This issue's column provides updates on issues pertaining to the ever-popular Rule 506 offerings and investment advisers.
A. Wassup with the "EFD"?
I had hoped that my most recent critical comments in the December 2011 issue of the Bugle would have lit a fire under the collective derrieres of our friends at the North American Securities Administrators Association ("NASAA"), and would have finally gotten NASAA's long-awaited and -promised "one-stop filing system" (which has been assigned the acronym "EFD," for "Electronic Filing of Form D") for notice filings of offerings complying with Rule 506 ("Rule 506") of Regulation D ("Regulation D") promulgated by the U.S. Securities and Exchange Commission (the "SEC") under the Securities Act of 1933, as amended (the "Securities Act"), off the ground. Considering that Willie Neumann, NASAA's outside consultant on the EFD project, took umbrage at my prior criticism of the glacial pace of the EFD project at the NASAA Annual Meeting last September, I was hoping that my last column would have spurred Neumann et al to at least announce the launch of the promised "Beta" testing of the EFD. A search of the NASAA website on August 20, 2012, however, turned up nothing new (and, frankly, no mention at all!) about the EFD, and an attempt on the same date to access the website "http://efd.nasaa.org/," a site purportedly set up by NASAA for information about the EFD, once again turned up a blank page.
Having heard from others in the Blue Sky community that Neumann was no longer on the EFD project (although it was unclear whether his departure was voluntary or involuntary) and that the EFD was officially dead, like a good reporter, I decided to go directly to Heath Abshure, the Arkansas Securities Commissioner and Chair of NASAA's "Regulation D Electronic Filing Committee," which is in charge of the EFD project, to check on its current status. Here's Mr. Abshure's verbatim response to my inquiry:
"Although Mr. Neumann is no longer NASAA's program manager for the development of the Form D filing system, it does not mean that the project 'is no longer moving forward.' Late last year, the developer with whom NASAA contracted to build the system unilaterally terminated the development contract after informing NASAA that it would not honor its contractual obligations. NASAA is in the process of selecting a new vendor and, in fact, is meeting with candidates at the end of this month. Once a vendor is selected and a new contract is signed we expect the project to be complete in 6- 8 months."
The foregoing was reiterated at the NASAA Ombudsman's Meeting at NASAA's Annual Public Policy Conference in Washington, D.C. on May 7, 2012.As readers may recall from my past Bugle columns discussing the sorry history of the EFD, it's now been: (1) over five years since the SEC first proposed the electronic filing of Form Ds through the EDGAR system in SEC Release No. 33-8814 (June 29, 2007); (2) over four years since the SEC adopted the final rules for the electronic filing of Form Ds in SEC Release No. 33-8891 (Feb. 6, 2008); and (3) over two years since NASAA entered into a Memorandum of Understanding with the SEC on April 5, 2010 concerning the creation and operation of the EFD. Considering that chronology, I'm not overly optimistic that the EFD will see the light of day this year (if ever), and I'm wondering whether the seemingly interminable delays mean that the EFD is simply a victim of the general antipathy of NASAA members towards Rule 506 offerings and perhaps a feeling among the state regulators that the EFD will only make things too easy for issuers relying on the Rule 506 exemption and its preemptive effect on Blue Sky laws.
I also find it ironic that in an October 21, 2011 letter from Jack Herstein, President of NASAA, to the leaders of the House Financial Services Committee, reprinted at NASAA Reports (CCH) ¶ 13,264, in which NASAA raised objections to provisions of H.R. 2930, the proposed "Entrepreneur Access to Capital Act," as regards that bill's deregulation of so-called "crowdfunding" offerings, NASAA also announced that it had voted to establish a special "Small Business Capital Formation Committee" which would "examine and propose steps that may be taken collectively by state securities regulators to promote and facilitate the formation of small business capital." Query whether making the Form D filing process as cumbersome and expensive as possible for small and new businesses by the prolonged delay in bringing the EFD to fruition is among the "steps" that NASAA is proposing?
B. SEC Rules Affecting Rule 506 Offerings
As most of our Committee members know, the SEC was supposed to adopt, by July 21, 2011, amendments to Rules 501(a)(5) and 506 of Regulation D, as mandated by Sections 413(a) and 926 of the "Dodd-Frank Wall Street Reform and Consumer Protection Act," Pub. L. No. 111-203 (the "DFA"). These provisions required the SEC to: (a) adjust the over $1,000,000 minimum net worth standard for natural person accredited investors in any SEC rules under the Securities Act (such standard also appears in Rule 215(e) under the Securities Act, promulgated under Securities Act § 2(a)(15)), so that the value of the primary residence of such an investor would have to be excluded from the investor's net worth; and (b) create certain "bad actor" disqualifications from use of Rule 506.
The SEC has adopted amendments to Rules 215(e) and 501(a)(5), revising the accredited investor net worth standard, effective February 27, 2012. Those amendments were proposed in Release No. 33-9177 (Jan. 25, 2011), reprinted at 76 Fed. Reg. 5307 (Jan. 31, 2011), and finalized in Release No. 33-9287 (Dec. 21, 2011), reprinted at 76 Fed. Reg. 81793 (Dec. 29, 2011). On February 27, 2012, the SEC issued a helpful "Small Entity Compliance Guide," explaining and providing examples of how the revised net worth standard works. Links to copies of both Releases, as well as to a copy of the Compliance Guide, may be found at the Dec. 21, 2011 entry for "33-9287" at http://www.sec.gov/rules/final/finalarchive/finalarchive2011.shtml.
As regards the "bad actor" disqualification, while the SEC proposed amendments to Rule 506 to add such a provision in Release No. 33-9211 (May 25, 2011), reprinted at 76 Fed. Reg. 31518 (June 1, 2011), that proposal was still pending as of August 20, 2012, and engendered a host of comment letters, including one which our Committee submitted jointly with other ABA committees. See, http://www.sec.gov/comments/s7-21-11/s72111.shtml. While the SEC's most recent "Regulatory Flexibility Agenda," Release No. 33- 9260 (Sept. 16, 2011), reprinted at 77 Fed. Reg. 8082 (Feb. 13, 2012), lists this rule proposal as being in the "final rule stage," with final action anticipated this past December, the last I heard about the proposal was that the SEC staff was working through the comment letters they received in response to Release No. 33-9211 and was preparing recommendations for the Commission; one of the major issues to be resolved involves the retroactive application of the "bad actor" disqualification provisions.
C. Title II of The JOBS Act – Effect on Rule 506 Offerings and a Cautionary Note
Public Law 112-106, the "Jumpstart Our Business Startups Act'' (the "JOBS Act"), was signed into law on April 5, 2012 (see, http://www.gpo.gov/fdsys/pkg/PLAW-112publ106/pdf/PLAW-112publ106.pdf). Title II of the JOBS Act, consisting solely of Section 201, and titled the "Access to Capital for Job Creators Act," incorporates and supplants H.R. 2940, which I discussed in my column in the December 2011 issue of the Bugle. As enacted, Section 201(a)(1) of the JOBS Act requires the SEC to amend Rule 506 within 90 days of enactment (i.e., by July 4, 2012) to provide that the prohibition on general solicitation and general advertising in Rule 502(c) of Regulation D shall not apply if all purchasers of the securities are accredited investors, with a requirement that the issuer take "reasonable steps to verify" that such purchasers are accredited, using methods determined by the SEC, and Rule 506 will continue to be treated as a regulation issued under Securities Act § 4(2). So as to reinforce the point that amended Rule 506 will conform to Section 4(2), Section 201(b) of the JOBS Act amends Securities Act § 4 to add a new paragraph (b), stating that offers and sales exempt under Rule 506 "shall not be deemed public offerings under the Federal securities laws as a result of any general advertising or general solicitation."
Unfortunately, the SEC missed the July 4 rulemaking deadline, and it's unclear as to when any such rules will be proposed, let alone adopted. In this regard, it is noted that the ABA, NASAA, and a host of others have submitted pre-proposal comments to the SEC concerning rulemaking under JOBS Act § 201. See, http://www.sec.gov/comments/jobs-title-ii/jobs-title-ii.shtml. In particular, the critical comments from NASAA and others focused on the "reasonable steps to verify" language in Section 201(a)(1), asserting that issuers would have to do more than merely rely on representations from investors as to their "accredited" status.
Assuming that the SEC ultimately establishes reasonable conditions for verification of the "accredited investor" status of purchasers, Rule 506 issuers willing and able to abide by those conditions and restricting sales to accredited investors may look forward to being freed from the constraints of Rule 502(c) of Regulation D, and proceed to open up their websites or otherwise publicly advertise or promote their offerings (I would assume that any generally-available solicitation or advertising materials will have to indicate that sales are restricted to "accredited investors"). However, such issuers must be aware that Title II of the JOBS Act has no effect on Blue Sky laws (except insofar that offerings complying with amended Rule 506 will continue to be treated as "covered securities" within the meaning of Securities Act § 18(b)(4)(D)). Therefore, an issuer which would rather rely (or which has previously relied) on a self-executing or otherwise less-onerous de minimis or other exemption in a particular state, in lieu of effecting a Rule 506 notice filing, may discover that such an exemption will not (or will no longer) be available if it engages in general solicitation or general advertising in that state. Thus, in the case of states enacting a version of the 2002 Uniform Securities Act (the "2002 USA"), while 2002 USA § 202(14) provides a self-executing exempt transaction for an offer and sale by an issuer to not more than 25 purchasers in the state during any 12 consecutive months, one of the conditions of that exemption is that "a general solicitation or general advertising is not made in connection with the offer to sell or sale of the securities."
By way of actual examples where reliance on amended Rule 506 may prove problematic, see: (1) Section 59.035(5) of the Oregon Securities Law (the "OSL") and Rule 441-35-010 thereunder, 3 Blue Sky L. Rep. (CCH) ¶¶ 47,104 and 47,553, which provides a self-executing exemption for offers and sales to any accredited investor (including natural persons), "but only if there is no public advertising or general solicitation in connection with the transaction"; and (2) OSL § 59.035(12), 3 Blue Sky L. Rep. (CCH) ¶ 47,104, which provides another self-executing exemption for an offering resulting in not more than 10 purchasers in Oregon (other than certain institutional investors) during any 12 months, provided that, among other conditions, "no public advertising or general solicitation is used in connection with any transaction under this exemption." Thus, while a Rule 506 issuer may currently be able to rely on either of those exemptions and avoid making a covered securities notice filing (and a $250 filing fee) under OSL § 59.049(3) and Rule 441-49-1051 thereunder, 3 Blue Sky L. Rep. (CCH) ¶¶ 47,105AA and 47,556Q, if that issuer were to engage in general solicitation or general advertising as permitted by amended Rule 506, it appears that it would have no choice but to make a notice filing.
Knowledgeable Blue Sky practitioners have counseled Rule 506 issuers to take advantage of self-executing exemptions under state laws and rules where available and practical (i.e., in the case of a continuing offering, it probably isn't advisable to rely on a de minimis exemption where there is a possibility that the issuer may exceed the applicable numerical limit on offerees or purchasers in the exemption), in lieu of effecting a notice filing, particularly if the issuer might otherwise face sanctions for a late notice filing in the particular state (see Part D of this column in that regard). With the advent of amended Rule 506, however, practitioners will have to reconsider whether these alternative exemptions will remain available to an issuer taking advantage of the general solicitation/general advertising option. If some practitioners think that states may amend these exemptions to remove or revise prohibitions on general solicitation or general advertising in conformity with amended Rule 506, I believe that it is doubtful that NASAA would encourage states to take such action. See, in this regard, the comments by Jack E. Herstein, President of NASAA, in a September 27, 2011 letter to certain House members, reprinted at NASAA Reports (CCH) ¶ 13,263, in which, among comments on other pending legislation, he expressed NASAA's opposition to "The Access to Capital for Job Creators Act of 2011" (H.R. 2940), an earlier version of Title II of the JOBS Act, on the basis that removing the prohibition on general solicitation for Rule 506 offerings "would exacerbate the regulatory black-hole created in 1996, when Congress passed the National Securities Markets Improvement Act (NSMIA) and stripped the states of their authority to fully regulate in this area."
Accordingly, with the advent of general solicitation or general advertising for Rule 506 offerings, I expect that Rule 506 issuers will be making more state notice filings, in lieu of relying on self-executing exemptions, and those issuers will have to become attuned to the need to make timely notice filings to avoid sanctions. Thankfully, to the best of my knowledge, none of the so-called "institutional investor exemptions" from securities registration in Blue Sky laws, such as 2002 USA § 202(13), prohibits general solicitation or general advertising, so that a Rule 506 issuer engaging in permitted general solicitation or general advertising and which is willing and able to restrict sales in certain states to the types of investors specified in such exemptions (assuming all such investors are also accredited) may continue to rely on such exemptions and avoid notice filings. In that case, however, it is recommended that generally-available solicitation or advertising materials clearly indicate that the securities are being offered and sold in certain states solely to certain types of institutional investors which are also "accredited investors."
D. States' Continuing Harassment of Rule 506 Issuers
I'd like to offer special thanks to Committee member and our California state liaison, Keith Bishop, for the January 18, 2012 posting in his "California Corporate & Securities Law Blog," "Enforcing Form D Filings – A Misguided State Policy" (see, http://calcorporatelaw.com/2012/01/enforcing-form-d-filings-a-misguided-state-policy/). [First, however, a shameless plug for Keith: if you're not already a subscriber to his Blog, you should be, since not only does Keith provide timely information about developments in California securities and corporate law (as well as developments at the SEC and in Nevada corporate law), but his postings are always literate (who else regularly includes extended quotes in Latin or Greek in a legal blog, and I'm not talking res ipsa loquitur or spanakopita?) and oftentimes amusing – see "Newsletter" on the home page at http://calcorporatelaw.com/ to subscribe.] In any event, Keith cited my column in the December 2011 issue of the Bugle, in which I questioned the statistics in NASAA's 2010 Enforcement Report concerning Rule 506 offerings, and then he went on to criticize the states for misusing enforcement resources to pursue Rule 506 issuers for late notice filings as "a form of low hanging enforcement fruit."
While I recognize that many, if not most, Blue Sky laws authorize the administrator to impose administrative sanctions on, or bring civil actions in court, against persons who violate any provision of the statute or any rule adopted or order issued thereunder (see, e.g., 2002 USA §§ 603 and 604), as I pointed out in my last column, it is questionable whether such actions are permissible under NSMIA in the case of a late notice filing, since Securities Act § 18(c)(3) would appear to provide the sole remedy premised on a failure to comply with a state's notice filing requirement – a suspension of the offering until a proper filing is effected. Nevertheless, I continue to receive reports from Committee members that more and more states are insisting on receiving information concerning the "date of first sale" in the particular state which triggered the notice filing (notwithstanding that, in most cases, neither the state's statute, nor any rule or order thereunder, requires an issuer to provide such information), and then using that information as a pretext to sanction the issuer with a monetary penalty and/or some form of administrative order, premised solely on the late filing (and some states have even asserted the legally-spurious position that a late filer has lost the use of the Rule 506 exemption, notwithstanding the fact that there is no basis for that position under Regulation D and courts have held to the contrary).
From my experience, these late filings are more often than not the product of an oversight or a misunderstanding on the part of the issuer, and not a deliberate attempt to evade the filing requirement. For example, the issuer may have erroneously advised its counsel that a sale took place in the state where an entity-investor was organized, rather than the state where the investor's office was located and the offering was actually effected, or the issuer may have erroneously concluded that the investor qualified under a self-executing "institutional investor" or some other exemption and that a notice filing therefore wasn't required, but counsel subsequently determined otherwise. Nevertheless, and notwithstanding the absence of any allegations of fraud or complaints by local investors, some states persist in treating these filings as "cash cows" to fatten their coffers at the expense of issuers (which expense, of course, ultimately comes out of investors' pockets), and boost their enforcement records, as I suspect is the case with many of the proceedings against Rule 506 issuers reflected in the NASAA Enforcement Report.
While there are some states which seem to have simply resolved this quandary by imposing minimal penalty fees for late filings (e.g., Iowa charges $100 for an on-time filing, or $250 for a late filing), some other state penalties are clearly disproportionate to the fee charged for an on-time filing. Thus, for example, Kansas charges $250 for an on-time filing, or the greater of $500 or 0.1% of the amount sold in Kansas, up to a maximum of $5,000, for a late filing, while Maine charges $300 or a late fee of $800. Is there any justification for Kansas charging 200% (or possibly 2,000%) of the normal fee, or Maine charging 267% of the normal fee, for a filing received one day late? Even more egregious is Mississippi, which charges $300 for an on-time filing, but imposes an additional late fee of 0.1% of the amount sold in the state, up to $5,000.
Without conceding that any such sanctions are actually permissible under NSMIA, it is submitted that these monetary penalties are totally disproportionate to the violation, particularly when one considers the fact that it should take a state examiner mere minutes to review one of these filings, whether or not it's timely (in fact, if one were to consider the amount of time most state examiners probably spend reviewing each of these filings, the fees charged by most states even for an on-time filing probably exceed my own exorbitant hourly billing rate).
As I've said repeatedly in the past, I certainly don't have any problems with states pursuing issuers who effect fraudulent Rule 506 offerings, or who negligently or deliberately violate one or more of the fundamental terms of Rule 506, such as engaging in general advertising or general solicitation (at least under the current version of the Rule), so as to void any claim of NSMIA preemption. However, there's no justification for states to dedicate scant staff and other resources to sanction an issuer solely for effecting a late notice filing; those states which have been engaged in or which may be contemplating this practice reveal themselves to be nothing more than a taxing entity, since such a "violation" has nothing to do with investor protection, but is solely a revenue generator for the state.
E. State Investment Adviser Regulation Post- Dodd-Frank
My articles in the December 2010, April 2011 and September 2011 issues of the Bugle went into extensive detail on investment adviser regulation under federal and state law resulting from the amendments to the Investment Advisers Act of 1940 (the "Advisers Act") by the DFA. However, while NASAA and some individual states have made an effort to smooth the way for SEC-registered advisers who were forced to make the "switch" from federal to state registration and regulation by June 28, 2012 by reason of the DFA amendments (see, http://www.nasaa.org/1719/ia-switch-resource-center/), or who no longer qualify for SEC registration, there remain many unresolved issues which such advisers must face. I suspect that many advisers who made the switch were, or who register with one or more states in the future will be, surprised as to the lack of uniformity among the states in a number of respects and differences from the regulatory scheme under the Advisers Act and the SEC's rules thereunder.
First of all, the application process in many states entails direct submission of additional documents and forms, in addition to the standard Form ADV filed electronically via the Investment Adviser Registration Depository ("IARD"). Thus, for example, in Connecticut, an adviser must submit originals or copies of: (i) a "Connecticut Supplement" to Form ADV, (ii) its financial statements with a "Registrant's Certificate," (iii) its standard form of advisory agreement, (iv) any advertising and sales literature which may be distributed to clients and prospective clients, (v) a "Form DBA-1" (relating to a trade or assumed name), (vi) any disclosure document furnished to clients in lieu of Part 2 of Form ADV, and (vii) "employer consent letters" for multiple registration of "investment adviser agents."
In addition, state applicants must submit documentation to register one or more individuals associated with the adviser as "investment adviser representatives" (principally a Form U-4 for each individual, filed electronically via the IARD). By way of contrast, while Advisers Act § 203A(b)(1)(A) and SEC Rule 203A-3 thereunder govern when an associated person of an SEC-registered adviser may be subject to state registration as an "investment adviser representative," and such registration may be required only when the associated person has a "place of business" in the state, individual state laws will govern who must register as an investment adviser representative of a state-registered adviser (and this may cover a broader group of individuals associated with the adviser than under the SEC's rule), and the registration requirement will generally apply, regardless of whether the "representative" has a place of business in the state.
Second, as I have pointed out before, pursuant to Advisers Act § 222(b) and (c), a state may not enforce any books and records, net capital or bonding requirement on an adviser in addition to, or higher than, any such requirement under the law of the state in which the adviser maintains its principal office and place of business (as those terms are defined in SEC Advisers Act Rule 222-1), provided that the adviser is registered in that state and is in compliance with the applicable requirement of that state. However, other than such limited preemption, all bets are off when it comes to other substantive requirements that a state may choose to impose on registered advisers, so that an adviser registered in multiple states may be subject to multiple provisions governing such matters as custody requirements and limits on performance fees.
As regards performance fees, while a number of states have statutory provisions or rules which permit an adviser to charge the same performance fees as may be permitted to SEC-registered advisers under Advisers Act § 205(a)(1), (b), (c) or (e) and any SEC rule (in particular, Rule 205-3) thereunder (see, e.g., Section 36b-5(d) of the Connecticut Securities Law, 1A Blue Sky Rep. (CCH) ¶ 14,104), other states have no such provision (see, e.g., Delaware Securities Act § 73-305(c)(1) and (d), 1A Blue Sky L. Rep. (CCH) ¶ 15,131, which doesn't even authorize the Commissioner to adopt a rule or issue an order permitting different fees than those allowed by the statute). There are also a number of states which haven't incorporated the federal limits by reference, but rather enacted a statutory provision or adopted a rule modeled on an earlier version of Advisers Act § 205 or Rule 205-3 (note that the SEC's authority to create the Rule 205-3 exemption was added as Advisers Act § 205(e) in 1996), so that an adviser registered in one of those states may actually be paid a performance fee on different or, in certain cases, less-stringent terms than presently allowable under the SEC rule (see, e.g., North Carolina Investment Advisers Act § 78C-8(c)(1), (d) and (f) and Rule .1805 thereunder, 2A Blue Sky L. Rep. (CCH) ¶¶ 43,183 and 43,497C). Until these states update their laws or rules to conform to the current version of Advisers Act § 205 and the rules thereunder, advisers registered in those states must abide by their outdated requirements, which may require a change in the fee arrangements with clients in those states to the extent they conflict with the federal standards which the adviser previously abided by.
Finally, one unresolved issue is a jurisdictional one. Thus, most Blue Sky laws apply not only to an adviser's dealings with clients in the particular state, but to its dealings with clients outside the state when the advice is rendered from the state. See, in this regard, 2002 USA Securities § 610(f), whereby 2002 USA § 502, which, among other things, authorizes adoption of rules specifying the contents of investment advisory contracts, will "apply to a person if the person engages in an act, practice, or course of business instrumental in effecting prohibited or actionable conduct in this State, whether or not either party is then present in this State."
In light of a statutory provision of this nature, would a state insist that its regulatory scheme must apply to an adviser with a place of business in the state when its advisory arrangements with clients in other states are managed out of its local office, regardless of conflicts with the requirements of those other states? Thus, would an adviser with its sole place of business in Delaware, which, as noted above, has strict limits on performance fees, be prohibited from charging performance fees to a client in Connecticut to the extent permitted by Connecticut law, which fully coordinates with SEC Rule 205-3? In this regard, it is noted that even if the securities administrator of the state where the adviser's office is located doesn't object to the adviser's arrangements with its clients in other states, query whether those clients could seek recourse under the law of the adviser's home state to the extent the arrangements conflict with that law? By analogy, there have been cases where an investor in state A has been able to seek rescission of a securities purchase from a seller in state B, where the securities were registered in state A, but not in state B, and there was no exemption in state B's law comparable to 2002 USA § 202(20). I can see this issue as a bit of a ticking time bomb for state-registered advisers, and particularly for SEC-registered advisers making the "switch."
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