Monday, April 18, 2016

States, SEC argue over definitions in Reg A preemption challenge

By John M. Jascob, J.D., LL.M.

The states of Massachusetts and Montana faced off with the SEC in oral argument before the D.C. Circuit in their ongoing challenge to the preemption of state authority over Tier 2 offerings under Regulation A. The states have asked the court to vacate the rule, contending that the SEC’s failure to impose any meaningful standards on the “qualified purchasers” eligible to invest in Tier 2 offerings oversteps the authority delegated to the Commission under the JOBS Act and strip investors of valuable state law protections (SEC v. Lindeen, April 14, 2016).

Adopted by the SEC under the mandate of the JOBS Act on March 25, 2015, so-called Regulation A+ raises the dollar limit for smaller offerings that are exempt from Securities Act registration. The amendments also create two tiers of offerings under Regulation A while preempting Tier 2 offerings of up to $50 million from state regulation.

Arguments for the petitioners. Arguing on behalf of the petitioners, Robert E. Toone of the Massachusetts Attorney General’s Office stated that the SEC’s rule defies the clear direction of Congress that preemption under the qualified purchaser statutes may only occur when the Commission actually places meaningful qualifications on purchasers, i.e., qualifications that identify those investors who do not require the protection of state law. In effect, Toone argued, the SEC’s regulation reads the qualified purchaser requirement out of the statute by saying that any purchaser in a Tier 2 offering is a qualified purchaser.

The panel countered by asking why the SEC’s rule could not be regarded as having addressed the issue by simply making a determination that any investor in the specific context of a Tier 2 offering should be deemed qualified. According to the petitioners, however, Congress did not intend for the rule to contain a definition of “qualified purchaser” that doesn’t disqualify anyone. Toone cited language from the House committee report on Securities Act Section 18(b)(3), which the JOBS Act incorporates, stating that the Commission’s definition must be firmly rooted in the belief that qualified purchasers are sophisticated investors capable of protecting themselves.

Although Congress reserved to itself the power to categorically preempt securities under Section 18, the power granted to the SEC is much narrower, Toone argued. If the current rule is upheld, then the SEC will be able to preempt any category of securities it wants by issuing a similar rule in the future. Moreover, the rule’s 10 percent investment limitation does not impose qualifications on purchasers. Rather, the limitation serves only to limit the losses of those purchasers of Tier 2 offerings who do not meet the standards for “accredited investors” under Rule 501(a).

Toone acknowledged that the Commission does have discretion to adjust its definition of “qualified purchaser” to different categories of securities, based on the risk profile or complexity of a security. Toone stressed, however, that the D.C. Circuit had dealt with a very similar issue in Financial Planning Association v. SEC (2007), where the court vacated an SEC rule permitting brokers to receive fee-based compensation without also registering as investment advisers. In that case, the D.C. Circuit rejected the rule under step one of the Chevron analysis, quoting language from the Supreme Court that “Ambiguity is a creature not of definitional possibilities but of statutory context.” Here, according to the petitioners, the statutory context is clear: Congress reserves the power to preempt state law for categories of securities. The SEC’s authority is limited to “qualified purchasers” as that term has been used previously in the federal securities laws, a use which requires some degree of wealth, sophistication or risk-bearing ability on the part of the investor.

Arguments of the SEC. Arguing on behalf of the SEC, Jeffrey A. Berger stressed the importance of Congress’s intent to use the JOBS Act to revitalize Regulation A, which had fallen into disuse partly because of the cost of complying with state registration and qualification laws. In implementing the mandate given to the SEC under the JOBS Act, the Commission exercised its express authority under Section 18 to define “qualified purchaser” to preempt those same state laws for Tier 2 offerings. This preemption removed a major impediment to the use of Regulation A while still providing a suite of investor protections by, among other things, requiring that the investors either be accredited or be subject to purchase limitations based on net worth or income.

Judge Sentelle inquired as to why, when Congress has delegated the authority to define the term “qualified purchaser,” we should not expect the definition produced by the SEC to include something about the characteristics of the purchaser, rather than simply to indicate the types of purchases to which the definition applies. Berger responded that the SEC’s definition does reflect the characteristics of the purchaser by either requiring that investors be accredited or by imposing investment limitations that incorporate by reference qualifications set forth in other SEC rules. Further, Berger noted that investment in Regulation A offerings had previously been available to anyone in any amount. And even though the Commission’s rule has removed the layer of state review from those offerings, the rule puts in place other protections, which form part of a plan to implement Congress’s desire to reinvigorate Regulation A. These protections include not only the purchase limitations but also a requirement that issuers provide audited financial statements with their offering circulars while subjecting those issuers to ongoing reporting requirements.

Berger emphasized that the states retain their antifraud authority over both Tier 1 and Tier 2 offerings. Moreover, Tier 1 offerings, which are not preempted by the SEC’s rule, are much likely to be localized offerings due to their smaller size. The state’s retention of registration over Tier 1 offerings thus offers the greatest marginal benefit in terms of investor protection. In contrast, a consistent federal regulatory standard is best able to do the job for Tier 2 offerings, which will likely be more national in scope. Berger disagreed with the petitioners’ argument that the Commission ignored investor protection when adopting the rule, stating that the SEC considered investor protection alongside the other aspects mandated by Congress, namely, efficiency, competition, and capital formation. The SEC considered all of these factors when developing a rule that fulfilled the goals of the JOBS Act in revitalizing Regulation A while still protecting investors.

The cases are Nos. 15-1149 and 15-1150.