Preemption Of State Securities Law For Small Business Capital Formation

Posted on November 22, 2011


The future of small business is more important than ever as the economic landscape becomes more and more defined by start-ups. Small firms of less than 100 employees employ approximately 36% of America’s workforce.

Small businesses often need outside capital to succeed. However, all types of fundraising for private companies are government regulated. Since start-ups are often dependent on outside investors, they must keep Securities and Exchange Commission (SEC) regulations in mind.

The most important SEC measure, known as Regulation D, defines how companies can go about raising needed capital. Rules 504, 505 and 506 are particularly important to the regulation. By qualifying under these exemptions, companies can receive investments and be exempt from federal securities law.

However, Reg D has certain disclosure requirements. If a company files under rules 504 or 505, it has certain disclosure requirements. Additionally, the investment is still subject to state regulation, also known as state blue sky laws, which regulate the securities of companies on a state-by-state basis. A company is subject to regulation in each state in which an investment takes place.  This state-by-state regulation creates significant compliance cost and is problematic in terms of gaining capital in a timely matter or not being able to meet the investment requirements of multiple states.

Rule 506 is perhaps the most relaxed regulation, as it states that only certain “accredited investors,” investors with significant funds and capital of a certain amount, can contribute freely to an enterprise. Additionally, under the National Market Securities Improvement Act of 1996 securities issued pursuant to a Rule 506 exemption are exempt from state regulation. Because of this preemption, Rule 506 is heavily used by accredited investors:

“Rule 506 imposes no disclosure in connection with sales to accredited investors. The purchaser qualification requirements of the rule are met if purchasers are accredited investors, and there is no limit on the number of accredit investors under 506.

“These are the reasons that roughly 80 percent of all offerings in the size range that would qualify under 504 or 505 are made under Rule 506 limited to accredited investors.  Issuers rationally conclude that an offering under Rule 506 limited to accredited investors involved lower transaction cost than offerings under Rule 504 or Rule 505, which are required to meet the registration provisions under each state’s blue sky law.”

p. 933, The Business Lawyer, The Wreck of Regulation D: The Unintended (and Bad) Outcomes for the SEC’s Crown Jewel Exemptions by Rutherford B. Campbell, Jr.

Thus, except for investments by accredited investors in Rule 506 offerings, Regulation D is problematic for small businesses. In an economy where smaller start-up companies make up a significant portion of the workforce, more coordination needs to be in place between state and federal exemptions in order to accommodate those investors who help the bulk of start-ups with smaller contributions, as many start-ups do not receive their capital from wealthy individuals.

There does seem to be some movement in this area. In addition to the above-cited articles, a decision by the House Financial Services committee backing legislation that would allow crowd funding may do away with many Regulation D woes. (Crowd funding is an easy option for entrepreneurs to raise funds. Backers receive a portion of a company in exchange for their investment.)

According to the Wall Street Journal, “Under the proposal, investors would be able to buy stakes of up to $10,000 a year, or 10% of their annual income, whichever is less. Companies would be able to sell up to $2 million in equity—but must provide audited financial statements if the total exceeds $1 million.” The proposal would enable the transfer of smaller amounts of capital that are more realistic gains for start-ups.

While opponents of this bill feel that fraud is more likely through crowd funding, many entrepreneurs feel that easier access to crowd funding offers them a greater chance to succeed in business. Indeed, those in favor of stringent state regulation of capital fundraising argue that it is a huge help in dispelling fraud. The Alabama Securities Commission has thwarted countless fraud without issues of securities.

At this stage, I have not formed an educated opinion on the legislation.  With a Congress that appears unlikely to pass anything, I reserve the right to wait until actual passage. However, when balancing investor protection with ease of capital markets for small business formation, I would urge lawmakers and administrators to take into consideration the following:

1) Are we really protecting investors if the regulation designed to protect small investors effectively precludes the investment? While some credence should be given to the securities motto that allows rich people to lose money, non-millionaires can provide crucial capital. Whether it is through crowd sourcing or through friends and family activities, I believe, with respect to small businesses, people can best judge for themselves the type of business they can investment in.

2) The general solicitation ban needs to be brought into the 21st century. A distinction should be made between active solicitation – i.e. the boiler room calls and passive solicitation. If an investor, through social media, website search reaches out to a company to invest, he or she should be afforded less protection. A company should be allowed to post on Facebook or on their website that they are offering stock. This investment solicitation is fundamentally different then a cold call, and the law needs to recognize this difference.

Mike Goodrich
Goodrich Law Firm, LLC

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