John Gitta
Associate Editor
Loyola University Chicago School of Law, JD 2019

Under Rule 506 of Regulation D (“Reg D”), the U.S. Securities and Exchange Commission (“SEC”) exempts companies making private placements to accredited investors from all federal and state securities registration requirements. As a federal safe harbor, Rule 506 of Regulation D preempts all conflicting state securities regulations, but reserves the states’ rights to require issuers to make notice filings, and to investigate and prosecute securities fraud under state securities laws, commonly known as “Blue Sky Laws.” On its face, Rule 506 of Reg D creates a more efficient securities marketplace. However, the historical lack of consequences for non-compliance at the federal level, combined with inconsistent state notice requirements for using exemptions, further complicates an already over-regulated securities marketplace.

SEC’s Rationale for Private Placement Exemptions

Falling under the National Securities Markets Improvement Act of 1996 , Rule 506 is part of the SEC’s effort to create a more efficient marketplace by preempting duplicative state securities regulations, while still providing for transparency and investor protection. Under the rule, small companies can quickly raise large amounts of capital by selling debt or equity securities to accredited investors without having to register such issuances with the SEC or state securities administrators. Generally, it is illegal to sell unregistered securities, because it is easy for issuers to take advantage of unaccredited investors. However, the registration exemption process presumes that accredited investors are sophisticated enough to assume and incur the risks associated with unregistered securities. Moreover, while private placements, by definition, are exempted from registration, the SEC still requires companies to declare these exemptions, i.e., make “notice-filings,” on the federal level by submitting “Form D” within 15 days of making a private placement in any state. However, the SEC does not require similar notice-filings at the state level. Instead, the federal securities laws leave this aspect up to the states, allowing each state to decide whether to impose its own separate notice requirement on issuers. Most states have incorporated some form of notice requirement into their respective Blue Sky Laws, and require issuers to notice-file by sending a copy of Form D (among other documents) to the state’s securities administrator.

The SEC treats federal notice-filing as a requirement for using certain registration exemptions under Regulation D, but not as a condition for claiming exemptions under Rule 506, consequently failing to satisfy the notice requirement does not prevent the securities from qualifying as covered securities under federal law. Federal notice-filing has two goals: first, it enables private investors to raise an unlimited amount of capital in a short period of time by fostering an active private issuer market, free of heavy regulations and the high costs typically associated with public offerings. Second, federal notice-filing helps the SEC oversee securities offerings and enforce relevant federal securities laws, a responsibility it shares with FINRA, and to a certain extent, the states. However, the preemptive aspects of Regulation D appear to undermine this joint effort by severely limiting the states’ ability to investigate and prosecute securities fraud and abuse within their borders.

States Question the Efficacy of Form D Filings

Because the SEC only requires federal notice-filing (with the states imposing their own, individualized filing requirements), conflicts often arise when private issuers fail to notice-file at the state level. Failure to notice-file at the state level frustrates the states’ ability to regulate securities fraud and abuse because such notice filings serve as a way for states to monitor compliance. Most state regulators find this to be particularly important, because Rule 506 is the most used Regulation D exemption, both for legitimate and fraudulent securities issuances (according to the most recent SEC study). As noted by the North American Securities Administrators Association (“NASAA”), the prevalent use of Rule 506 for fraudulent purposes is reflected in its annual appearance as one of the most reported avenues for investor fraud schemes leading to enforcement actions by state securities regulators. While this trend recently improved, state securities regulators remain concerned that bad actors will continue to use Rule 506 exemptions to victimize unknowing investors.

The states’ concern is further heightened by the SEC’s history of failing to take effective corrective actions in response to documented Regulation D deficiencies. Findings in a 2009 Office of Inspector General (“OIG”) performance audit of the SEC’s Division of Corporation Finance revealed that the Division did not substantively review Form D filings to determine whether issuers appropriately used Regulation D exemptions, and also failed to document or report non-compliance to the Division of Enforcement. While a 2016 OIG performance audit revealed that the SEC took measures to address most of these concerns over the years, the OIG nevertheless found that the Division of Corporation Finance still operated under outdated policies and procedures, and that it lacked effective documentation and monitoring mechanisms to enforce compliance.

Too Much Pushback from State Notice Filing Requirements?

While the SEC has improved its efforts to protect investors from fraud, the historic lack of accountability for non-compliance on the federal level has damaged its partnership with the states, leading states to trust more in their own abilities to monitor notice-filing requirements under Blue Sky Laws. This monitoring, however, may, in certain circumstances, exceed the states’ powers under federal law. Under Blue Sky Laws, states require notice-filing with securities administrators, and charge initial and late filing fees ranging from fifty to six-hundred dollars (federal notice- filing is free). While these questionable filing requirements and fees can be overlooked, some states go as far as attempting to completely revoke exemptions offered under Regulation D. Wisconsin’s notice filing statute, for example, disqualifies private issuers from claiming registration exemptions under Rule 506. Similarly, New York’s securities statute, treats notice-filing as a precondition for all Regulation D exemptions, including registration exemptions offered under Rule 506. Thus, the states’ notice -filing monitoring, while justifiable, in some cases undermines the SEC’s goal to deregulate the private placement market.

Possible Solutions

The SEC must continue to balance its duties (1) to protect investors from fraudulent issuances, and (2) to promote capital formation. These duties can be accomplished by implementing the OIG’s corrective action plans and recommendations, including improving communication and information-sharing with states and investors. A promising initiative that will help with this goal is the North America Electronic Filing Depository (“EFD”), a central electronic filing database that allows states and investors to view submitted Form D filings. Additionally, the SEC should improve its internal compliance mechanisms by updating technology to better flag, document, and respond to suspected cases of non-compliance, giving private issuers an incentive to notice-file. Likewise, states can assist the SEC by participating in electronic filing, which should limit the need to use Blue Sky Laws as tools to frustrate federal securities laws.