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 and administrative review of securities offerings, and requirements for 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, Puerto Rico, Guam, and the U.S. Virgin Islands have Blue Sky Laws. Most modern versions of these laws are modeled on the first Uniform Securities Act promulgated in 1956, or later iterations, principally including the 2002 Uniform Securities Act. From inception, the objective of state securities regulation has been to protect the public from fraud and insubstantial or speculative offerings. To that end, Blue Sky Laws generally established “merit” regulation or review as qualification requirements for securities offerings, although the number of states doing so today is quite small and broad authority to do so has been significantly preempted by federal law in any event.
At the federal level, Congress entered the field of securities regulation with the enactment of the Securities Act of 1933 (the “Securities Act”), aimed primarily at distributions of securities and investor protection through full disclosure of material information by registration statement and prospectus delivery requirements. The Securities Act includes a number of securities and transaction exemptions from the registration requirement as well as provisions for limited forms of public offerings. The Securities Act was soon followed by the Securities Exchange Act of 1934, with its particular focus on market and securities intermediary regulation and the mechanisms for assuring a continuous flow of information regarding public companies to markets and the investing public.
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 broader and is more accurately described as realigning state and federal regulatory roles.
Although states may no longer exercise registration and qualification authority (including any exercise of “merit” regulation) over securities falling within the definition of NSMIA covered securities, they do retain important intermediary licensing and antifraud enforcement authority with respect to all securities offerings and the conduct of securities business generally. NSMIA also allows the states to impose “notice filing” and fee requirements for offerings of covered securities. NSMIA preserves unfettered registration authority for offerings that do not involve NSMIA covered securities.
Blue Sky Laws, with some variations and degrees of emphasis, involve three principal elements of regulation:
Although offers and sales of securities in all states are always subject to the antifraud provisions of Blue Sky Laws, 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 state 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 that provided in Rule 506 of SEC Regulation D adopted under the Securities Act of 1933 (“Rule 506”).
Accredited investors are most commonly introduced to securities regulation through participation in private offerings made pursuant to Rule 506. Rule 506 is a “safe harbor.” Compliance assures the availability of the exemption from federal registration and offering process requirements provided by Section 4(a)(2) of the Securities Act of 1933 for transactions by an issuer “not involving a public offering.” Compliant Rule 506 private offerings may be made in unlimited amounts to an unlimited number of accredited investors. The natural person accredited investor definition in Regulation D is intended to encompass persons whose financial sophistication and ability to bear the risk of the investment or fend for themselves render the protection of the Securities Act registration and offering process requirements unnecessary. Since the inception of Regulation D in 1982, with only an exception for directors, executive officers, or general partners of the issuer, accredited investor status has been defined by income or net worth. That binary definition, however, is likely to be broadened in 2020 to include additional categories of natural persons who will qualify as accredited investors based on professional certifications or designations of other credentials reflecting financial sophistication.
Although Rule 506 permits private offerings in unlimited amounts to an unlimited number of accredited investors, access to potential accredited investor purchasers and issuer responsibilities regarding accredited investor status is impacted by alternative approaches to the conduct of an offering. Rule 506(b) permits offerings to persons who the issuer reasonably believes are accredited investors, and the offering is subject to other Regulation D conditions, not the east of which is the limitation on manner of offering that prohibits any form of general solicitation or general advertising. Rule 506(c), added in 2013 by a mandate of the Jumpstart Our Business Startups (JOBS) Act, permits general solicitation and advertising by the issuer provided sales are made only to persons for whom the issuer has taken reasonable steps to verify accredited investor status.
To facilitate access to accredited investors for Rule 506(c) compliant offerings the JOBS Act also expressly authorized creation of intermediary-operated platforms or mechanisms to permit general solicitations, advertisements or other related activities by issuers, as well as for the offer, sale, purchase, or negotiation with respect to the securities. Although the JOBS Act exempted these platforms from the broker-dealer registration under the Securities Exchange Act of 1934, state Blue Sky Laws requiring registration or licensing of broker-dealers were not affected. However, JOBS Act limitations on the operations of these platforms are such that Blue Sky Law broker-dealer registration or licensing requirements will generally not apply. Through compliant intermediary-operated platforms private offerings may be exposed to accredited investors who are most often pre-qualified by platform operators and for whom the issuer’s verification obligation is made easier.
Proceeding with a private offering under Rule 506(b) or 506(c) is an either/or proposition involving an election by the issuer. An issuer may not proceed under both and having made the election, which is specifically indicated on Form D filed with both the SEC and relevant states, the election may not be changed.
Although securities offered and sold in compliant private offerings pursuant to either Rule 506(b) or (c) are NSMIA “covered securities” such that Blue Sky Law registration or qualification requirements are preempted, and there is no need for an issuer to rely on a state exemption, 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. Several courts have also recognized the authority of state securities administrators to determine the validity of the Rule 506 exemption, in which case NSMIA covered security status may be rejected and the offering is subjected to broader state regulation.
Moreover, with the JOBS Act elimination of the prohibition on general solicitation and advertising in Rule 506(c) offerings, state anti-fraud enforcement takes on even greater importance. State regulators scan Internet websites, social media and other advertising media with a view to fraud prevention. The North American Securities Administrators Association (NASAA) has expressed the concerns of state regulators for potential fraud resulting from the elimination of the ban for Rule 506(c) private offerings.
As noted earlier, Rule 506 of Regulation D is a safe harbor to assure the application of the private offering exemption from registration requirements under the federal Securities Act provided in Section 4(a)(2) of the Act. Rule 506 is expressly non-exclusive, however, and issuers are free to rely on any other available exemption –which for traditional private placements generally means the Securities Act Section 4(a)(2) private offering exemption. However, 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 pre-NSMIA coordinate exemptions, and most have adopted a form of accredited investor exemption as well. That said, private offerings outside the Rule 506 safe harbor 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:
Although accredited investors are most commonly the focus of Regulation D Rule 506 private offerings, they may also become involved in limited offerings up to $5 million of securities by qualifying issuers made in reliance upon Rule 504 of Regulation D. Rule 504 federally exempt offerings do not involve NSMIA covered securities and state registration or qualification requirements under Blue Sky Laws are fully preserved unless a Blue Sky Law exemption is available. Issuers relying on the Rule 504 federal exemption must satisfy certain alternative conditions regarding state Blue Sky Laws, one of which is that the offering is made exclusively according to state law exemptions from registration that permit general solicitation and general advertising so long as sales are made only to accredited investors. Not all states have such exemptions, or an exemption to specifically coordinate with Regulation D Rule 504. However, where available to issuers who elect to proceed under Rule 504, accredited investors (as defined in Regulation D) can play an important role.
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. They provide 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 provides 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. The liability extends to controlling persons of a violator and in some states to persons who materially aid or participate in such transactions.
Under the current definition of “accredited investor” there are far greater numbers of individuals who meet the income or net worth criteria. Using wealth as a proxy for the financial sophistication that is intended to be the defining characteristic of natural person accredited investors has become increasingly unreliable, particularly as the only adjustment in financial criteria since the inception of Regulation D has been the exclusion of the value of one’s principal residence from calculation of net worth. Neither the baseline net worth nor income parameters have ever been adjusted, even for inflation.
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 on so-called “Reg D Mills.” 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 investor protection with considerable 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 post-NSMIA dual structure.
State securities regulators regularly push back on the generalized notion that retail, non-accredited, investors should have greater access to private offerings, and have likewise expressed concern over initiatives to significantly broaden the definition of accredited investor. The generally recognized inadequacy of the current increasingly unrealistic accredited investor defining criteria solely in terms of income or net worth is, however, now propelling an SEC initiative to add categories of natural persons who qualify as accredited investors. Proposed rulemaking would add persons who hold certain professional certifications or designations, or other credentials, to the accredited investor definition. A new category of individuals who are “knowledgeable employees” of a private fund and are investing in the private fund would also be added. However, the accredited investor definition may be broadened, state securities regulators will continue to apply general antifraud and intermediary regulatory provisions in Blue Sky Laws with the goal of maximum investor protection where that protection is needed most.
(Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Options for the Accredited Investor and Securities Law Compliance. This is an updated version of an article that first appeared in 2013.)
Robert N. Rapp is Visiting Assistant Professor of Law at the Case Western Reserve University School of Law, where he teaches Securities Regulation, Advanced Securities Regulation and Law, Theory and Practice in Financial Markets. He is a Retired Partner (1975-2017) in the Securities and Capital Markets Practice of Calfee, Halter & Griswold LLP Cleveland, Ohio.…
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