Whenever your company decides to raise some money and undergo a financing, it is important to make sure that your business will comply with all applicable regulations, and this includes securities laws. Abiding by securities laws is no walk in the park, so having a lawyer guide you through the compliance process is essential in order to adhere to tax requirements. The government is interested in regulating transactions of securities to make sure that the sales of securities are based on realistic valuations of the security’s worth. Even with federal regulations in place, it is common for states to double-down on the potential gaps by enforcing extra laws, commonly known as Blue Sky laws. 

Originating as protection for investors against bankrupt companies, shell companies, blind pools, and blank checks, Blue Sky laws serve primarily to bolster the federal laws that prevent securities fraud from occurring. When it comes to the legal guidelines that regulate the sale of financial securities that come with a financing, your company will want to comply with both levels of regulation: the nationwide requirements and any applicable Blue Sky laws (which may differ on a state-by-state basis). The ramifications for failing to comply with these rules can cost your company the investments that you are about to raise, and even subject your business to a government lawsuit.

What is a financial security?

A security is an item of monetary value that represents ownership (or the right to ownership) of a profit-seeking entity—a stock, bond, or option. For a startup undergoing a fundraise, this may be something like their Series Seed or Series A stock issuance. Due to the inherent risk of owning a security, sales and trades of these items are regulated by the Securities and Exchange Commission (SEC). The SEC is an independent government entity that is the primary enforcer of the nation’s security laws. They set broad guidelines for how securities can be traded and what kind of information companies must provide when issuing them. You can read more about the goals of the SEC on its website for investors

What are Blue Sky laws?

While the SEC spearheads securities laws at a federal level, each individual state has its own securities laws and rules, which serve as an additional measure of protection for investors against securities fraud or overly speculative investments. You will have to comply with the Blue Sky laws in all of the states where your company conducts its business and where your investors reside. The name “Blue Sky laws'' originates from a ruling in the Kansas Supreme Court during the 1910s, when individuals were conned into buying securities "which have no more basis than so many feet of 'blue sky’ (SEC Law Introduction to Securities Law).” Generally, Blue Sky laws require sellers of new stock issuances to register with the state or follow federal exemptions from registration. 

Blue Sky Law Exemptions: Rule 504 and Rule 506

There are exceptions to the Blue Sky laws which may apply to your business. While the legal intricacies of security registration are complex, private companies and startups often fall under the “covered securities” category, which is exempt from Blue Sky laws. These eligible companies qualify for federal exemptions listed as Rule 504 or Rule 506 of the Securities Act of 1933. At a high level, these rules were established to help small businesses and startups raise capital. More specifically, Rule 504 allows for investors to receive restricted securities but ceases to apply after a certain threshold of financing has been met. Therefore, the more common of the two exemptions is Rule 506. This rule does not limit the amount of money that a company can raise, yet it narrows down legal purchasers of the company’s securities to “accredited investors” only. When a company meets one of these exemptions, they must file Form D with the SEC, which informs the government of the private placement offering. 

You Should Always Speak To Your Lawyer

Even if you are not relying on a federal exemption, your counsel will want to check whether or not a comparable state exemption applies. Because Blue Sky laws vary, you should always consult with your lawyer to see what disclosures of materials and regulations you must comply with before issuing any equity in your company. If necessary, your legal advisor will help you complete the filing requirements and register with your state for the sale of securities. This will typically include a merit review by state agents to determine whether your offerings are fair for the buyer. It is unwise to assume that you are exempt from a state’s Blue Sky laws without consulting a lawyer; any failure to disclose information or false statements could open your company up to lawsuits and legal actions. Once your lawyer knows more about your situation, they will be best equipped to guide you through the necessary processes that you must comply with.

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Third party mentioned and Fidelity are not affiliated. Fidelity does not provide legal or tax advice. The information herein is general in nature and should not be considered legal or tax advice. Consult an attorney or tax professional regarding your specific situation.

 Tags: Fundraising