State Securities Officials Bid to Readjust State-Federal Regulation as Part of Legislative Reform Effort
State securities regulators have asked for increased authority over investment advisers and the general ability to address fraud in its earlier stages as part of financial regulatory reform legislation, effectively asking Congress to revisit the SEC-state model established by the National Securities Markets Improvements Act of 1996. In testimony before the Senate Banking Committee, Fred Joseph, President of the North American Securities Administrators Association, noted that the Markets Improvement Act preempted much of the states’ regulatory apparatus for securities traded in national markets, and although it left state antifraud enforcement largely intact, it limited the states’ ability to address fraud in its earliest stages before massive losses have been inflicted on investors. Mr. Joseph is also the Colorado Securities Commissioner.
NASAA is asking for nothing less than a reordering of the state-federal regulatory regime set up for investment advisers by the Markets Improvement Act. More specifically, the NASAA chief asked Congress to give state regulators authority over investment advisers with up to $100 million in assets under management. Currently, as provided by the Markets Improvement Act, state securities regulators have authority over investment advisers managing up to $25 million in assets, while all advisers managing assets over that amount must register with the SEC.
According to Mr. Joseph, Congress intended that the SEC would periodically review this allocation of authority and adjust it appropriately. Indeed, the Markets Improvement Act specifically authorizes the SEC to set an amount higher than $25 million, as the Commission deems appropriate. Urging legislation to increase the assets under management test for state regulation purposes to $100 million, he said that such an adjustment is appropriate in light of changes in the economic context. He pointed out that even small investment advisers typically have more that $25 million under management. In addition, this increase will reduce the number of federally registered investment advisers, thereby permitting the SEC to better focus its examination and enforcement resources on the largest advisers. The term ``assets under management’’ is one of art; and is defined in the Act as securities portfolios over which the adviser provides continuous and regular supervision or management services.
The NASAA head also asked Congress to increase the states’ enforcement authority over large investment advisers. Currently, a state can only take enforcement action against an SEC-registered investment adviser if it finds evidence of fraud. He urged that this authority be broadened to encompass any violations under state law, including dishonest and unethical practices. This enhancement of state authority will deter all forms of abuse by the large investment advisers, he emphasized, without interfering with the SEC’s exclusive authority to register and oversee the activities of the large investment advisers.
Until 1996, both federal and state regulations governed securities offerings. The Markets Improvement Act eliminated the dual system of regulations for certain securities offerings, and prohibited states from requiring the registration of such securities. NASAA is now asking Congress to reinstate state regulatory oversight of all Regulation D Rule 506 offerings by repealing Section 18(b)(4)(D) of the Securities Act. Even though these securities do not share the essential characteristics of the other national securities offerings addressed in the Markets Improvement Act, Congress precluded the states from subjecting them to regulatory review. These offerings also enjoy an exemption from registration under federal securities law, he noted, so they receive virtually no regulatory scrutiny. The Markets Improvement Act preempted the states from prohibiting Regulation D offerings even where the promoters or broker-dealers have a criminal or disciplinary history.
Moreover, Mr. Joseph said that some courts have held that offerings made under the guise of Rule 506 are immune from scrutiny under state law, regardless of whether they actually comply with the requirements of the rule, citing Temple v. Gorman (SD Fla 2002), CCH Fed. Sec. L. Rep. No. 2019, ¶91,733. In Temple, a federal judge ruled that claims for violations of state registration requirements were preempted by the National Securities Markets Improvement Act. Securities offered pursuant to the registration exemption of Regulation D's Rule 506 were covered securities and exempted from state registration requirements, held the court, even if the private placement did not comply with the substantive requirements for the exemption.
Since the passage of the Markets Improvement Act, NASAA has observed a steady and significant rise in the number of offerings made pursuant to Rule 506 that are later discovered to be fraudulent. Further, most hedge funds are offered pursuant to Rule 506, so state securities regulators are prevented from examining the offering documents of these investments, which represent a huge dollar volume. Although Congress preserved the states’ authority to take enforcement actions for fraud in the offer and sale of all covered securities, including Rule 506 offerings, he stressed that this power is no substitute for a state’s ability to scrutinize offerings for signs of potential abuse and to ensure that disclosure is adequate before harm is done to investors.