Wednesday, October 1, 2014

State Regulation of Deal Makers: Offering, Broker-Dealer and Investment Adviser Laws (Article 14 in a series of 14 articles about Deal-Makers)

By Jim Verdonik
I'm an attorney with Ward and Smith PA. I also write a column about business and law for American Business Journals , have authored multiple books and teach an eLearning course for entrepreneurs. You can reach me at
Or you can check out my eLearning course at or purchase my books
or read my newspaper articles at
This article is one of 14 articles in a series of articles about Deal-Makers called:
Most people focus on the SEC when we talk about broker-dealer registration, investment adviser regulation and exemptions from registrations for securities offerings.

But we would be remiss if we fail to deal with the roles states play.

States require registration and otherwise regulate:

  • Securities offerings.
  • Broker-dealers
  • Investment advisers.
  • Certain people who work for broker-dealers and investment advisers.
Each state has its own combination of exemptions and regulations, but state securities administrators meet regularly to try to adopt rules that embody common general principles.

Since complying with 50 sets of securities rules are burdensome to people in the securities business without adding much additional protections for investors, Federal law sometimes pre-empts state laws.

Securities Offerings Exemptions

Let's talk about state exemptions for offerings of securities from registration of offers and sales of securities for two reasons.

·         First, because state laws about exemptions often drive the choices people make about what Federal offer exemption they use for their offering.  One reason why over 90% of private placements use SEC Rule 506 is because Section 18 of the Securities Act includes securities sold under Rule 506 in the definition of "Covered Securities.  Covered securities are exempt from state laws that require you to submit offering materials to state securities regulators for review before you offer or sell securities in a state.  State pre-offering or pre-sale review requirements added substantial time and expense to the offering process.  People often had to comply with state laws before they knew whether there were any actual investors in a state.  While some comments received from state securities regulators added useful disclosures for investors, much time was wasted dealing with comments on disclosure documents that added little protection for investors.  A Rule 506 offering, however, allows you to wait until after you sell securities in a state and then file a notice that you sold securities in that state.  States maintain these post-closing filing requirements primarily to collect filing fees.

  • Many state exemptions from registration of securities offerings are conditioned on the issuer not paying unlicensed brokers a commission for sales in that state.  If you paid an unlicensed broker a commission, investors could demand a refund even if no fraud was involved in the offering.  This automatic loss of state offering exemptions in many states created issues liability issues for using unregistered finders.  What was initially a problem for unregistered finders became a problem for issuers.  By choosing to use Rule 506, the state exemptions were unnecessary.  Using Rule 506 does not totally negate issuer liability for using unregistered finders.  Paying an unregistered broker may be a material fact that should be disclosed to investors.  The SEC's position is that it is always a material fact, but one can argue that disclose that the commission is being paid is material, but the identities or unregistered status is not material.
Broker-Dealer Registration

State securities laws generally mimic the language of the Exchange Act by defining a broker or a dealer as "any person engaged in the business of effecting transactions in securities for the account of others or for his own account."

Most state statutes, however, create specific exclusions to specific classes of people and entities, including business brokers, issuers engaged in certain transactions and people who assist issuers in certain exempt transactions. 

We should note, however, that even if the issuer is selling a "covered security" in a Rule 506 offering such that the offering is exempt from state pre-sale review by reason of Federal law, a person who is compensated for soliciting investors in the offering, may be deemed to be a broker-or a dealer. 

As discussed in article (2) of this series of articles, paying an unregistered broker or dealer may cause loss of the Rule 506 exemption and might constitute fraud under both state and Federal law.

Finally, many states require individual sales people associated with brokers to register with the state even if the entity they work for is not required to register.

Investment Adviser Registration

In article (12) of this series of articles, we discussed single purpose venture capital funds and buy-out funds and how the Federal Investment Advisers Act applies to them.

Now, let's discuss how state law and Federal law interact with one another.  Federal law deals with three categories of advisers based on the amount of assets they manage:

  • Less than $25 million
  • $425 to $100 million
  • $100 million or more
Federal law precludes anyone registering as an investment adviser if they manage less than $25 million, unless the state where the adviser has its principal office and place of business has not enacted a statute that regulates investment advisers.  Being regulated can be something less than being required to register.  States often prohibit fraud and other practices even if the adviser is exempt from registration.

If the adviser manages between $25 million to $100 million of assets, the adviser is not allowed to register with the SEC, if the adviser is registered (or is required to register) with the state where it has its principal office and place of business and the adviser is subject to examination by the state regulator.

At $100 million or more assets, the adviser must register with the SEC, unless an exemption from registration applies.

This means that if an adviser that manages less than $25 million of assets is exempt from state registration, there is no requirement to register at either the state or Federal level.

The most common registration exemption for advisers under Federal law was that advisers who had 14 or fewer clients did not need to register, if they did not hold themselves out to the public as an investment adviser.  This Federal exemption from registration was repealed by the Dodd-Frank Act, but many states continue to have this exemption from registration. 

Traditionally, the Federal rule was that investors in funds are not counted as "clients" of the manager of the investment fund for purposes of the 14 or fewer clients exemption.  Only the fund itself was considered a client.  In 2004 the SEC changed this rule to count fund investors as clients, but the SEC's rule was declared invalid by the DC Court of Appeals in the 2006 Goldstein case.  Consequently, for purposes of most states laws you count each fund as a client not each investor in a fund.

It is likely that states will eventually follow the Federal government's lead in abolishing the 14 or fewer exemption.  This is likely to occur faster in states where the exemption is contained in a rule issued by a securities administrator, but take longer where the exemption is included in a state statute.

Another common exemption from registration is for managers of "business development companies."  Some venture capital finds fall within the definition of "business development company."  Other venture capital funds do not qualify.

Section 222 (d) of the Investment advisers Act also provides a uniform exemption from state registration, unless the adviser:

·         Has a place of business in the state.

·         Or during the preceding 12 months the adviser has had six or more "clients" who are residents of that state.

Because advisers usually have great flexibility in choosing where its investment funds are located, most advisers to funds should be able to avoid registration in most states.

Other common state exemptions from registration or exclusions from the definition of investment adviser include persons who do not hold themselves out to be investment advisers.

Combining Federal and State Exemptions

In article (12) of this series of articles, we discuss investment funds that are special purpose entities formed to invest in a single specific business. 

The focus of some state laws on the number of clients or funds and the focus of Federal exemptions in the types of investments of the types of investors creates a target for a registration free zone where:

·         Total assets of all funds an adviser manages is less than $25 million, which would provide exemption from registration under Section 203A (a) of the Investment Advisers Act, and the adviser manages14 or fewer investment funds or another state exemption described above.

·         Total assets of all funds an adviser manages is less than $150 million and all investors are Qualified Investors, which would provide exemption from registration under  the Investment Advisers Act, and the adviser manages14 or fewer investment funds or another state exemption described above.

·         The adviser uses the venture capital fund exemption for funds that have an unlimited amount of assets in reliance on Section 203 (l) of the Investment Advisers Act and the adviser manages14 or fewer investment funds or another state exemption described above.

Fitting within this registration free zone will present different challenges depending on an adviser's business model.

Some of these special purpose entities are formed by people who want to do a single deal.  Other people business model requires the managers to form a new entity for each of an ongoing series of investments in multiple issuers.  Some of these multiple deal entities call themselves "online venture capital funds."

Certainly, most managers who want to do "one off" deals or a deal every couple of years can fit within the exemption provisions we discuss above for the states and within the Federal exemptions we discuss in article (13).  Managers who want to churn out a steady stream of SPE deals will have greater challenges avoiding Federal and state registration.

The part of the registration free zone described above that relates to managers of private funds that have 99 or fewer investors and less than $150 million of assets is in the process of being cut back by state regulators.  Proposed NASAA model rule would require state registration of all advisers who advise private funds with assets under $150 million that are exempt from the definition of investment company under the Investment Company Act by reason of Section 3 (c) (1), unless all the fund's owners are qualified investors.  This provision would cover advisers to most venture capital funds, unless the adviser is also exempt from registration under Section 203 (m) of the Investment Advisers Act.

Shifting Management Responsibilities and Ownership Interests

One way to deal with the state issues may be to resign from managing duties as the number of entities grows.  This might be accomplished by having ownership vest over an agreed number of years and then not being active in some deals to make room for other deals.  Groups of managers may be able to allocate management duties while still sharing the upside gains of the investment entities.

For the most part, both Federal and state regulation depends the nature of the services an individual provides to determine whether someone is providing investment advice, not on ownership.  Before employing such programs to manage the number of entities managed and the dollar amount of investments managed, however, advisers should consult with their lawyers about beneficial ownership rules that might cause an owner to be deemed to be an adviser even if the owner no longer actively managers a fund..

Rules that Apply to Exempt Investment Advisers

As we discuss in article (12) of this series of articles, some SEC rules apply to investment advisers who are exempt from the registration requirements of the Investment Advisers Act. 

Fund managers should be careful to understand what state rules may apply to investment advisers who are exempt from registration or to persons who are excluded from the definition of investment adviser under state laws, but who perform activities governed by state statutes.  For example, many state statutes apply to any person who accepts compensation for providing advice even of that person is excluded from the definition of investment adviser or is exempt from registration as an investment adviser.

If the manager of a venture capital fund is permitted to register with the SEC under the Investment Advisers Act of 1940 because of the amount of assets it manages, but qualifies for the venture capital fund exemption from registration afforded by Section 203 (l), the venture fund manager must file a Form ADV with the SEC and amend the form ADV not less often than annually. 

Therefore, a manager of one or more single purpose venture capital funds should value the assets it manages for all funds each year to determine whether the manager exceeds the threshold for state regulation and falls within Federal regulation.  Likewise, fund managers who manage less than $100 million of assets should monitor changes in state laws about investment advisers, which may affect their Federal registration requirements.

The SEC also has the right to inspect records of investment advisers who are exempt from registration and the exempt advisers must comply with anti-fraud and conflict of interest rules.

The same rules apply to managers of "private funds" with under $150 million of assets, which qualify for the exemption from registration afforded by Section 203 (m) of the Investment Advisers Act of 1940.

If you would like to learn more, you can reach me at
Or you can check out my eLearning course at
or read my newspaper articles at


1 comment:

  1. My uncle recently started a small business and he had a hard time dealing with all the regulations and red tape involved. Luckily he's had help from some reliable friends and resources. I'm looking to be an entrepreneur as well so I appreciate articles like this. Thanks for sharing!