Tide Shifts in Federal Preemption of State Securities Cases Involving Rule 506 Transactions

The National Securities Markets Improvement Act of 1996 (NSMIA) was designed, among other things, to curtail over-regulation of securities at the state level and, hence, increase capital formation, by preempting the states from regulating securities in transactions considered to belong exclusively to federal regulators such as the SEC. One of the most key and popular transactions among Blue Sky practitioners and their issuer-clients that was affected by NSMIA turned out to be the Rule 506 offering transaction. NSMIA preserved to the states the right to require a notice on SEC Form D and collect a fee for the filing but eliminated the states' right to regulate the merits of the offering. The thinking at the time was that NSMIA retained the states' right to prosecute the issuer for fraud, as well as the defrauded investors' right to have the deal rescinded, and thereby justified eliminating the duplicate efforts of the SEC by the states to regulate a transaction that came out of a federal Act and rule. Still, it seemed for the longest time, from the mid to late 1990s and into the 2000s, that the states' hands were tied where Rule 506 transactions were concerned...at least at the legislative level.

Then a curious thing began to emerge in the early 2000s, but at the judicial level: the rights of the states to regulate Rule 506 offerings by striking them down in transactions considered to be invalid started to show up in federal court. The first two cases now considered the minority view, Temple v. Gorman from 2002 and Lillard v. Stockton from 2003, held against the states and investors by siding with the defendant issuers' claims that the states were preempted from regulating the Rule 506 transactions by NSMIA. The states argued that the particular transactions violated the substantive requirements of federal Rule 506 but the South District Court of Florida in Temple v. Gorman and the Northern District Court of Oklahoma in Lillard v. Stockton held that the mere fact that the defendants brought forth the claim that Rule 506 transactions were preempted from state regulation under NSMIA was all that was necessary to rule in their favor.

But the tide has since shifted away from this view, and the majority view in more recent decisions starting with Buist v. Time Domain Corp., and proceeding to Private Equity Fund v. Miresco Investment Services, Pinnacle Communications International Inc. v. American Family Mortgage Corp., Hamby v. Clearwater Consulting Concepts, Grubka v. WebAccess International Inc., in re Blue Flame Energy Corp., and Brown v. Earthboard Sports USA, Inc. holds that if the transaction violates the substantive requirements of Rule 506 by allowing, for example, general solicitation and advertising, then federal preemption does not apply and the states may invalidate the transaction before the offering goes forth in their respective jurisdictions.

History is being made as the preemptive effect of the NSMIA Act continues to be tested in court through the currently most popular securities transaction at the state level, the Rule 506 offering.

The above summary is attributed to Jeffrey D. Chadwick who wrote a Comment "Proving Preemption by Proving Exemption: The Quadary of the National Securities Markets Improvement Act," 43 U. Rich. L. Rev. 764 (2009).