Blue Sky Laws and the Cannabis Industry
By Charles S. Alovisetti, Partner
Oct 7, 2019
The sale of securities associated with a cannabis company are subject to the same legal requirements as those of a company in any other industry, and compliance with these is more important due to higher regulatory scrutiny. In this article, we'll discuss instances where companies raising funds by selling securities need to worry about blue sky laws.
Offer of Sale of Securities Must Be Registered or Exempt from Registration
Section 5 of the Securities Act of 1933 requires that any offer or sale of securities in the United States either needs to be registered with the US Securities and Exchange Commission (SEC) or sold pursuant to an exemption from registration. An example of a federally registered offering of securities is an Initial Public Offering (IPO). In an IPO or other registered offering, the company files forms that provide key facts about the company with the SEC. Then, the SEC reviews and comments on these registration forms to ensure adequate disclosure is made (the SEC does not opine on the merits of an offering). In an exempt offering, often referred to as a private placement or unregistered offering, the SEC does not evaluate any registration statement to determine if disclosure requirements are met. Investors must generally make their own determination as to the adequacy of the information.
Blue Sky Laws
In addition to federal securities laws, each state and territory has its own securities laws. These laws are often referred to as “blue sky” laws. The term “blue sky” allegedly comes from the words of Kansas Supreme Court Justice J.N. Dolley in 1920, who sought to protect the public from schemes without any more basis than “so many feet of blue sky.” While memorable, this quote may be fictional.1
State securities laws often predate the federal laws regulating the sale of securities and emerged to combat serious abuses in the securities markets. Blue-sky laws vary from state to state and compliance can be challenging due to the patchwork nature of the requirements. The varied nature of the state by state laws can still create issues and raise the costs of regulatory compliance associated with raising capital.
National Securities Markets Improvement Act of 1996 and Covered Securities
The National Securities Markets Improvement Act of 1996 (NSMIA) attempted to address the challenges associated with complying with blue-sky laws by amending Section 18 of the Securities Act to create a category of securities known as “covered securities.” Covered securities are exempt from state registration and qualification requirements; however, states are still permitted to require a general notice filing and a fee. In most cases, this consists of a copy of the Form D filed with the SEC (discussed below) and a form U-2 (a consent to service of process). State securities regulations also maintain their authority to investigate suspected fraud and unlawful conduct.
The definition of covered security includes securities issued pursuant to several registration exemptions, including Rule 506(b) and (c), which are the most common exemptions for larger private financings. The following chart, taken from the SEC website, shows what exemptions qualify for covered security status2
|Securities Act Exemption||Is the offering potentially subject to blue-sky laws?|
|Rule 506(b) [Regulation D exemption]||No|
|Rule 506(c) [Regulation D exemption]||No|
|Rule 504 [Regulation D exemption]||Yes|
|Regulation A – Tier 1||Yes|
|Regulation A – Tier 2||No|
|Rules 147 and 147A||Yes|
Reg D Filings and State Notices
Since the most frequently used exemptions are subject to the requirements of Regulation D, it’s important to understand what filings are associated with a Reg D offering.
Rule 503(a) of Regulation D requires an issuer to file a Form D notice with the SEC within 15 days of the first sale of securities. Under federal law, the Form D filing is not a condition to the availability of Rule 504 or 506 for an offering, though the SEC could prohibit issuers from relying on Regulation D in the future for past failures to file a Form.3 However, it is effectively impossible to comply with the state notice filing requirements if an issuer fails to make a Form D filing, as many states require a copy of Form D to be filed with the state. As a result, some state regulators may view the failure to file a Form D as a nullification of the “covered security” status under NSMIA for which state registration and qualification requirements are preempted. This means that the securities issued pursuant to the offering may be viewed as having ignored blue-sky laws and could create rights of rescission and expose the issuer to sanction.
While it may seem unlikely that a regulator with limited resources and time would become aware of a private financing that is not publicly disclosed, many offerings that turn into regulatory issues come to light because an upset investor reports the issuer to a state securities regulator. The issuer is then put in the difficult position of having to explain its non-compliance to the authorities.
New York and the Martin Act
While the Reg D associated state notice and filing fees are generally straightforward, there are some states that have complexities worth mentioning. New York, in particular, has a difficult system to follow. New York requires pre-filing (called a Form 99) to comply with Article 23-A of the General Business Law, known as the Martin Act. Many people, including the New York State Bar Association (NYSBA), believe the Martin Act is preempted by NSMIA as it goes beyond a mere notice filing and fee. The NYSBA has been vocal about this point of view and has published a position paper setting forth its arguments.4 This position, however, has never been tested in court and the New York Attorney General’s office declined to amend its filing requirements in response to the position paper. And, under the Martin Act, while there is no private right of action, New York’s Attorney General does have wide authority to conduct investigations and even to criminally indict persons for securities violations. Nevertheless, many issuers partially rely on the NYSBA position paper and file the Form 99 on the federal 15-day post-sale filing schedule, or even omit the Form 99 filing entirely.
Making a Form D filing can result in unwelcome scrutiny. A Form D filing is a public document and journalists can, and do, track these filings and report on what has been released. A Form D requires the disclosure of a number of sensitive pieces of information, including the names of its directors and executive officers, the total amount being raised, and the amount sold as of the date of filing (which can be especially sensitive if the raise is off to a slow start). For this reason, some issuers consider relying on 4(a)(2), which is the broad exemption based on the absence of a public offering that lacks the certainty of a specific safe harbor like Reg D. However, this exemption would not provide the “covered security” status of the NSMIA and means that blue-sky laws would have to be analyzed in all applicable states. The wide scope of this analysis can make the blue-sky issue expensive and time-consuming.
Risks of Noncompliance
In addition to the risks of regulatory inquiry and upset investors, there are also issues related to IPOs and exits. If a company undergoes an IPO, it needs to file what’s called a Form S-1 with the SEC. The S-1 requires disclosure of all securities sold in the preceding three years and asks for details about the exemption(s) relied upon by the issuer. Since S-1s are closely scrutinized by the SEC and the investing public, securities law violations may get unwelcome attention. And in an acquisition scenario, a purchaser may also be interested in past securities violations – either due to near-term plans to go public or fear of inheriting securities-related liabilities. Securities issuance liabilities regulatory issues can arise long after the initial sale.
Cannabis Specific Risks
The sale of securities associated with a cannabis company are subject to the same legal requirements as those of a company in any other industry and, as is the case with many aspects of the cannabis industry, compliance with these rules may be more important due to heightened regulatory scrutiny. For example, the SEC has a message on its website warning investors fraud risks in the cannabis industry.5 The Colorado Division of Securities has also issued a very similar warning.6 Regulators in several different states, including Hawaii and Massachusetts, have followed up on cannabis financings and, in some cases, have issued subpoenas to gather additional information. Cannabis companies should certainly be on the alert for additional regulatory scrutiny and should make sure their offerings are as compliant as possible.
This article only discusses instances where companies raising funds by selling securities need to worry about blue-sky laws. The actual impact of blue-sky laws themselves is a separate, state-specific question and requires the assistance of specialized legal counsel. Any issuance of securities subject to blue-sky laws should be closely scrutinized well in advance of any sale.
1 Macey, Jonathan R. and Miller, Geoffrey P., "Origin of the Blue Sky Laws" (1991). Faculty Scholarship Series. Paper 1641
3 SEC Compliance and Disclosure Interpretations (C&DI) 257.07 and 257.08.