Rule 506(b)'s Merit - and Is there Merit to Merit Review?

An overwhelming majority of private placements of securities in America are done by means of sales strictly to accredited investors in reliance upon the exemption from the registration requirements under the Securities Act of 1933 afforded by Rule 506 under Regulation D (now known as Rule 506(b)).

So what so great about Rule 506(b)?  Some of the key benefits are as follows:

1. No Uncertainty.  Rule 506(b) provides a tremendous amount of clarity for issuers of securities seeking to ensure that they have a valid private placement exemption. So long as an issuer has a reasonable belief that all of its investors are accredited and the issuer refrains from engaging in public solicitation activities, the issuer will generally have a valid private placement. Outside of the "safe harbor" of Rule 506(b), other factors (some of which are identified below) can complicate the analysis and/or limit an issuer's freedom when offering securities. For example, if an issuer wishes to rely upon the exemption afforded by Section 4(2) of the Securities Act, it better get ready to sort through decades of case law and SEC releases on what exactly it means to have a "transaction by an issuer not involving any public offering." 
2. No Dollars Limits.  This benefit speaks for itself.  Rule 506(b) puts no limits on the dollar size of a private placement.  Contrast that with Rule 504 which limits issuers to raising $1 million or Rule 505 which limits issuers to raising $5 million.
3. No Investor Limits.  Rule 506(b) permits sales to an unlimited number of accredited investors. Contrast that with the Section 4(2) exemption which provides no statutory guidance regarding how many investors may invest before a private placement turns into a public offering. 
4. No Blue Sky Compliance.  Securities sold in reliance on Rule 506(b) are deemed to be "covered securities," thereby preempting most state level blue sky regulation. States may require issuers to make a notice filing, pay a small filing fee, and consent to service of process in any state where it sells securities, but issuers who sell "covered securities" need not register or find a valid exemption from registration in up to 50 different states.
5. No Disclosure Requirement.  While Rule 506(b) permits sales to up to 35 unaccredited investors, issuers rarely permit unaccredited investors to participate in Rule 506(b) private placements because doing so requires issuers to provide a detailed private placement memorandum to every investor, which is generally cost prohibitive. By limiting sales exclusively to accredited investors, there is no information disclosure obligation upon the issuer (though it is generally advisable to provide at least some disclosure document to each investor to insulate the issuer from potential securities fraud claims).  
6. No Verification Requirement. The SEC recently adopted Rule 506(c) which permits issuers to engage in public solicitation in connection with private placements so long as the issuer "verifies" that all investors are accredited. But since the steps that an issuer must take to "verify" an investor's status are somewhat vague (and/or are somewhat intrusive on the investor) at this point, most issuers engaging in private placements continue to rely upon Rule 506(b) and its lower standard that the issuer have a "reasonable belief" that its investors are accredited. 

Today I want to focus on Item 4 above - the preemption of potential multi-state blue sky registration and/or review by state level securities regulators (such as the Texas State Securities Board).  How valuable is it to avoid such review and regulation?  Very.  Even if every individual state securities regulatory body was a marvel of efficiency and reasonableness, merely getting familiar with the registration requirements and/or exemptions from registration in up to 50 states would be a challenging task for issuers. 

But consider states that require so-called "merit review" of a securities offering. That's when a state-level blue sky regulator takes it upon themselves to look beyond whether or not the issuer has fully disclosed the material information about the issuer and the offering to determine if a particular investment is "fair" to potential investors.

I have serious doubts that the twin goals of investor protection and facilitating capital formation for the US economy are advanced by merit review by state blue sky securities regulators.  For example, according to an article by Samual S. Guzik in a recent issue of the Texas Journal of Business Law, in 1980 securities regulators in the Commonwealth of Massachusetts and other states prohibited "ordinary investors" from participating in an IPO for Apple Computer, reasoning that the offering price was too high relative to the company's book value!