Corporate & Securities Article
January 27‚ 2014
Limits on Martin Act Regulation of Rule 506(c) Offerings
By Daniel DeWolf and Ilan Goldbard
This memorandum examines the interplay between three pieces of legislation: (1) the recently enacted Rule 506(c) under the Securities Act of 1933 (the “Securities Act”), (2) Article 23-A of the New York General Business Law (“GBL”), commonly known as the Martin Act, and (3) the National Securities Markets Improvement Act of 1996 (“NSMIA”) amendments to § 18 of the Securities Act. Specifically, we consider whether NSMIA preempts Martin Act regulation of Rule 506(c) offerings, and whether, regardless of NSMIA preemption, Rule 506(c) offerings should be exempt from regulation under the Martin Act as non-public offerings.
We conclude that NSMIA narrowly constrains, though does not entirely preempt, New York’s ability to regulate Rule 506(c) offerings, but that the Martin Act exceeds these constraints. We further conclude that Rule 506(c) offerings should not be considered public, given the clear guidance from federal courts and legislators that such offerings not be considered public and the lack of any compelling reason for New York to regulate such offerings. Such offerings should therefore be entirely excluded from Martin Act regulation, regardless of preemption by NSMIA.
Under the Martin Act, brokers and dealers who offer securities for sale to the public must comply with certain registration and disclosure requirements. These include disclosure of current and past offerings undertaken by the registrant or its principals, disclosure of past wrongdoing by the registrant or its principals, provision of offering documents and the payment of certain fees, among other requirements.1 The term “dealer” under the Martin Act specifically includes a corporation or other entity that offers securities that it itself has issued, as in the typical private placement scenario.2 However, the statute is less clear on what constitutes an “offer for sale to the public,” a phrase which is not explicitly defined. Where an offering does not constitute an offer for sale to the public, the offeree is exempt from the Martin Act’s requirements.
NSMIA limits the authority of states to regulate those securities already subject to federal regulation, thus reducing the burden on issuers to comply with the regulatory requirements of each state in which they sell securities. Specifically, NSMIA prohibits states from requiring the registration or qualification of securities transactions in federally “covered” securities.3 Among the class of covered securities are those issued in transactions exempt from federal registration pursuant to rules or regulations issued under § 4(a)(2) of the Securities Act.4
Rule 506 is promulgated under § 4(a)(2) of the Securities Act as part of Regulation D. Transactions which comply with the requirements of Rule 506 are deemed not a public offering under § 4(a)(2) of the Securities Act and exempt from the federal registration requirements.5 Securities issued in Rule 506 offerings are therefore “covered” securities under NSMIA, and exempt from state registration.
NSMIA does, however, permit states to impose “notice filing requirements that are substantially similar to those required by rule or regulation under § 4(a)(2)”6 with respect to such covered securities, and allows them to require a consent to services of process and to charge certain fees.7 In compliance with this rule, most states require, at most, that issuers engaged in Rule 506 offerings file with the state a copy of the Form D as filed with the SEC, along with a fee and a consent to service of process.
In 2002, the New York State Bar Association (the “NYSBA”) published in an influential position paper that the requirements of the Martin Act, when applied to Rule 506 offerings, clearly go beyond the scope of state regulation permitted by NSMIA for covered securities.8 Rather than the required registration statement, New York can “receive only a fee, a consent to service of process and the first five pages (Parts A-D) of Form D together with the ‘State Signature’ portion of page 6 of Form D, within 15 days after the first sale.”9 The requirements of the Martin Act are not “substantially similar” to those required by Section 4(a)(2) and Rule 506; they far exceed them, and constitute a second impermissible regulatory regime running parallel to the Securities Act.
The NYSBA paper was written long before the enactment of Rule 506(c), but its arguments apply equally to any sort of offering under Rule 506. Rule 506(b) and 506(c) are both promulgated under § 4(a)(2), and therefore both constitute transactions in covered securities. The registration requirements of the Martin Act therefore exceed the narrow constraints of NSMIA for Rule 506(c) offerings as well.
Many practitioners, including the authors of the NYSBA paper, take the position that NSMIA’s preemption of the Martin Act with regard to Rule 506 offerings is a moot point. This is because Rule 506 offerings are private, and the Martin Act, on its own terms, only regulates offerings of securities “to the public.”10 Thus, if securities are not sold to the public, the Martin Act can impose no requirements, regardless of preemption.
The practical concern in this argument is that an offering “to the public” under the Martin Act is not specifically defined, and practitioners cannot state with absolute certainty that a Rule 506 offering is not an offering to the public. At the federal level, an offering that complies with Rule 506 is explicitly deemed not a public offering under § 4(a)(2), and is therefore exempt from registration requirements under federal law.11 However, the Martin Act does not provide, and no New York court has specifically held, that such an offering is not public for purposes of the Martin Act. Nor has a New York court held that an offering should always be deemed not public under the Martin Act if it would be deemed not public under the Securities Act.
Despite these shortcomings in the Martin Act and case law, the majority of practitioners have concluded that a Rule 506 offering is in fact not public under the Martin Act.12 This is partly due to the characteristics of a Rule 506 offering, and partly due to the clear interest in maintaining uniformity between state and federal definitions of a public offering. While we agree with this consensus, we note that it was initially reached only with respect to offerings under Rule 506(b). The NYSBA paper, around which this consensus was formed, did not contemplate whether Rule 506(c), which allows for general solicitation by issuers to the public, should also be considered non-public under the Martin Act. We must therefore examine the basis for the conclusion that Rule 506(b) is not public, and see if it is wide enough to accommodate Rule 506(c) as well. We conclude that it is.
Citing People v. Landes, 84 N.Y.2d 655 (1994) and other New York cases, the NYSBA notes that New York courts interpreting the concept of a public offering under the Martin Act regularly look to federal case law interpreting the phrase “not involving a public offering” under § 4(a)(2) of the Securities Act. These federal interpretations are relevant to New York courts because, as stated by the Landes court, the Martin Act and the Securities Act have similar aims: to “regulate parties selling securities and to advance the public’s knowledge about the securities offered for sale.”13 Thus, where federal courts have deemed an offering non-public, and therefore unworthy of regulation under the federal securities laws, New York may by analogy reach the same conclusion regarding regulation of such an offering under the Martin Act.
In determining whether an offering is public, federal courts look first to the purpose of the registration requirements, and then decide whether such purposes are served by requiring registration of the offering as public. In Securities & Exch. Commn. v. Ralston Purina Co., 346 U.S. 119 (1953), the seminal federal case on the subject of public versus private offerings, the court concluded that the purpose of the registration requirements is “to protect investors by promoting full disclosure of information thought necessary to informed investment decisions.”14 Where investors do not require this protection, the purpose of the registration requirement is not served and the offering should not be considered public. In the words of the court, “an offering to those who are shown to be able to fend for themselves is a transaction not involving any public offering.”15 The “knowledge of the offerees”16 is therefore a key question in determining whether an offering has been made to the public, or whether it has been made privately to a group of offerees who do not require the disclosures compelled by the Securities Act.
As argued by the NYSBA, when this method of inquiry is applied to Rule 506(b) offerings, it is clear such offerings should be considered non-public. Where a 506(b) offering is made to unaccredited investors, the issuer is required by Regulation D to provide extensive disclosures regarding itself and the offer.17 Where such an offering is made only to accredited investors, no such disclosures are required by Regulation D, but the accredited investors have the sophistication and leverage to obtain this information — in other words “to fend” — for themselves. The purposes of the Martin Act are therefore not furthered by designating such offerings public and requiring further disclosure.
This argument applies equally, if not more so, to offerings under Rule 506(c). Unlike in offerings under Rule 506(b), purchases under Rule 506(c) can only be made by accredited investors. Moreover, Rule 506(c) imposes a strict verification process to ensure that those purchasers claiming to be accredited investors actually do meet the net worth requirements for such a designation, reducing the risk that an investor unable to fend for itself will sneak into the offering.18
More importantly, all Rule 506 offerings are now subject to so-called “Bad Actor” rules that obviate the need for Martin Act disclosure requirements entirely. As noted by the Landes court, the Martin Act focuses on disclosure regarding the issuer, and “is useful to offerees in only the general sense of warning them about those they are trusting with their money.”19 For example, the Form 99 statement that issuers are required to file under the Martin Act requires disclosure of any criminal conviction, expulsion or suspension from a securities exchange or any other legal action relating to securities offerings by the issuer or its principals. This is information that public offerees must be aware of for their protection. However, Rule 506 obviates the need for such disclosure because, pursuant to its recently adopted Bad Actor provisions,20 as required by the Dodd-Frank Act, any issuer who has engaged in wrongdoing of the sort that must be disclosed on Form 99 is specifically barred from relying on the rule. Therefore, an issuer relying on Rule 506 can have no wrongdoing to disclose to offerees on Form 99, and New York has no interest in requiring such an issuer to file one.
Finally, the restrictions imposed on the resale of securities purchased in Rule 506(c) offerings are a further indication that they are not public offerings. As noted by the NYSBA, Rule 506 offerings should not be considered public because resale of securities sold in such offerings is restricted. Securities sold in Rule 506 offerings, whether under Rule 506(b) or 506(c), cannot be resold without registration under the Securities Act or an exemption from registration.21 Moreover, such securities must bear a legend notifying the holder that they are unregistered and subject to restrictions on transfer.22 These restrictions on liquidity are not consistent with an offering to the public, and ensure that the securities will not be distributed to a wider group of less sophisticated investors.
To retrace the argument: New York courts have endorsed the federal court’s view that an offering should only be considered public and therefore subject to regulation if its offerees, as members of the general public, require the protections and disclosures that such regulation will provide. The purchasers in a Rule 506(c) offering are all accredited investors and therefore sufficiently sophisticated to fend for themselves and demand whatever disclosures from the issuer they require. Furthermore, because of the new Bad Actor provisions that apply to all Rule 506 offerings, such offerees can rest assured that the issuer and its principals have not engaged in the types of wrongdoing that would have otherwise been disclosed to them if the offering were subject to the Martin Act. Finally, the restrictions on liquidity of securities sold in Rule 506(c) offerings are inconsistent with a public offering and ensure that the securities will not ultimately be distributed to the public at large. Rule 506(c) offerings should therefore be excluded from regulation under the Martin Act as non-public.
It may also be argued that the above analysis is not even necessary to determine that Rule 506(c) offerings are not public under the Martin Act; New York need only follow the bright line laid down by Congress in calling for the rule itself.
Rule 506 is a safe harbor under the non-public offering exemption to registration under the Securities Act. It is not a separate exemption from registration, but rather a legislative determination that such offerings are in fact not public. This is a subtle but important distinction given New York’s stated desire to maintain consistency with federal securities regulation, and its use of federal statutory interpretation to apply to its own laws.
As noted by the NYSBA, the legislators who approved substantial revisions to the Martin Act in 1959 were concerned that offerings deemed private under the Securities Act might nevertheless be deemed public under the Martin Act, and sought to ensure that the Martin Act would only be applicable to situations “tantamount to public offerings” in “accordance with a philosophy comparable to that underlying the [Securities Act].”23 This, in part, has motivated the New York courts to use federal precedent in defining a public offering under New York law, as they did in Landes.
It follows that where Congress has given the federal courts a bright line for determining when an offering is non-public, as they have with the passage of the JOBS Act, which mandated the enactment of Rule 506(c), New York should take heed of this line as well. In other words, if New York will follow the federal judiciary’s interpretation of a non-public offering, it should also follow Rule 506(c), where Congress has provided the federal judiciary with a hard and fast rule to guide its interpretation.
Through passage of the JOBS Act and Rule 506(c), Congress and the SEC have delineated a type of offering that they deem non-public and therefore unworthy of burdensome registration requirements. Recognizing that the states have no special, additional interest in regulating inter-state securities offerings, Congress passed NSMIA to make such delineations the law of the land, such that issuers who comply with Rule 506(c) are not burdened with additional, unnecessary regulatory requirements of the various states.
New York’s Martin Act violates NSMIA by imposing additional registration requirements on issuers complying with Rule 506(c). Moreover, even if such requirements were not impermissible under NSMIA, they would not and should not be imposed, as Rule 506(c) offerings are not public, and therefore beyond the scope or interest of the Martin Act.
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Endnotes
1 GBL § 359-e.
2 GBL § 359-e(1)(a).
3 Securities Act § 18(a)(1).
4 Securities Act § 18(b)(4)(E).
5 Securities Act Rule 17 CFR 230.506(a).
6 Securities Act § 18(b)(4)(E).
7 Securities Act § 18(c)(2).
8 The Committee on Securities Regulation of the New York State Bar Association, Private Offering Exemptions and Exclusions Under the New York State Martin Act and Section 18 of the Securities Act of 1933(2002) (“NYSBA Paper”).
9 Id.
10 GBL § 359-e(1)(a).
11 Securities Act Rule 17 CFR 230.506(a).
12 NYSBA Paper.
13 Landes, 84 N.Y.2d at 660.
14 Ralston, 346 U.S. at 124.
15 Id. at 126.
16 Id. at 127.
17 Securities Act Rule 17 CFR 230.506(b)(1).
18 Securities Act Rule 17 CFR 230.506(c)(i).
19 Landes, 84 N.Y.2d at 662.
20 Securities Act Rule 17 CFR 230.506(d).
21 Securities Act Rule 17 CFR 230.503(d).
22 Securities Act Rule 17 CFR 230.503(d)(3).
23 NYSBA Paper (citing 1959 N.Y. Sess. Laws 1767 at 1768).
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