By Sarah N. Lynch

WASHINGTON, Dec 6 (Reuters) - It does not seem like it would be difficult for regulators to block felons and other law-breakers from pitching private investment deals to unsophisticated customers, but nearly 20 months after proposing its "bad actor" rule, the U.S. Securities and Exchange Commission is having trouble finalizing it.

More than a year after the legal deadline for finishing its work on the rule, the agency is stymied by internal disagreements, limited resources and a heavy workload.

Now, state securities regulators, consumer groups and some legislators are saying that if the SEC does not move soon, the agency could open the door to shady late-night television pitches from convicted criminals.

That is because of possible interplay between the so-called bad actors rule and a second SEC proposal loosening restrictions on the advertising of these offerings.

But with SEC Chairman Mary Schapiro leaving on Dec. 14, the commission will be split between two Democrats and two Republicans, making it more difficult for the agency to come to a consensus on either rule.

The "bad actor" rule, required by the 2010 Dodd-Frank financial reform law, would bar securities law violators from a safe harbor that allows hedge funds and other firms to raise cash via private offerings that are not registered with the SEC.

Aimed primarily at sophisticated, so-called "accredited" investors, these private offerings have become increasingly significant and one of the most common ways for companies to raise capital.

The second SEC proposal, meanwhile, would allow those same companies to advertise these private-placement investments to general audiences, potentially via TV and the Internet.

Last week, U.S. House and Senate Republicans wrote letters urging the SEC to finish work on the advertising rule before Schapiro departs.

The advertising proposal, required by the 2012 Jumpstart Our Business Startups (JOBS) Act, represents a major shift from the current practice of limiting general solicitation to protect unwitting investors. When coupled with the safe harbor loophole, it sets up the scenario that keeps some investor advocates up at night.

"When you get home on a Saturday night... and you watch a little TV and you see a hedge fund coming at you... it would be better if people with known disciplinary records were prohibited from being associated from that kind of marketing," said David Massey, North Carolina's deputy securities administrator.

To be sure, anti-fraud laws in place do require investment sales people to disclose material legal problems to new clients. In addition, sales of those products pitched to a general audience still would be largely restricted to accredited investors.

But because anyone whose net worth exceeds $1 million, or who individually earns more than $200,000 in each of the two most recent years is considered accredited, that means there are a lot of potential investors for these private placements.

Some investor advocates, including U.S. Senator Jack Reed, a key Democrat on the Senate Banking Committee, and incoming U.S. House Financial Services Ranking Democrat Maxine Waters, say they would like to see the SEC close the "bad actor" loophole before loosening the advertising restrictions.

"The Commission should work swiftly to impose the 'bad actor' disqualification before expanding the availability of general solicitation and advertising, particularly since Congress directed the Commission to institute this disqualification provision nearly two years before the JOBS Act," Waters said in an Oct. 16 letter to the SEC.

Officials at the SEC have said they hope to complete work on the rule soon and believe it will offer important investor protections.

"It could have the benefit of providing additional comfort to investors... and that could lead to increased access to capital for companies," said Meredith Cross, director of the SEC's Corporation Finance Division, who announced earlier this week that she plans to leave the agency at the end of the year.

SEC Commissioner Luis Aguilar, a Democrat who favors the "bad actor" rule, said on Thursday he agrees it should be adopted "as soon as possible," noting it should be done "before any lifting of the ban on general solicitation."

SHOULD OLD PROBLEMS COME HOME TO ROOST?

The main controversy is an internal SEC dispute about whether people with pre-existing legal problems -- black marks that pre-date the Dodd-Frank law -- should be subject to the rule. When the rule was first proposed in May 2011, two Republican commissioners, Troy Paredes and then-commissioner Kathleen Casey, dissented and suggested it should not allow those backward looks.

For well over a decade, state securities regulators have been raising concerns about the potential for fraudsters to reach unsuspecting investors through the safe harbor known as Rule 506 of Regulation D.

Regulation D contains a series of exemptions that let companies avoid registering their securities. Rule 506 lets companies raise an unlimited amount of money from accredited investors.

These offerings were originally conceived as a way to lower the cost of raising capital for small new companies, but they have grown astronomically. In the fiscal year ending September 30, 2010, the SEC received more than 17,000 initial Reg D filings, and 93 percent of them claimed the 506 exemption.

Unlike some rules under Dodd-Frank which are voluntary, the "bad actor" rule is mandatory, and should have been completed no more than a year after the July 2010 law was enacted. The SEC had proposed an earlier version of the rule in 2007, but it was never made final.

The current proposal would prohibit a wide array of companies, directors and placement agents from conducting 506 offerings if they were convicted of, or faced civil actions such as court injunctions and restraining orders in connection with, securities law violations.

If the rule were applied retroactively, defendants who had already settled cases with state or federal regulators could suddenly find themselves banned from privately raising capital -- something they never expected at the time the deal was inked.

Not everyone agrees with critics who think that it is crucial to finalize the rule quickly.

Merely telling bad actors they cannot qualify for a Reg D exemption will not deter them if they are already intent on breaking the law, said Covington & Burling law firm partner David Martin, who previously served as the SEC's corporation finance director.

"I don't think it solves that much," he said.

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