By James Hamilton, J.D., LL.M.
Depending on who you talk to some will say that most Rule 506 are filed without problems and succeed as offerings; others will say that many Rule 506 filings are suspected of being deficient or fraudulent in some way. In any event, it has seemed for a long time that as long as the issuer filed Form D, the consent to service of process and the applicable fee within the prescribed 15 day period after the first sale in the state, NSMIA pretty much preempted the states from saying much about the securities offering, unless of course the state decided to use its enforcement power to investigate fraud, or go after the broker-dealer or agent for selling without a license or claiming a licensing exemption.
In 2006, however, cases began to surface and find in favor of state regulation of Rule 506 offerings. In a California case, Consolidated v. DuFauchard, Consolidated filed a notice on Form D, consent to service of process and $300 fee with both the SEC and California Commissioner Preston DuFauchard to make a Rule 506 offering in the state. The Commissioner order Consolidated to cease and desist from marketing unregistered securities. In an administrative hearing, the Commissioner argued that Consolidated did not have a preexisting relationship with the persons it was marketing to, so that its using mass mailings and seminars to market the securities violated the terms of offering and did not federally preempt state authority. Consolidated then sued in Federal District Court claiming that Rule 506 federally preempted state regulation. The Federal District Court abstained from adjudicating the matter, holding that the plaintiff's claims against the Commissioner could be litigated in state court.
In another case from Ohio, Blue Flame Energy Corporation v. Ohio Division of Securities, the Ohio Court of Appeals overturned the trial court's determination that federal preemption of state regulation in a Rule 506 offering applied. The Appellate Court agreed with the Ohio Division of Securities' assertion that the securities were not federally covered securities because the Blue Flame Corporation violated the conditions of the offering by engaging in general solicitation and advertising in offering the securities on public postings of its website. Blue Flame had argued that its offerings did not need to comply with Rule 506 conditions as long as the securities were offered and sold in reliance on Rule 506.
What's common to both cases is a state securities commission alleged violation in the issuer's manner of offering the securities, i.e., using general solicitation and general advertising to offer the securities that, thereby, violates the private nature of the Rule 506 offering and renders it no longer federally preempted from state law.
It's interesting to note that in a March 22, 2007 White Paper by the ABA State and Federal Securities Subcommittee to John White, Director of Corporate Finance, SEC, in which the ABA requests the rewriting of SEC private offering rules [See separate Blog article] to better distinguish these rules from recently rewritten public offering rules, one of the requests calls for the elimination of the limitation on the manner of offering ["general solicitation," "general advertising" provisions at least with respect to Rule 506.
Oh, the battle for Rule 506 goes on.