Sen. Chris Dodd's proposed overhaul of U.S. financial regulations includes a provision that would give state regulators greater authority over most PIPEs.

The proposal would return to states the power to regulate private offerings made under Rule 506 of Regulation D. Rule 506 is the exemption from registration requirements that most publicly traded companies rely on to execute PIPEs.

While registered direct transactions would not be affected, companies pursuing privately negotiated restricted stock sales may have to register the offerings in each state in which investors are based or ensure that they meet the states' guidelines for private offering exemption.

That could add tens of thousands of dollars to a company's tab to complete some deals and delay closings of private placements.

And Rule 506 offerings aren't exclusive to PIPE investors: They're the most common vehicle that small private companies use to seek capital, too.

"This is typical of regulation right now - it hits those least able to bear the expense," said Jack Hogoboom, a partner with the law firm of Lowenstein Sandler in Roseland, N.J.
"It's just another circumstance where something stupid is done out of outrage that makes no sense and doesn't achieve a reasonable policy objective."

Investment advisors from at least 36 states have participated in 846 PIPEs this year through Oct. 31, according to PrivateRaise, DealFlow Media's data service.

The proposal's passage would give a policy victory to the North American Securities
Administrators Association, the trade group of state securities regulators.

Denise Voigt Crawford, president of the NASAA, suggested that legitimate PIPE issuers would see few changes from current rules: Generally states require issuers to file Form D and pay a fee in states in which they're selling securities.

But state commissions want the ability to review a private placement memorandum when they suspect fraud, she said. That's something that states cannot do now.

Plus, Crawford suggested that the threshold for what defines an accredited investor is currently too low to fully protect investors, particularly as private offerings have ballooned in size over the past several years.

"Rule 506 has become the tool of choice for fraudulent promoters because there is not good oversight," said Crawford, who is commissioner of the Texas State Securities Board.  "We don't want the exemption to be used by people who really shouldn't have the ability to avail themselves of it."

A Matter of State

Dodd, chairman of the Senate Committee on Banking, Housing and Urban Development, released a discussion draft of his financial reform bill in early November. Known as the "Restoring American Financial Stability Act of 2009," the 1,136-page tome includes Section 928, "Restoring the Authority of State Regulators Over Regulation D Offerings."  That section would scale back changes made under the National Securities Market Improvement Act of 1996 (NSMIA), which limited the scope of state securities regulation and blue sky laws.

The specific proposal focuses on Section 18 of the Securities Act of 1933.  Section 18 was used under the NSMIA to establish "covered securities" - or securities that were national in character - and preempted state regulation of them.

Rutherford Campbell, a professor of law at the University of Kentucky, briefly discussed Section 928 during a panel discussion on accredited investor standards at the Securities and Exchange Commission's annual Government-Business Forum on Small Business Capital Formation on Nov. 19.

Campbell credited Gerald Laporte, chief of small business policy in the SEC's division of corporate finance, for bringing the scant four-line proposal to his attention during a pre-conference telephone call.

During the forum, Campbell said Section 928 was a "wrongheaded" way to reform financial regulations. In a later interview, he called the proposal "absolutely stupid."

"Rule 506 is a very sound and well thought-out policy-based exemption that balances capital formation and investor protection very well," said Campbell, who pushed for even broader limitations on state regulation of national securities during hearings on the NSMIA more than a decade ago.

"The brilliant part is that you've got an incredibly contentious and important piece of legislation, and this innocuous little provision is stuck in the middle of it," he added.  "There's not a chance it's going to get a fair debate."

Chipping Away at NSMIA

NASAA has made no bones about its distaste for Rule 506.  Indeed, from testimony in front of Dodd's banking committee early this year to the organization's conference in Denver in September, NASAA has repeatedly cited the exemption as an invitation to fraud and has urged Congress to reinstate state oversight.

In a Nov. 18 letter to Dodd that expressed support for Section 928, NASAA called "many" Rule 506 offerings fraudulent and claimed that NSMIA prevented state regulators from ferreting out deceit until it was too late.

"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," the letter stated, "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."

Not only did NSMIA preempt state regulation of Rule 506 offerings, Crawford said, but it also removed a state's ability to disqualify bad actors from using the exemption.

What's more, over the last few years some states have begun to challenge NSMIA preemption, distinguishing between an issuer that merely claims reliance on Rule 506 and those that actually comply with it, according to Robert Rapp and Fritz Berckmueller, co-authors of an article discussing NSMIA in the May 2008 issue of The Business Lawyer law journal.

In the 2005 case Buist v. Time Domain Corp., for example, the Alabama Supreme Court determined that NSMIA did not preempt Alabama securities law where the issuer failed to show that securities offered and sold in the state under Rule 506 met all the criteria for the exemption, according to the review, entitled, "Testing the Limits of NSMIA Preemption: State Authority to Determine the Validity of Covered Securities and to Regulate Disclosures."

Following Alabama's lead, several courts have "flatly held that the plain language of NSMIA preempts state securities registration requirements only with respect to securities that actually qualify as 'covered securities'," the authors said.

Expected Hassle

Even if Section 928 passes, Crawford said it is unlikely that states will initiate full-blown merit reviews of PIPEs.

Still, Texas investors are particularly susceptible to fraudulent oil and gas offerings, she said, and the Texas Securities Board may request that some oil and gas PIPE issuers provide their private placement memorandum.

"We're not going to disrupt the deal or slow it down; we just want a copy of the private placement memorandum from time to time if conditions warrant," Crawford stated.

Attorneys who represent issuers in Regulation D transactions are skeptical that the states have the expertise, experience, or manpower to oversee Rule 506 transactions.  Hogoboom recently worked on a public offering for a company that did not qualify as a covered security.  The issuer had to register in several states, and it took months to clear the blue sky issues, he said.

"At the end of the day, [the states] played no role in anything other than slowing us down and costing our client and the issuer more time and money," Hogoboom said.

David Feldman, founder of the Feldman law firm, suggested that PIPE issuers would likely bypass states that have tedious regulations if Section 928 becomes law.  That would deny opportunities for investors in those states.

"Some states take quite a bit of time when a merit review is required, and they can pretty much do what they want," Feldman said.  "If this passes, one would hope that the states would be responsible and not require too many onerous burdens on issuers."