant. Before launching an equity crowdfunding campaign, Michigan businesses should work with an experienced crowdfunding attorney to conduct the required bad actor due diligence, prepare the required disclosure statement, and structure the offering in compliance with all applicable requirements.

Revision Legal’s crowdfunding attorneys have extensive experience advising Michigan businesses on equity crowdfunding under the MILE exemption. Contact us today at 855-473-8474 or through our website to schedule a consultation.