Secondary trading of securities – risks & exemptions

 By Scott Purcell
FundAmerica Technologies, LLC

The good news is that under Reg A (and 506b&c), securities offerings by an issuer are exempt from state blue-sky registration. This is fantastic as it means that each one of the 51 “mini-SEC’s” don’t have to get involved prior to starting your fundraise. Sure, the “sale” of those securities may be subject to state dealer registration, especially for serial issuers or anyone using general solicitation aspects of Reg A or 506(c), but that’s different than having to fully qualify the offering via Blue Sky review.

The bad news is that secondary sales (in other words, when an investor wants to sell his/her securities that they originally bought from the issuer) are not automatically exempt from Blue Sky.

e.g. Texas requires an issuer to have 3 years of audited financials before they will qualify a security for secondary transactions. Other states have different requirements for getting qualified.

I’ve been spending quite a bit of time on this issue with both my in-house and external securities attorney’s, and with the team at OTC Markets. This is a minefield that Rep McHenry is proposing to fix with the new “venture exchange” legislation, but that’s a long way from being done. Until then, we (as an industry) have a fairly messy situation on our hands.

·         NASDAQ & NYSE securities are exempt from state Blue Sky registration.

·         OTC and privately traded securities are not exempt. Sort of. Let’s discuss this…

Why does this matter? Because your securities, after the original offering has closed, cannot be solicited, recommended or have research distributed unless they are Blue Sky qualified in every state in which an investor resides. So if you worry about creating liquidity for your investors, then this is critical.

Blue Sky Registration – an issuer can clear 38 states by publishing in a “manual”. CA, IL, TX, NY and other states have to be qualified one-at-a-time as each requires different things. Your attorney will have to do this for you and it won’t be cheap. You’ll need to pay state fees and file annual reports.

Exemptions – you can generally avoid getting Blue Sky registration per certain exemptions. Non-issuer transaction exemptions in Blue Sky Laws are intended for bona fide non-issuer owners of the securities, and are critical for purposes of resales of securities. Although there are variations among states, exempt non-issuer and resale transactions generally include the following:

  • Isolated Transactions. The exemption for isolated transactions is intended to allow a holder of securities to make occasional sales, and is available whether or not transactions are effected through a broker-dealer. In simplest terms, an exempt isolated transaction must not be one made in the course of repeated and successive transactions of a similar character.
  • The “Quality” Exemption. A non-issuer transaction exemption is available for the sale of fixed maturity or fixed income securities that have a proven record of paying interest or dividends, and as to which there has been no default in payment during the current fiscal year or within the three preceding fiscal years.
  • Transactions by Fiduciaries and in Judicial Sales. In the same manner that Blue Sky Laws exempt sales of securities by bankruptcy trustees, receivers, or conservators on behalf of an issuer, a transaction exemption covers sales on behalf of non-issuers by the same persons and fiduciaries or court-appointed and supervised persons.
  • Pledgee Transactions. Securities pledged as collateral to secure a loan may be sold by the non-issuer pledgee without registration provided the underlying pledge and the transaction are bona fide, and the transaction is not made for the purpose of evading the Blue Sky laws.

And, perhaps most important…

  • Unsolicited Brokerage Transactions. A non-issuer transaction by or through a broker-dealer effecting an unsolicited order or offer to purchase is exempt. (by/through the issuer directly would NOT be exempt)

Okay, again, why does this matter? A couple of reasons
1.       If liquidity is important to you, then you want brokers to be able to proactively sell your securities (not just process investor-directed trades) and you want to be able to distribute research. It’ll be very tough to build an active market for your securities without broker support.
2.       Some brokers will refuse to process trades for non-Blue Sky securities even though marked “unsolicited”. Probably due to compliance fears that the rep on the transaction may not be completely forthright about his/her discussions with the investor buying the stock in the secondary market (or, more likely, an investor’s remembrance and interpretation of any conversations). This effectively shuts the issuer out of many (perhaps most) of the major brokers. This is tricky for qualified non-Blue Sky’d Reg A securities and even harder for restricted securities (e.g. 506-D) as brokers are subject to FINRA NTM 09-05.

So, what should an issuer do? I think there are three choices;
a.       Don’t worry about secondary liquidity. Heck, the company raised money to build and grow, not to provide immediate market-driven upside to investors (that may come later). If an investor does need to liquidate/sell, let them go to one of the alternative auction/listing websites that are coming online such as ASMX, CTTauctions, CFX, and FNEX and see if they can find a buyer;
b.      List on OTCQX, don’t worry about encouraging brokers to solicit investors or write research, and let investors buy securities on an unsolicited basis; or,
c.       List on OTCQX and go through the process & expense of getting Blue Sky registered in all states.

REALITY CHECK: How important is liquidity, especially for Reg A securities? Not very. My thoughts on that in my next article.

See Also: OTC Markets FAQ on State Blue Sky Laws


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