Securities Attorneys Offering Counsel For Blue Sky Law Compliance
Generally, an offering and sale of securities must be either registered or exempt from registration under the Federal Securities Act of 1933 (“Securities Act”) and state securities laws. As a result of a lack of uniformity in state securities laws and the associated burden on capital-raising transactions, on Oct. 11, 1996, the National Securities Markets Improvement Act of 1996 (“NSMIA”) was enacted into law.
The NSMIA amended Section 18 of the Securities Act to preempt state “blue sky” registration and review of specified securities and offerings. The preempted securities are called “covered securities.” The NSMIA also amended Section 15 of the Exchange Act to preempt the state’s authority over the capital, custody, margin, financial responsibility, making and keeping records, bonding or financial or operational reporting requirements for brokers and dealers.
In enacting the NSMIA, the legislature purposefully did not include specific securities subject to the dual regulation of states and the federal government. Examples of guarantees expressly excluded from the NSMIA list of “covered securities” include securities traded on the over-the-counter market, registered direct public offerings and securities issues in Rule 504 offerings.
An Overview Of Blue Sky Laws
Securities issued in transactions that are not covered securities, such as Regulation D Rule 504 offerings, intra-state offerings, and registered direct or initial public offerings, must comply with state blue sky laws. In addition, securities resale (secondary trading) must either be pre-empted or comply with state blue sky laws.
Like federal laws, state securities laws require registration or the availability of an exemption for the offer or sale of securities and provide statutory exemptions from registration. In addition, every brokerage firm, individual registered representative of a brokerage firm, issuer and issuer representative must either be registered as or exempt from the broker-dealer registration requirements before selling securities. There are 54 U.S. jurisdictions, including all 50 states and four territories, each with different securities laws.
Although many states have adopted the Uniform Securities Act of 1956 (the “Uniform Act”), or variations on such Act, state blue sky laws still differ significantly. Even in states with identical statutes, the state’s interpretations or focus under the rules vary greatly. The most common areas of divergence among the conditions are related to the following:
- Notice and filing requirements can be highly different regarding the amount of money required, the paperwork demanded, the questions asked and the time to review and approve registration.
- Standards of merit review – see discussion below on merit review standards. Different states can issue vastly different comments in other focus areas for the same issuer.
- Length of comment periods – The review time can be inconsistent from days in certain states to weeks and even months in others.
- Suitability standards
- Notice requirements for exempt offerings, even under the Uniform Limited Offering Exemption.
- Required legends on offering materials.
- Disclosure requirements can be varied, and some states will make the issuer sticker the offering with different disclosure items or put in language changing the meaning of some phrases.
- Required forms in addition to the standard Form D in exempt offerings.
- Treatment of offerings of asset-backed securities.
- Financial statement requirements – some states require audited financial statements, and others do not.
Most states have some form of limited offering exemption based on either the number of offerees or purchasers, the dollar amount of the offering, or a combination of these limitations. Most states have a private offering exemption, many substantially similar to the federal Section 4(a)(2). Many states have exemptions for offerings limited to accredited investors. Many states have adopted the NASAA’s Uniform Limited Offering Exemption, similar to the federal Rule 506(b) exemption.
What Is The State Merit Review?
Over 40 states apply a merit review approach to state-registered offerings. In conducting a merit review, state regulators decided on the fairness of the offering to investors. A merit review is a substantive review of the issuer and the offering designed to prevent fraudulent or inequitable offerings. Common merit review topics include:
- Discounted stock sales, including sales to insiders and promoters completed near the offering at significantly discounted prices.
- Affiliate transactions, including loans. Loans to affiliates usually must be repaid before the offering, and affiliate transactions must be on arm’s length terms.
- Debt offerings will generally require sufficient cash flows to cover debt servicing charges and payments, and states may ask that a sinking fund be established or a trust indenture meeting the requirements of the Trust Indenture Act of 1939.
- A state may require that the issuer agrees to the impoundment of offering proceeds.
- Options and warrants – the state may request limits on the number of outstanding options or warranties or may dictate the terms of exercisability (such as no less than 85% of market value); limits may be set on compensatory underwriter issuances.
- Preferred Stock – states may require current and past net income to cover dividends or other obligations under selected instructions; if the preferred Stock is being offered, the state may require redemption provisions and other investor-friendly rights.
- Promoter’s equity investment – the state may require a promoter’s equity interest to be more than 10% of the post-offering equity (i.e., ensuring the champion is an affiliate and subject to affiliate resale restrictions).
- Promotional shares – the state may require the escrow of shares or the reduction of the offering price where equity securities of a development-stage company have been issued to promoters and/or insiders for less than 85% of the offering price.
- Selling expenses and selling security holders – states may limit the costs to a percentage of the offering amount or require selling security holders to pay a pro-rata share of offering prices.
- Unequal voting rights – states may prohibit or limit unequal voting rights.
- Capitalization requirements – states may prohibit the issuance of any security except common equity for development-stage or less seasoned issuers.
- Specifying offering price – states may require that the offering price be related to book value, earnings history and/or industry price/earnings multiples or set other parameters on the offering price.
The NASAA has published Statements of Policy regarding merit standards for specific industries. Many states have adopted or referred to such policies as guidelines in their review process.
Blue Sky Laws And Secondary Trading
Only the secondary trading of securities traded on a national securities exchange is automatically preempted from compliance with state blue sky laws. The NSMIA preempts Sections 4(a)(1) secondary sales and 4(a)(4) broker transactions on behalf of customers, where the issuer is subject to the Exchange Act reporting requirements. Section 4(a)(1, is a registration exemption for “transactions by any person other than an issuer, underwriter, or dealer.” Section 4(a)(4) of the Securities Act of 1933 (“Securities Act”) provides an exemption for broker-dealers when executing customers’ unregistered sales of securities if, after reasonable inquiry, the broker-dealer is not aware of circumstances indicating that the customer would be violating the registration requirements of Section 5 of the Securities Act. Section 4(a)(4) is not, in and of itself, an exemption from registration. Section 4(a)(4) allows brokers to process the sale of unregistered securities with a valid exemption from such registration. Section 4(a)(4) generally works in conjunction with Section 4(a)(1), and the two together provide the basis for most secondary trading of securities on established trading markets.
The secondary trading of securities for issuers that are not subject to the SEC reporting requirements, including those that voluntarily report transactions that do not qualify under Sections 4(a)(1) or 4(a)(4), must satisfy state blue sky laws. If a security is not blue sky eligible in a given state, broker-dealers and investment advisers cannot provide advice, solicit, distribute research or make recommendations to investors in that state.
It can be challenging, if not impossible, to comply with blue sky laws for secondary trading in all 54 jurisdictions. The Manual’s Exemption discussed further below, assists in this regard. However, Alabama, Kentucky and Virginia have no exemption for the secondary trading of non-reporting issuers’ securities.
In a letter written to the SEC on March 24, 2014, arguing for blue sky preemption for Regulation A offerings, OTC Markets Group, Inc. (“OTC Markets”) homed in on blue sky issues in general and related explicitly to secondary trading. OTC Markets pointed out that “[T]he prohibition on advice and research in certain jurisdictions leaves investors uninformed of investment opportunities and risks, and, just as importantly, prevents investment professionals from advising their clients of the specific risks of investing in a security. Investors are left to determine an investment’s risks and potential benefits, which contradicts each jurisdiction’s otherwise worthy investor protection goals.”
Even though a broker may not solicit or make recommendations, it can process unsolicited trades on behalf of a customer requesting into. However, if that customer later claims that the broker recommended such a trade, that broker can be liable for damages. Accordingly, many brokerage firms refuse to process any exchanges for securities that are not blue sky eligible.
The OTC Markets letter to the SEC provides an excellent analysis of the lack of uniformity in blue sky laws related to secondary trade, particularly the difficulty for a non-reporting issuer to satisfy such requirements. The letter poignantly points out that “[O]TC Markets Group is itself a non-SEC registered company that makes annual audited financial reports, quarterly and current information available to investors; has profiles published in both major securities manuals; and has worked at length with every jurisdiction to gain Blue Sky compliance. Despite our diligence, we have gained only 44 jurisdictions, which means we are not Blue Sky eligible to over 11% of the U.S. population.”
The OTC Markets letter includes statistics on blue sky compliance by companies trading on the OTCQB and OTCQX. OTC Markets reviewed 395 companies. Of the 395 companies, not one complied with all jurisdictions,s and only 0.5%comply with secondary trading in New Hampshire, California, Guam, Kentucky, Montana, North Dakota, Utah and Virginia. The statistics clarify the difficulties companies face in complying with blue sky requirements and the need for further federal intervention.
The Manual Exemption
The Manual Exemption is a state exemption for the secondary trading of securities. There are 54 U.S. jurisdictions, including all 50 states and four territories, each with its own securities laws. Forty-four of these jurisdictions offer a form of Manual Exemption for the secondary trading of securities. Issuers that trade in states that do not have the Manual Exemption must satisfy a secondary trading exemption in other ways.
The Manual Exemption is an exemption for the secondary trading of securities where the issuer has a profile published in a recognized securities manual such as Mergent’s or Standard & Poors, including specific enumerated information and financial statements. Some states require the filing of supplemental or additional information to qualify for the Manual Exemption. Moreover, differing state statutory language is confusing,g and determining whether a company has or is qualified for the Manual Exemption is often tricky.
NASAA Regulation: A Coordinated Review Process
Of the 54 U.S. jurisdictions, including all 50 states and four territories, 48 participate in the Regulation A Tier 1 coordinated review process. The NASAA coordinated review process is well put together and seems to focus on investor protection and supportive assistance for the issuer. An issuer elects to complete the coordinated review process by completing Form CR-3b, submitting the application with a copy of the completed Form 1-A, and audited financial statements to Washington State by email. The application contains a “check the box” for the states where the issuer desires to qualify. Filing fees are mailed separately to each of the states.
A lead merit and a lead disclosure examiner are then appointed to manage the review process. If the issuer is not applying in any state with merit review, only a lead disclosure examiner is appointed. The filing goes through a review, comment and amendment process, with the lead examiner issuing comment letters on behalf of all states.
The review process timing is relatively quick. Within three days of filing, an issuer receives a written receipt for the filing and a letter detailing the review process. Within ten days of the filing confirmation, the lead examiner drafts a proposed comment letter for the individual states to review and add to. The first comment letter must be delivered to the issuer within 21 days of filing.
The lead examiner schedules conference calls to discuss the comments and how the issuer can address the concerns. Moreover, the examiners make themselves available to discuss comments and responses throughout the process, allowing for a cooperative relationship between the examiner and the issuer. Issuers’ comment responses are reviewed within five business days of receipt. If there are no comments, the offering will be cleared within 21 business days of filing.
The review standard itself is based on the NASAA Statements of Policy, which cover a wide array of topics — including, for example, impoundment of proceeds, loans and other material affiliated transactions, options and warrants, preferred stocks, promoter’s equity investment, promotional shares, specificity in the use of profits, underwriting expenses, unstabled financial condition and voting rights.
NASAA Coordinated Filing Program For Form Ds Associated With Regulation D, Rule 506
The NASAA offers a coordinated multi-state filing system allowing issuers to submit a Form D for Regulation D, Rule 506 offerings and pay-related fees to participating state securities regulators. The system is called the Electronic Filing Depository and is currently only available for Rule 506 Form D filings. Not all states participate with the plan. Arizona, California, Connecticut, Delaware, Florida, Louisiana, Massachusetts, Michigan, Minnesota, New York, North Carolina, and Oregon are omitted. In addition to state filing fees, the NASAA charges a one-time $150 fee to use the system.
Anthony L.G., PLLC, Can Assist You With These Complex Matters
We are advocates of further federal preemption in all levels of registration and exemption requirements for the direct issuance and secondary trading of securities. Regardless of offer and sale preemption, the states retain jurisdiction over anti-fraud protections and the right and ability to investigate and prosecute fraud in any offer. They play an essential role in this regard. We support allowing the federal government to control the disclosure process, including the forms and review process, and continuing the combined efforts of the states and federal authorities in policing, preventing and prosecuting fraud.