Blue Sky Regulation: A Primer for Accredited Investors
By: Robert Rapp, Calfee, Halter & Griswold LLP
I. An Introduction to “Blue Sky” Laws
Blue Sky Laws –state securities laws– have been a part of the American legal landscape since the early days of the Twentieth Century. Kansas is credited with adopting the first Blue Sky Law in 1911. By providing for registration of securities and licensing of securities salespersons, Kansas established the key elements of state securities regulation that would form the core of legislation in all states to follow.
Today, all fifty states, the District of Columbia, and U.S. Territories have Blue Sky Laws, the majority of which are modeled on the first Uniform Securities Act promulgated in 1956, or it most recent iteration, the 2002 Uniform Securities Act. At the federal level, Congress entered the field of securities regulation with the enactment of the Securities Act of 1933, followed soon thereafter with the Securities Exchange Act of 1934, with its particular focus on market regulation and the mechanisms for assuring a continuous flow of information to markets and the investing public.
Although there was, in 1996, a significant realignment of federal and state securities regulatory authority, including the outright preemption of certain aspects of state Blue Sky Laws, the dual federal/state structure of securities regulation in the U.S. remains in place, and both state and federal securities laws impact the offer and sale of securities and the people engaged in or performing intermediary roles in them.
Blue Sky Laws, with some variations and degrees of emphasis, involve three principal elements of regulation:
- Securities Registration. Unless exempted, excluded by definition, or outside the scope of state regulatory authority by reason of federal preemption, a securities offering in any state is subject to registration — a process of application to and review by administrators who in some states engage in “merit review,” a qualitative assessment of the fairness of the offering by applying certain standards. The authority of states to require registration and to engage in merit review has largely been preempted by federal securities laws where certain securities and offerings are national in character.
- Intermediary Regulation. The licensing of investment intermediaries –broker-dealers, agents or salespersons, investment advisers and their representatives– and enforcement authority in regard to their activities, is a key function of state securities regulation.
- Anti-fraud and Enforcement. All state securities regulation is aimed at preventing and redressing fraudulent and abusive practices. State securities administrators are often referred to as “cops on the beat” in investor protection. State securities laws also generally include one or more private civil remedies for purchasers or sellers of securities who are victimized in fraudulent transactions or in a transaction that otherwise involved a violation of the law.
Although offers and sales of securities in all states are always subject to the anti-fraud provisions of a Blue Sky Law, and the full authority of state administrators in the enforcement of those provisions, there have always been a number of issuer exemptions from registration requirements for certain types of offerings, or offerings that are limited in size and scope. Over time, these exemptions came to include traditional “private placements” or “private offerings” for which a federal exemption also existed. States more or less uniformly adopted exemptions from the securities registration process to coordinate with federal exemptions, most prominently the federal exemption created by SEC Rule 506 of Regulation D under the Securities Act of 1933, which permits offers and sales of securities in unlimited amounts to accredited investors when certain “safe harbor” conditions are satisfied.
II. The Realignment of State and Federal Securities Regulation
In 1996 Congress enacted the National Securities Markets Improvement Act of 1996 (NSMIA), which altered the dual system of federal/state securities regulation to clearly define the lines of regulatory authority in the context of a national securities market.
NSMIA is most often described only in terms of preempting state authority under Blue Sky Laws, and it does preempt state authority to regulate securities offerings and transactions that are national in character –based on what are identified in the Act as “covered securities.” As discussed below, this is particularly meaningful for accredited investors because NSMIA “covered securities” today include those offered and sold in compliance with Rule 506 of Regulation D under the federal Securities Act of 1933. However, NSMIA is more accurately described as realigning state and federal roles.
Although states may no longer exercise registration (nor any merit review) authority over securities falling within the definition of covered securities, states retain important intermediary licensing and antifraud enforcement authority with respect to all securities offerings. NSMIA also allows the states to continue to impose “notice filing” requirements for the offer and sale of covered securities, and preserves registration authority for offerings that do not involve NSMIA covered securities.
III. Blue Sky Regulation of Rule 506 Offerings and Private Placements
Accredited investors are most commonly introduced to securities regulation today through participation in offerings made under Rule 506 of Regulation D under the federal Securities Act of 1933. As mentioned above, securities offered and sold in compliance with Rule 506 of Regulation D are NSMIA covered securities. Large scale “private” offerings to accredited investors are carried out without regard for any exemption from registration available in state securities laws.
Although not without controversy in the courts over actual compliance with Rule 506, a valid Rule 506 offering involves only a mandated notice filing “(“Form D”) and fee requirements with the states. Rule 506 compliant offerings may be made to an unlimited number of accredited investors, in unlimited amounts. Regulation D is a “safe harbor” exemption, and as such imposes certain requirements that, prior to passage of the “JOBS Act, included manner of sale limitations regarding accredited investors. Issuers could not engage in any form of general solicitation or advertising in offering the securities. The JOBS Act, and 2013 rulemaking by the U.S. Securities and Exchange Commission, eliminated the prohibition on general solicitation and advertising from Rule 506, provided that actual sales are made only to accredited investors.
As discussed above, after NSMIA, state securities regulators retain the full scope of enforcement authority under the general anti-fraud provisions of Blue Sky Laws. Rule 506 offerings to accredited investors remain fully subject to that regulatory authority of the states to police against fraud, as, for example, materially false or misleading information in private placement memoranda typically used by issuers.
With the JOBS Act elimination of the prohibition on general solicitation and advertising in Rule 506 offerings, state anti-fraud enforcement takes on even greater importance, as state regulators will police Internet websites, social media and other advertising media. The North American Securities Administrators Association (NASAA) has been extremely vocal in expressing the concerns of state regulators for potential fraud resulting from the elimination of the ban, and it can be expected that significant resources will be committed to addressing fraud in the offer and sale of securities under Rule 506 that use general solicitation or advertising. Accredited investors familiar with issuer “Form D” notice filings with the SEC and states in Rule 506 offerings will appreciate a modification made to Form D to indicate the issuer’s election to carry out an offering using general solicitation or advertising, which will signal heightened anti-fraud-based review by the states regarding activity in or directed to the states if the issuer elects to do so.
Rule 506 of Regulation D is a safe harbor for an exemption from registration requirements under the federal Securities Act of 1933. It is expressly non-exclusive, however, and issuers are free to rely on any other available exemption –which for traditional private placements means the so-called “private offering” exemption in §4(2) of the federal act.
These traditional, or “old school” offerings do not involve NSMIA covered securities, and are subject to the full range of state regulatory authority. In one form or another, however, most states have coordinate exemptions, and most have adopted a form of accredited investor exemption as well. Private offerings outside of Rule 506 are not common today.
Apart from particular considerations in regard to Rule 506 offerings to accredited investors, under Blue Sky Laws state administrators have considerable powers in policing any offering. They involve:
- Investigations and subpoenas;
- Civil enforcement powers in the courts;
- Administrative enforcement actions, including civil money penalties and fines;
- Judicially enforceable cease-and-desist orders; and
- Criminal penalties.
IV. Private Civil Remedies under Blue Sky Laws
Private civil remedies have always been an important part of the state securities regulatory structure, and the civil liability provisions in Blue Sky Laws play a major role in accomplishing investor protection goals by providing investors with remedies for fraud and other misconduct that are preferable to what might otherwise be available. Only New York has no private civil remedy in its Blue Sky Law (the “Martin Act”).
The central statutory right of action in Blue Sky Laws provided for a purchaser of a security to sue persons who “sell” a security to obtain rescission of the purchase, or damages as a rescission equivalent, in some cases with the right to recover attorneys’ fees as well. Many states also extend the remedy to defrauded sellers of securities. For the most part these are strict liability provisions in transactions that violate the law, and the liability extends to persons who materially aid or participate in such transactions.
V. What Accredited Investors Need to Know about Blue Sky Laws
The definition of “accredited investor” is such that today there is a vast number of individuals who meet the basic income or net worth criteria. The concern for investor protection that is the heart of state securities regulation has led to a focus on individuals who may have accredited status, but who may nevertheless be entirely unsuited for the investment offered.
This is particularly a concern for the elderly. State regulators also focus to today on so-called “Reg D Mills,” the concern for which is now heightened by the elimination of the ban on general solicitation and advertising. Historically, accredited investors have been viewed as individuals capable of knowing, understanding, and bearing the risk of an investment opportunity presented to them. That presumption is no longer valid across a large segment of the investor population, and state securities regulators approach their investor protection mission with renewed zeal. In simplest terms, Blue Sky Laws have from their inception been designed to protect the public from fraud. The unique dual federal/state regulatory structure is based today on commitments to achieve as much uniformity as possible among states and between states and federal regulators, and to minimize the burdens on capital formation. Much progress has been achieved through initiatives such as the 2002 Uniform Securities Act, and state and federal regulators will continue to be challenged to maximize the effectiveness and efficiency of the dual structure.
Robert N. Rapp (B.A., J.D., Case Western Reserve University; M.B.A., Cleveland State University) is a partner in Calfee, Halter & Griswold LLP, Cleveland, Ohio, and is Adjunct Professor of Law (“Law, Theory and Practice in Financial Markets”) at the Case Western Reserve University School of Law.
To further our ongoing commitment to present a diversity of perspectives about alternative investments, AIMkts is proud to share this exclusive content. The opinions expressed here are those of the author and do not necessarily represent the opinions of Accredited Investor Markets.