The National Markets Improvement Act of 1996 (NSMIA)

Generally, an offering and/or sale of securities must be either registered or exempt from registration under both 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 associated burden on capital-raising transactions, on October 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 pre-empt 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 pre-empt the state’s authority over 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 certain securities which remain subject to the dual regulation of states and the federal government. Examples of securities that are specifically excluded from the NSMIA list of “covered securities” include securities that trade on the over-the-counter market, registered direct public offerings and securities issues in Rule 504 offerings.

State Blue Sky Laws in General

Securities issued in transactions which 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, the re-sale (secondary trading) of securities must either be pre-empted or comply with state blue sky laws.

Like the 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 prior to selling securities. There are 54 U.S. jurisdictions, including all 50 states and 4 territories, each with separate 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 greatly. Even in states that have identical statutes, the state’s interpretations or focus under the statutes differ greatly. The most common areas of divergence among the states relate to:

• Notice and filing requirements can be extremely different in terms of the amount of money required, the paperwork demanded, 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 different focus areas for the same issuer;
• Length of comment periods – The amount of 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; and
• 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 of which are 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, which is similar to the federal Rule 506(b) exemption.

State Merit Review

Over 40 states apply a “merit review” approach to state registered offerings. In conducting a merit review, state regulators make a determination regarding the fairness of the offering to investors.  A merit review is a substantive review of the issuer and the offering and is designed to prevent fraudulent or inequitable offerings. Common merit review topics include:

• Discounted stock sales, including sales to insiders and promoters that are completed in close proximity to 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 agree to the impoundment of offering proceeds;
• Options and warrants – the state may request limits on the number of outstanding options or warrants or may dictate the terms of exercisability (such as no less than 85% of market value); limits may be set on underwriter compensatory issuances;
• Preferred Stock – states may require current and/or past net income to cover dividends or other obligations under preferred 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 that a promoter’s equity interest be more than 10% of the post-offering equity (i.e., ensuring the promoter 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 expenses to a percentage of the offering amount or require selling security holders to pay a pro rata share of offering expenses;
• 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; and
• 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 both generally and for specific industries.  Many states have either adopted such policies or refer to them as guidelines in their review process.

Blue Sky Laws and Secondary Trading

Only the secondary trading of securities that are 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 where there is 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, or 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 give advice, solicit, distribute research or make recommendations to investors in that state.

It can be very difficult, if not impossible, to comply with blue sky laws for secondary trading in all 54 jurisdictions. The Manual’s Exemption, discussed further below, provides some assistance in this regard.  However, Alabama, Kentucky and Virginia have no exemption whatsoever 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 specifically related 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 the risks and potential benefits of an investment on their own, which runs counter to each jurisdiction’s otherwise very worthy investor protection goals.”

Even though a broker may not solicit or make recommendations, it can process unsolicited trades on behalf of a customer that requests it to do so. However, if that customer later claims that the broker recommended such a trade, that broker can be liable for damages.  Accordingly, many brokerage firms simply refuse to process any trades 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 trading and in particular, 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 related to blue sky compliance by companies trading on the OTCQB and OTCQX. OTC Markets reviewed 395 companies. Of the 395 companies, not a single one was in compliance with all jurisdictions and only 0.5% are in compliance for secondary trading in New Hampshire, California, Guam, Kentucky, Montana, North Dakota, Utah and Virginia. The statistics make clear the difficulties companies face in complying with blue sky requirements, and the obvious need for further federal intervention.

The Manual Exemption

The Manual Exemption is a state exemption for the secondary trading of securities. There are a total of 54 U.S. jurisdictions, including all 50 states and 4 territories, each with their own securities laws. Forty-four (44) of these jurisdictions offer a form of the 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 and it is often difficult to determine whether a company has or is qualified for the Manual Exemption.

NASAA Regulation A Coordinated Review Process

Of the total 54 U.S. jurisdictions, including all 50 states and 4 territories, 48 participate in the Regulation A Tier 1 coordinated review process. The NASAA coordinated review process is well put together and seems to have a focus on both investor protection and supportive assistance for the issuer. An issuer elects to complete the coordinated review process by completing a Form CR-3b and submitting the application together with a copy of the completed Form 1-A and audited financial statements to Washington State by e-mail. The application contains a “check the box” for the states in which 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 for discussion of comments and responses throughout the process, allowing for a type of cooperative relationship between the examiner and 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 use of proceeds, underwriting expenses, unsound financial condition and voting rights.

NASAA Coordinated Filing Program for Form D’s 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 system. Arizona, California, Connecticut, Delaware, Florida, Louisiana, Massachusetts, Michigan, Minnesota, New York, North Carolina and Oregon are not included. In addition to state filing fees, the NASAA charges a one-time $150 fee to use the system.

The initial sale of securities to the public, often called an IPO.

A non-accredited investor is any investor who does not meet the income or net worth requirements set out by the Securities and Exchange Commission (SEC). The concept of a non-accredited investor comes from the various SEC acts and regulations that refer to accredited investors.

Regulation CF, The Crowdfunding exemption, allows Issuers to raise up to $1 million in a twelve-month period, as long as no individual investment exceeds certain threshold amounts. The threshold amount sold to any single investor, cannot exceed (a) the greater of $2,000 or 5% of the annual income or net worth of such investor, if their annual income or next worth is less and $100,000; and (b) 10% of the annual income or net worth of such investor, not to exceed a maximum $100,000, if their annual income or net worth is more than $100,000. The Crowdfunding Act reads such that this exemption will integrate with (i.e. be added to) securities sold under other exemptions during the 12 month period.

Regulation D under the Securities Act provides a number of exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the offering with the SEC.

Rule 504 of Regulation D exempts from registration the offer and sale of up to $10 million of securities in a 12-month period. A company is required to file a notice with the Commission on Form D within 15 days after the first sale of securities in the offering. In addition, a company must comply with state securities laws and regulations in the states in which securities are offered or sold.

The Securities Act of 1933 (“Securities Act”) Rule 144 sets forth certain requirements for the use of Section 4(a)(1) for the resale of securities. Section 4(a)(1) of the Securities Act provides an exemption for a transaction “by a person other than an issuer, underwriter, or dealer.” The terms “Issuer” and “dealer” have pretty straightforward meanings under the Securities Act, but the term “underwriter” does not. Rule 144 provides a safe harbor from the definition of “underwriter.” If all the requirements for Rule 144 are met, the seller will not be deemed an underwriter and the purchaser will receive unrestricted securities.

Rule 144 provides certain conditions that must be met for sales by both affiliates and non-affiliates which conditions vary depending on whether the Issuer of the securities is a reporting or non-reporting Issuer. The following chart summarizes the Rule 144 requirements.

The term rules and regulations as used in sections 7, 10 (a), (c) and (d) and 19(a) of the Act, shall include the forms for registration of securities under the Act and the related instructions thereto.

General Rules and Regulations, Securities Act of 1933

Rule 144 Persons Deemed Not To Be Engaged In A Distribution and Therefore Not Underwriters

Rule 147 Exemption for Intrastate Offers and Sales of Securities

Rule 155 Integration of Abandoned Offerings

Regulation A Conditional Small Issues Exemption

Regulation C Registration and Filing Requirements

Regulation D Rules Governing the Limited Offer and Sale Of Securities Without Registration Under the Securities Act

Rule 701 Exemption For Offers and Sales of Securities Pursuant To Certain Compensatory Benefit Plans And Contracts Relating To Compensation

Regulation S Rules Governing Offers and Sales Made Outside The United States Without Registration Under The Securities Act)

General Rules and Regulations, Securities Act of 1934

Regulation 12B Exchange Act Registration and Reporting

Regulation 13D and 13G Securities Ownership

Schedule 13D Statement Of Beneficial Ownership

Schedule 13G Statement Of beneficial ownership

Rule 13e-3 Going Private Transactions

Regulation 14A Proxy Rules

Schedule 14A Proxy Statement Pursuant To Section 14(a) Of The Exchange Act

Regulation 14C Distribution Of Information Pursuant To Section 14(c) Of The Exchange Act

Schedule 14C Information Statement Pursuant To Section 14(c) Of The Exchange Act

Section 16 Rules Ownership Reports and Trading By Officers, Directors And Principal Security Holders

Regulation FD Fair Disclosure

Regulation BTR Blackout Trading Restrictions

Descriptions of Exchange Act Forms Forms Prescribed Under The Exchange Act

Industry Guides Securities Act and Exchange Act Industry Guides

Regulation S-K

Statutes

The Securities Act of 1933

The Exchange Act of 1934

The Investment Company Act of 1940

Jumpstart Our Business Startups Act (JOBS Act)
The JOBS Act requires the SEC to write rules and issue studies on capital formation, disclosure and registration requirements.

Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)
The Dodd-Frank Act was written to promote the financial stability of the United States by improving accountability and transparency in the financial system, to end ‘‘Too Big To Fail’’, to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

Sarbanes-Oxley Act of 2002 (SOX)
SOX was written to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws, and for other purposes.

“Testing the Waters” refers to the process permitted under Regulation A of the Securities Act of 1933 that allows an issuer, or a person authorized to act on its behalf, to solicit indications of interest from potential investors prior to the qualification of an offering statement by the U.S. Securities and Exchange Commission.

Indications of interest obtained through Testing the Waters are non-binding, do not constitute commitments to invest, and do not involve the acceptance of funds or the sale of securities. Any offer to sell securities may be made only after an offering statement has been filed with and qualified by the SEC, and only through a final offering circular.

Friends and family, angel investors, and venture capital funds are common types of investors in early-stage companies. However, each differ in their investor profile, the stage or funding round(s) in which they generally invest in companies, the structure of their investment, their level of involvement with the company, and the size or scale of their investments.

Source: https://www.sec.gov/education/capitalraising/building-blocks/investor-types