But Wait, There's More! Dodd Would Let States Tinker with Reg D Offerings

In a comment today to my second post about not-so-goodies buried in the Dodd financial system reform bill, Joe Wallin points out that the Senator is also entertaining ending federal preemption of state authority to regulate securities offerings that are exempt under Reg D.

Sure enough, there it is in Dodd's draft, taking up nine numbered lines crossing pages 686-687. (Good eye, Joe!) 

Under current law, a startup or emerging company (or any issuer of securities) that is able to meet an exemption under Reg D isn't going to have to worry about state regulators imposing their own substantive standards on a private financing. States may (and do) impose fees and require copies of a standard form to be filed when their residents are purchasers in a Reg D offering, and states retain jurisdiction to bring enforcement actions for fraud or deceit; but startups and emerging companies raising private money today focus on finding investors who are accredited and on otherwise meeting the federal Reg D requirements, not on state securities laws.

What would it mean, were this aspect of Dodd's bill to become law? Potentially, it could mean that securities regulators of various states might impose inconsistent standards for exemptions from state registration requirements. If this happens, then, as Joe points out in his comment, legal fees for companies raising money would increase.

Some states may feel that the bar set by Reg D is too low, and that investors in their jurisdictions may need further protection than what they receive under federal law. See for example this historical letter to the SEC from the Massachusetts Securities Division, which expresses a decidedly investor-protective point of view: "In our regulatory experience, it is possible for an individual to meet [the $1,000,000] net worth threshold [to qualify as an 'accredited investor'], and nonetheless be an unsophisticated investor who would benefit from the protections provided by registration or exemption under state law."

The implications could be far broader, too, than an increase in the thresholds needed to meet the federal "accredited investor" standard. For the startup or emerging company, navigating different rules in different states might be necessary at every stage of raising private capital: seed stage angel financings and VC-led preferred stock rounds could all become more complex and more expensive.

That's the gist of this post. For kicks, I'll include below some discussion of the mechanics of the legislative language. I don't know about the big themes of Dodd's bill (the creation of new regulatory agencies), but the provisions pertaining to Reg D are not good.

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Here are the nine lines in question from the Dodd bill:

SEC. 928. RESTORING THE AUTHORITY OF STATE REGULATORS OVER REGULATION D OFFERINGS.

Section 18(b)(4) of the Securities Act of 1933 (15 U.S.C. 77r(b)(4)) is amended--

    (1) in subparagraph (B), by adding "or" at the end;

    (2) in subparagraph (C), by striking "or" at the end; and

    (2) by striking subparagraph (D).

The "subparagraph (D)" to be struck is a reference to SEC rules or regulations, including Reg D, exempting from registration requirements "transactions by an issuer not involving any public offering."

The to-be-stricken "subparagraph (D)" functions as one of several definitions of the term "covered security"  under Section 18(b) of the Securities Act. The definition "covered security" is in turn pertinent because of Section 18(a) of the Securities Act, which preempts state regulation of "covered securities." Specifically, Section 18(a) states in pertinent part that "no law, rule, regulation, or order, or other administrative action of any State or any political subdivision thereof requiring . . . registration or qualification of securities transactions, shall directly or indirectly apply to a security that is a covered security" (clause numbers and letters removed for readability).