What Are California Blue Sky Laws?
California blue sky laws are a series of state regulations that govern the sale and purchase of securities within California. Their primary purpose is to protect investors from fraud, misrepresentation, and non-disclosure on the part of issuers and other sellers of securities. Unlike federal securities laws, which are focused mostly on disclosure and anti-fraud, the state blue sky laws are intended to regulate the sales process itself and are primarily enforced through a regulatory approval process.
As a general rule, "securities" under California blue sky law include stocks, bonds, interests in limited partnerships, interests in profit-sharing or other agreements, certificates of interest in real estate investment trusts (REITs), collector’s certificates, and certain debentures. With a few exceptions, blue sky laws do not apply to real estate or other securities that are considered to be real estate-related, and they generally do not apply to securities that are sold to fewer than 35 purchasers within the previous 12 months.
Selling or offering to sell securities to the public in California requires so-called "blue sky clearance" from the California Department of Business Oversight under the Corporate Securities Law of 1968 (SB 1260). The following types of securities are generally exempt (subject to certain conditions) from the blue sky registration requirement, and therefore may be sold without blue sky clearance: securities issued by the issuer’s own parent or subsidiary; securities sold by a security holders upon a merger of the issuers; securities of a publicly traded parent company that are delivered as part of a merger; securities offered by the federal government, state of California, or other states or municipalities; interests in real estate; and certificates issued by a real estate syndicator if certain conditions are satisfied. In addition to the exemptions listed above, the following types of securities may also be offered and sold in California without registration, but only after the filing and acceptance of an offering document, including private offerings and solicitations (e.g . , Rule 506 in Reg D under the Securities Act, intrastate offerings, structured finance securities, and certain offerings to accredited investors.
There are several exceptions to the California blue sky laws as well, in addition to the aforementioned securities that are exempt from the registration and sales approval requirements. No notice or subsequent filing is required under blue sky law for the following types of transactions: transactions by an issuer in its own securities and transactions by a pledgee, or any transaction effected by, or incidental to, the collection of a judgment or to forecloser on or enforcement of security interests, except to the extent that a sale or execution or pledge is made in a public offering; transactions in the course of the issuer’s business involving securities that have been outstanding for at least 90 days and that have had a market price in the U.S. equal to or greater than $20 per share or per unit; transactions recorded on a specified national or foreign exchange, or with a minimum of 1,000 investors; transactions by a pledgee, or incidental to the collection of a judgment, or the foreclosure upon or enforcement of a lien or security interest, except any sale or execution or pledge in connection with a public offering; transactions in an issuer’s own security or security of an affiliate, at an amount that does not exceed $1,000,000 in any 12 consecutive month period, if a specified disclosure is made to purchasers; from any person registered as a market maker in such security under the Corporation Securities Law; or of any security in a transaction by an issuer that has been designated by the commissioner as an "infomercial loan company or organization."
Any person or entity that offers to sell securities in California must submit an application to the commissioner as well as a filing fee. The application includes information about: the issuer’s financial position; target industry; proposed use of proceeds; ownership, and officers and directors. The commissioner may then issue a permit authorizing the sale of the securities during a specified offering period. Sales that occur during a designated offering period are considered to be part of the same transaction or offer.
A Brief History of California Blue Sky Laws
In seeking to attract the investment of out-of-state investors, it is important for an issuer to understand the evolution of blue sky laws in California. The first general blue sky law was enacted in 1911 when the California legislature was spurred to action by the discovery of a gold mine that had been sold for a pittance to an East Coast financier by a grizzled miner who died soon thereafter in an accident. Legislative responses required the registration of all securities offerings and mandated that brokers and dealers and their agents be licensed. Although an attempt was made to recapture the dynamism of California’s gold rush capitalism, the legislature lifted many restrictions to allow for this capital raising.
The next few years saw California take the lead in the enactment of increasingly liberalized securities laws and regulatory regimes, while requiring a variety of disclosures. California became the first state to require the delivery of an offering circular to investors in an unregistered offering and the first to require the filing of an offering document with a securities regulator in a registered offering.
The California Department of Corporations took over jurisdiction for securities regulation in 1960, but the legislature resisted efforts to transition to a federal/state regulatory framework similar to that adopted by other states. Instead, the state created a profit-based licensing and statutory auditing regime for sales agents that remains in place to this day, along with antifraud provisions, whereas the majority of states permit self-reporting and avoidance through offer rescission.
By 1979, the State Bar of California held that the blue sky laws were unconstitutionally vague and ordered their suspension. The legislature responded by enacting a broad remedial and enabling law to replace the old securities laws that implicated First Amendment concerns. The new regulations demonstrated the state’s pro-business, pro-disclosure approach by broadening the exemptions from registration, such as by allowing an offering through a qualified accredited investor representative – a unique provision not adopted in any other state.
A few more significant changes were made through the early 1980s, when the plurality of California’s blue sky statutes were repealed and replaced with the short title "Corporate Securities Law of 1968" and a single comprehensive statute. Through the 1990s and early 2000s, legislators tended to err on the side of caution by codifying many targeted prohibitions to increase the number of factors determining what SAEs are or can become, thereby ensuring fewer violations of blue sky statutes.
The Major Provisions of California Blue Sky Law
The key provisions of California’s blue sky laws are set forth in the Corporations Code ("Code") Sections 25000 et seq. (known as the Corporate Securities Law of 1968). Sections 25005 and 25110 set forth the general prohibition against the offer and sale of securities in California unless exempt or qualified (i.e., registered) under Sections 25111, 25120, 25130 or 25140. Section 25110 provides definitions of "offer[] and sale[]" that are used throughout the Code and are applicable to California blue sky laws generally. Section 25019 defines a "security" for purposes of the securities laws. Under California blue sky laws, the term security is expansive and generally encompasses any interest in any type of enterprise. The definition of security includes stocks, bonds, limited partnerships, investment contracts, certificates of deposit, voting trust certificates, collateral trust certificates, preorganization certificates and participation certificates. The California definition of "security" also includes notes evidencing a loan to a small business investment company. Note that California no longer regulates interests in franchises, commodities, or mortgages if the issuer is not otherwise subject to the California blue sky laws (however, offerings so exempt may still be regulated under the California Franchise Investment Law). Furthermore, the California Department of Business Oversight treats equity interests in a California LLC as "securities" subject to qualification and registration under California’s blue sky laws despite the lack of an explicit reference to LLC’s in the definition of "security" under Section 25019. Section 25102 provides a broad list of exemptions from California’s blue sky laws. These include, among others: Section 25102(a)(10), which is the predecessor to the existing safe harbor exemptions in Section 25102(n); and Section 25102 (or 25102(n)) for limited offering or private placement exemptions, which will apply to offerings without general public solicitation or advertising only up to $1 million in a 12-month period. Above that amount, an offering must be registered with the California Department of Business Oversight (the "DBO") unless it meets a different exemption. Section 25102(o) provides exemptions for private placements or limited offerings for up to $5 million on an aggregate basis in a 12-month period if no general solicitation or general advertising is used. When an offering exceeds $5 million in a 12-month period, it must be registered with the DBO. Whether or not the offering is below the relevant threshold amounts, the issuers must use reasonable efforts to make the exemption available by (i) placing a written legend on the securities or the investment contract that they have not been registered with the DBO, (ii) filing Form D with the DBO, and (iii) filing a notice with the DBO claiming the exemption. Specific filing notices are provided under Sections 25102.1 and 25102.1.5, depending on the exemption claimed. Offering documents must also be filed by issuers under Regulations D and A+, if they are claiming exemptions under those statutes, and a notice must also be filed under the corresponding California rule (17 Cal. Code Regs. Section 260.102.2 for Rule 506 and 18 Cal. Code Regs. Section 260.141.10 for Rule A+). Section 25104 provides for a registration requirement for all broker-dealers and agents doing business in California. Broker-dealers must file Form BD, and agents must file Form U4.
Registration and Compliance Requirements
In California, there are two common options that an issuer may pursue in the context of a private placement in order to qualify for an exemption from registration: (i) the private offer and resale exemption and (ii) the small corporate offering registration system ("SCORS"). The SCORS program provides a streamlined process for the registration of qualifying small securities offerings.
Private Offer and Resale Exemption Some exemptions from qualification are available for issuers that comply with the antifraud provisions of the California Corporations Code and follow the steps set forth below:
- Publish or Deliver Notice of Offering. A prospective issuer of securities is first required to file a Notice of Intention to Sell Securities with the Department of Corporations and deliver a copy of this notice to the Department of Corporations and to each prospective offeree before any offer or sale of securities. The notice need not be published when it has been delivered to each offeree prior to an offer or sale. The notice itself should be in writing, contain a short description of the proposed terms of the offering, and be signed by the persons proposing to make the offering.
- Offer and Sale. The next step is to distribute the specific offering document to the investors that would be purchasing the securities, such as an offering memorandum or private placement memorandum or similar document. The specific offering document provides more detail regarding the specific information about the offering, the business, the management and other crucial information that will help the investor make the purchase decision. This generally includes a discussion of risk factors and other material information.
- Provide a California Disclosure Document. If the offering is not registered with the Department of Corporations, the issuer must provide the offeree a disclosure document that includes substantially all of the information that would be required in an application for qualification under California laws, including risk factors.
- Permit Exemption. The exemption is not available if the issuer has taken a "selling order" from, or has entered into a contract of purchase with, any person, prior to the delivery of the notice and a copy of the disclosure document.
SCORS Process The purpose of SCORS is to provide companies that are reorganizing or going through a business acquisition, merger, recapitalization or other similar type of transaction that meets certain criteria the ability to complete these types of transactions on an expedited basis and without the normal registration restrictions. Qualifying offerings are those offerings of qualifying equity securities in amounts of up to $500,000 that would ordinarily be subject to the qualification requirements of California law other than SCORS. SCORS was enacted in 1981 and was patterned after the intrastate registration exemption provision of Rule 146 of the Securities Act.
To qualify for SCORS, the issuer must be a corporation, partnership, limited liability company, trust, unincorporated association or investment trust that is organized and operated exclusively for participation in SCORS, and that intends to issue and sell SCORS qualifying securities in a SCORS qualifying offering, which is an offering of qualifying SCORS equity securities. Additionally, issuers will be required to have sold at least $250,000 of qualifying securities (or $200,000 if the issuer’s aggregate gross receipts are less than $2,000,000) for at least one year immediately preceding use of SCORS.
To the extent the offering is not completed within 180 calendar days of SCORS qualification, the issuer can be required to re-qualify under SCORS or some other registration or exemption. Qualification will be achieved simply by filing a SCORS application with the California Department of Corporations, making the necessary representations and qualifications, and paying the filing fee.
Exemptions from Carrying Out Registration
By requiring a filing with the state prior to the sale of securities or an exemption from filing, State Securities Administrators can keep track of who is licensed to engage in certain types of business or develop new business opportunities. State Securities Administrators can also monitor small business offerings developed for accredited investors. There are several exemptions from filing requirements under both Federal and State Securities Laws that would permit the offer and sale of securities without a registration statement or a corresponding filing with the state. Both SEC Rule 504 and under California Corporations Code Section 25102(f), there is a private offering exemption from filing with the Securities Administrator. The offering may not exceed $5,000,000 within a twelve month period and may be made to an unlimited number of accredited investors and up to 35 non-accredited investors under certain circumstances. The offering may be a standalone offering or one of multiple offerings in accordance with SEC Rule 502. For example, if an offering of $500,000 is made, it may be followed by an offering of $1,000,000, another offering at $2,000,000, a $1,000,000 offering, etc. that would not exceed the $5,000,000 limit. In addition, Blue Sky laws in most states provide for this exemption. Indeed, every state provides for an intrastate exemption from filing. In addition, there is the Rule (506) Private Placement exemption provided under 17 C.F.R. ยง 230.506, incorporated by reference in ss. 25206 of the Corporations Code. This exemption requires the purchaser to be accredited, i.e., a net worth exceeding $1,000,000 excluding equity in the home, or a net income above $200,000 in the prior two years and a reasonable expectation of a similar level of income in the current year. In addition, under Rule 506(b), solicitations should not be made through advertisements that would otherwise be prohibited when registering securities with the SEC. Generally, the SEC has held that an offering to up to 35 non-accredited investors will not negate an otherwise valid Rule 506 exemption. This Rule is available in most states and the offering itself qualifies for both federal and state exemptions.
Enforcement, Penalties & Other Provisions
The California Department of Business Oversight (DBO), through its Division of Corporations, is charged with the administration and enforcement of the state’s blue sky laws. The DBO is authorized to seek criminal penalties, civil penalties, and other remedies, including injunctive relief and restitution. In addition to civil and criminal liability, the DBO may seek an administrative fine up to $50,000 for each offer or sale of a security in violation of existing securities laws.
The Corporate Securities Law also provides for a statutory private right of action for recovery of damages for violations of the law. The statute of limitations for bringing an action is three years. Some courts have held that the Federal Securities Laws can be used offensively by private parties , whereas some courts have permitted California securities law to be raised in private actions. The California Uniform Securities Act establishes a statutory right of rescission for purchasers of securities who have been sold unqualified (non-exempt) securities. A general partner of a partnership or a corporate officer or director can be liable for selling unqualified securities. The California Uniform Securities Act also has a statute of limitations for rescission claims that is shorter than the ideal four-year federal statute of limitation since the Uniform Securities Act itself has a three-year statute of limitations. Key California cases suggest that the four-year statute of limitations applies to any securities-related federal action. The statute of limitations for a breach of fiduciary duty claim is three years with a far longer remedy period of up to ten years in certain circumstances.
Recent Developments & Current Trends
The most significant recent development in the context of California Blue Sky Laws is an increased focus on the misuse of exemptions. The Department of Corporations has recently started disqualifying corporate federal exemptions for California issuers. In the case of Glenfed Financial Corp., the California Commissioner of Corporations held that Glenfed was not eligible for the Rule 505 exemption codified in Section 230.505 of the Securities Act of 1933 based on its prior dealings. The Commissioner did not revoke the Rule 504 exemption (which is similar to Rule 505), but it holds that no California issuer may rely on that exemption if it has engaged in activities such that it would not have been able to use the Rule 505 exemption.
In addition, the Department of Corporations has recently increased its efforts to assert personal liability against control persons and corporate officers and directors, based on their role in facilitating or participating in the misconduct of their company. Well known issuers that have had to deal with California Blue Sky Law include: eBay Inc. (see Consent Order and Order Denying Request for Reconsideration) and NetCreations, Inc. (see In Re NetCreations, Inc.). These actions have made headlines and acted as a warning to out-of-state corporations of what they face should they get into any type of trouble with California law.
Investor Protections Afforded by Blue Sky Laws
Blue sky laws were originally enacted in response to abuses that took place in the 1800s and early 1900s, where "bloodsuckers" would target unsophisticated investors for fraudulent or heavily risky investments. While it could be argued that most blue sky laws have become outdated and irrelevant, California’s blue sky law still plays a vital role in protecting investors by requiring any security offered in California to have been registered with DBO or exempt from registration under an available exemption.
However, the protection is limited to those who have invested in securities that are exempt or not required to be registered in California. Local exemptions include limited partnerships that raise less than $300,000 in any 12-month period and securities offered by issuers with less than $300,000 in assets and that offer less than $100,000 in any 12-month period.
Generally, before being offered to investors through a purchase or sale of a stock, bond or other money-related instrument, the security must go through either the registration process or an exemption. Ideally, all securities sold in California should be registered. However, based on limited exceptions, a security may be exempted, as long as it falls into one of the following categories:
If an exemption or registration is not available, then the security must comply with Regulation D promulgated by SEC, which has three basic registered offerings: Rule 506(b), Rule 506(c) and Rule 504. 506(b) and 506(c) pertain to offerings exceeding $1,000,000, and the availability of the private placement exemption. 504 pertains to offerings that do not exceed $1,000,000.
Practical Considerations for Businesses and Investors
California blue sky laws significantly affect both businesses and investors. For businesses, the regulatory environment created by blue sky laws in California and each state in which an issuer intends to sell its securities is a critical aspect of any offering. For investors, the various state blue sky laws, when triggered, create a set of protections and liabilities dependent on the nature of the transaction, the issuer, and the investor.
For businesses, careful advance preparation can help avoid pitfalls in attempting to navigate through the twenty-first century framework of federal and state securities laws. At the same time, the more recent developments in state securities regulation in the form of certain "crowdfunding" exemptions, which allow entities of all different sizes to raise capital through broker-dealers and general advertising, may open the door for previously non-compliant issuers looking to raise funds.
For investors, careful attention must be given to the details of how an investment is structured. Depending on the structure, the investor could have important rights and important risks. Investments involving a registered entity are less risky in many respects, as investors have available to them the broad range of protections enacted under federal law, which, in turn, are supplemented or sometimes supplanted by applicable state laws. When dealing with a non-registered entity (or issuer), it is even more important that investors familiarize themselves with the nature and extent of the protections afforded by applicable state and federal laws.
Navigating the California Regulatory Landscape
In sum, a public or private offering can be conducted in California under the federal securities and California blue sky laws without much of a problem, so long as the issuer and underwriter are aware of the regulations that must be followed and are willing to comply with such requirements. In the case of a non-public offering, an exemption from the federal securities laws (for example, Regulation D and/or Regulation S) and the California securities laws, qualify for a safe harbor from federal and state blue sky registration requirements when applicable . In other words, most private offerings can be completed quickly, efficiently and without registering the offering with the California Department of Business Oversight (the "DBO") and/or Federal and state regulatory agencies. If the contemplated offering is a registered public offering, as already mentioned above, as a threshold matter, an issuer may register the securities under the Securities Act of 1933 (the "Securities Act") and not have to worry about blue sky laws (this is assuming that there are no "covered securities" involved in the offering i.e., transaction requirements of state securities laws typically only apply to transactions involving "non-covered securities" as defined in Section 18 of the Securities Act).