Bad Actor checks are mandatory for anyone doing a Security Token Offering (STO) on Regulations D506c, Regulation S or Regulation A+. This is an important anti-fraud and due diligence requirement to ensure disqualified persons do not raise funds.
Token offerings have attracted numerous scammers in the past. Before various countries started to crack down on initial coin offerings (ICOs), it was pretty easy for some con artists to put together a fake white paper and a roadmap, launch a token and split with the money.
The U.S. Congress is now in the primary stage of a series of legislative fixes directed specifically toward the blockchain economy, has introduced H.R. 7356, The Token Taxonomy Act of 2018. But in the meantime, all token offerings, in the US are considered to be securities under the existing laws, administered by the Securities and Exchange Commission (SEC).
The SEC was established a year after the Securities Act of 1933 was made into law. Part of the New Deal, it was established as a result of the stock market crash of 1929. The legislation had two main goals: to ensure more transparency in financial statements so investors can make informed decisions about investments; and to establish laws against misrepresentation and fraudulent activities in the securities markets.
The SEC’s raison d’etre to protect investors. It enforces laws and regulations like the Sarbanes Oxley Act and the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Another regulatory agency; FinCEN (Financial Crimes Enforcement Network) was established by the US Treasury Department in 1990. It’s mission “is to safeguard the financial system from illicit use, combat money laundering, and promote national security through the strategic use of financial authorities and the collection, analysis, and dissemination of financial intelligence.” It enforces laws like the Patriot Act and the Bank Secrecy Act.
(Note: I discussed the Bank Secrecy Act (BSA) and its relevance to security token offerings in a previous post. For anyone launching an STO in the U.S., compliance with the BSA cannot be stressed enough. Failure to do so could result in significant jail time and/or fines.)
Are Bad Actor checks mandatory for Security Token Offerings?
Yes, Bad Actor checks are mandatory for security token offerings (STOs) under Regulations D506c, Regulation S or Regulation A+.
Most startup founders who want to launch their own token realize that they have to pass through KYC and AML. But what is sometimes overlooked is that Regulation D, rule 506 and the Dodd-Frank Act requires them to also go through a Bad Actor Check. This is an important anti-fraud and due diligence prerequisite to ensure disqualified persons do not raise funds. It is part of any broker, bank or platform risk analysis procedures. Token issuers and their associated persons can NOT raise capital by selling securities if anyone is deemed to be a “bad actor”.
Who should do a Bad Actors check prior to a Security Token Offering (STO)?
Under the rules, Bad Actor Checks are required for every “covered person” involved in the campaign. The SEC defines “covered persons” to include the following:
- The company issuing securities, including its predecessor entities and affiliated entities issuing securities;
- Directors, general partners, and managing members of the company;
- Executive officers of the company, and other officers of the company that participate in the offering;
- 20% beneficial owners of the company;
- Any entities (LLC, C-Corp, etc.) owning >20% beneficial ownership of the issuer will also require Bad Actor Checks for all “covered persons” of the underlying entity
- Promoters connected to the company;
- Any person compensated for soliciting investors, including any directors, general partners and managing members of those solicitors; and
- For pooled investment funds, the fund’s investment manager and its principals.
Below are some examples:
- James is the CEO and sole director of XYZ Inc.:
- James and XYZ Inc. need Bad Actor checks.
- James is the CEO and a director, and John is a director of XYZ Inc.:
- James, John, and XYZ Inc. need Bad Actor checks.
- James is the CEO, John is an investor owning 25%, Alex is an investor owning 10% of XYZ Inc.:
- James, John, and XYZ Inc. need Bad Actor checks.
- James is CEO, ABC Investments LLC owns 50% of XYZ Inc. Alex is the managing member of ABC Investments LLC:
- James, XYZ Inc., ABC Investments LLC, and Alex need to do Bad Actor checks.
As part of a Bad Actor Check, verification of name, address, Social Security Number, Employer Identification Number (EIN), date of birth, address and phone number are just a few of the data points that are scanned.
A more comprehensive check is run through OFAC:
- Office of Foreign Assets Control
- SDN list
- Financial Crimes Enforcement Network (FINCEN)
- Special Alert List, Homeland Security, Interpol
- United Nations Named Terrorists
- Foreign Agent Registrations Act
- Criminal Background Checks
- Corporate Affiliations
- Securities Trial Court Orders
- Securities Administrative Decisions
- EDGAR Filings & Disclosures
- Finance & Banking Administrative Decisions & Guidance
- and many others
A Bad Actor Check costs $250, and don’t even think about trying to avoid it. Any licensed escrow service will typically perform one for all relevant persons involved in your security token offering. BrightCOIN requires all “covered persons” do a Bad Actor check for STOs.
By requiring KYC, AML, and Bad Actor checks, the SEC is doing its job by making it very difficult for con men to take advantage of investors by selling them dreams of overnight wealth from investing in their tokens.
NOTE: This article is provided for informational purposes only and should not be construed as legal or tax advice.