Preempting state securities laws

Larry Ribstein —  14 December 2011

States can be a wonderful laboratory and platform for jurisdictional competition.  But sometimes the laboratory seems to belong to Dr. Frankenstein and then federal law must step in to bring order.

Biff Campbell thinks Reg D has failed its intended purpose and the reason is state law.  Here’s part of the abstract:

Regulation D * * * offers businesses — especially businesses with relatively small capital requirements — fair and efficient access to vital, external capital.  * * * The data show that Regulation D is not working in the way the Commission intended or in a way that benefits society. The data reveal that companies attempting to raise relatively small amounts of capital under Regulation D overwhelmingly forego the low transaction costs of offerings under Rule 504 and Rule 505 in favor of meeting the more onerous (and more expensive) requirements of Rule 506. Additionally, these companies overwhelmingly limit their relatively small offerings to accredited investors, which dramatically reduces the pool of potential investors. This unintended and bad outcome is the result of the burdens imposed by state blue sky laws and regulations, and this has to a large degree wrecked the sensible and balanced approach of the Commission in Regulation D.  Congress. . . could solve the problem by expanding federal preemption to cover all offerings made under Regulation D.

He has a point.  Permitting the states to regulate national securities transactions enables individual states to impose regulatory costs outside their borders for the benefit of local interest groups.  This can have perverse effects — in this case, by letting individual states impede national capital formation and entrepreneurship .Indeed, a key economic rationale for federal law is to address this problem.  See Easterbrook & Fischel, Mandatory Disclosure for the Protection of Investors, 70 Virginia Law Review 669 (1984).  

But we don’t have to eliminate state securities laws, along with state law’s potential advantages of competition and experimentation, to deal with this problem.  There’s an alternative:  apply state law only to intrastate transactions, or to corporations that have contracted for the securities law of a particular state (e.g., by incorporating in the state).  In other words, apply the same choice-of-law rule to state securities law as to state corporate governance law.  I discuss this approach in Dabit, Preemption and Choice of Law and Preemption and Choice-of-Law Coordination (with O’Connor).

Larry Ribstein

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Professor of Law, University of Illinois College of Law

2 responses to Preempting state securities laws

  1. 

    In my experience, counsel steer clients toward offerings to all accredited investors pursuant to Rule 506 because meeting the information condition in Rule 502(b) is considered too costly. While Rule 504 doesn’t impose the same specific disclosure condition, it is limited to very small offerings (the aggregate offering price may not exceed $1 million less the offering price of all securities sold in the previous 12 months).

    In my view, Regulation D imposes a number of conditions that increase, rather than diminish investor risk. These include:

    Prohibiting general solicitation and advertising adversely impacts minority and women owned businesses.

    It is a condition to Rules 505 and 506 that neither the issuer nor anyone acting on its behalf shall offer or sale the securities by any form of general solicitation or general advertising.13 Similarly, California’s limited offering exemption prohibits the publication of any advertisement. Cal. Corp. Code § 25102(f)(4). These restrictions give an advantage to the well connected issuer because there is no need to engage in a general solicitation if the issuer already has ready access to prospective investors. Minority and women owned businesses that are not part of the “old boys’ club” may not enjoy these advantages and therefore face greater obstacles in obtaining capital. The ability to engage in a general solicitation under Rule 504 can put minority and women owned businesses on a more equal footing with companies that may be better connected to possible sources of capital.

    Prohibiting general solicitation and advertising encourages the use of unregistered finders.

    Issuers that do not have preexisting relationships with prospective investors are likely to utilize the services of a finder. For a fee, finders will make their contacts available to issuers. In other words, “if you don’t know them, buy them”. In many instances, however, finders are not registered as brokers. The use of unregistered brokers or finders is more likely in a small offering since registered brokers are likely to find that it is not economical to act as underwriters or placement agents in small offerings. This is yet another example in which small businesses are at a disadvantage to larger businesses in the capital formation process. While the use of an unregistered finder may be permissible in limited circumstances, it presents a variety of risks to the issuer. If it is subsequently determined that the finder should have been registered, the issuer may be subject to regulatory action and the purchasers may have a right of rescission. The ability to engage in a general solicitation under Rule 504 reduces the incentive for issuers to use unregistered finders by making it possible for such issuers to solicit investors directly.

    Prohibiting general solicitations and advertising puts small businesses at a bargaining disadvantage vis-à-vis accredited investors.

    Although federal and state securities laws are focused on investor protection, small businesses often lack both sophistication and bargaining position in dealing with accredited investors that by definition must be wealthy or sophisticated. For example, many small businesses receive funding from venture capital companies that are professional investors with substantially greater net worths. A small business that is prohibited from engaging in a general solicitation is necessarily limited in its ability to establish a competitive buyers market. Thus, they can be faced with “take it or leave it” situations in which they have no legal method of finding alternative buyers. One effect of prohibitions on general solicitation is to foster monopsony conditions for issuers.

    Prohibiting general solicitations and advertising increases investor risk by limiting public exposure of information to the market.

    The federal securities laws are premised on a disclosure philosophy. It is therefore ironic that the prohibition on general solicitation works is at complete odds with this fundamental principle. Rather than encouraging disclosure, it discourages it.

    Requirements of a preexisting relationship encourage affinity fraud.

    Although Regulation D does not explicitly require that investors have a preexisting relationship with the issuer, the staff of the Commission has considered the existence of such a relationship as a significant factor in determining whether a general solicitation has occurred. Inherent in the requirement of a preexisting relationship seems to be the perverse policy preference that if you are going to engage in securities fraud, society somehow prefers that you defraud friends, relatives and business associates rather than strangers. Ironically, this peculiar preference in favor of affinity fraud is reinforced by the fact that it may well be easier to defraud those whom you know than those whom you don’t know. This requirement therefore encourage offers and sales to persons known to the issuer. Unfortunately, this may have the unintended consequence of directing sales to persons who may be more trusting because of their relationship to the issuer. Indeed, persons are likely to be less trusting of persons they don’t know than those they do. The ability to engage in a general solicitation may actually reduce risk to all investors by making the offering subject to more extensive examination by the market.

    Limitations on resales increase risk to investors by concentrating risk and limiting liquidity.

    Except for securities offered and sold in Rule 504 Public Offerings, the issuers must exercise reasonable care to assure that the purchasers are not underwriters within the meaning of the 1933 Act. Thus, these securities have the status of securities acquired in a transaction under Section 4(2) of the 1933 Act and cannot be resold without registration under the 1933 Act or an exemption from registration. Restrictions on resales ultimately increase investor risk by requiring at a minimum an inefficient after-market. From the issuer’s perspective, this can be expected to result in higher costs of capital because investors will discount the price of securities in consequence of the lack of liquidity. Permitting resales may therefore both reduce the cost of capital and investor risk.

    Limitations on resales discriminate against small businesses.

    As noted above, securities that are not offered and sold in a Rule 504 Public Offering are “restricted securities” under Rule 144. While Rule 144 has a minimum of one year holding period, securities held for one year must still be sold pursuant to the other conditions of Rule 144, including the requirement that there be available adequate public information. Because small businesses may not be able to satisfy this condition, stockholders who are non-affiliates must hold an additional year if they wish to resell their shares in reliance on Rule 144. Thus, small businesses face a disadvantage vis-à-vis larger companies.

  2. 

    I am not sure about that, many long years ago before NISMIA and the pre-emption of blue sky laws, we had viable public markets in the shares of small local issuers. Indeed in that era there were IPOs in this small Midwestern city, of companies that are now household names. A $50,000 investment in one of them made my father a wealthy man.

    That market disappeared, and I don’t think that the state securities laws had much to do with it. The real change was the disappearance of small local broker-dealers who would conduct the offerings and make markets in the stocks. I think that was caused by other changes in the financial system. Most of those b-ds got rolled up into bigger ones, or were bought by banks.

    I think we lost something important when that happened, but, I don’t think we can go back home again.

    I am not saying that the securities laws shouldn’t be sanded down. They should be. But, this is the tail, it is not the dog.