The financial services and securities industries face a dense and ever-changing fabric of regulation, enforcement and rulemaking that govern all aspects of these businesses. That fabric is changing significantly in a number of states that have adopted a new uniform securities act.
In 2002, the National Conference of Commissioners on Uniform State Laws completed a new comprehensive uniform state securities statute, the Uniform Securities Act of 2002 (USA). The USA has been adopted by 12 states—Hawaii, Idaho, Indiana, Iowa, Kansas, Maine, Minnesota, Missouri, Oklahoma, South Carolina, South Dakota and Vermont—and the U.S. Virgin Islands. The USA has already taken effect in each of these jurisdictions, except Indiana and Minnesota. Minnesota’s USA becomes effective on Aug. 1, 2007, and Indiana’s USA takes effect on July 1, 2008.
The overarching goals of the USA are to increase coordination between the state and federal regulatory schemes and to provide uniformity in state securities regulatory schemes around the country. A brief overview of the framework within which the USA exists is presented below, followed by a discussion of key issues that broker dealers, their employees, and others involved in the financial services industry in these states will need to know.
Federal Law
Federal regulation of securities began with Congress’ enactment of the Securities Act of 1933, and the Securities Exchange Act of 1934, creating the SEC. These statutes, along with the Investment Company Act and the Investment Advisers Act, enacted in 1940, constitute the core federal law in this area. The National Association of Securities Dealers (NASD) and the New York Stock Exchange (NYSE), otherwise known as Self Regulatory Organizations or SROs, have rule-making power and enforcement roles under the authority of the SEC.
State Law
The bedrock of state securities regulation has long been state statutes, commonly known as "blue sky" acts. The nickname was coined in a Supreme Court decision from 1917, in which Justice McKenna wrote:
The name that is given to the law indicates the evil at which it is aimed…, "speculative schemes which have no more basis than so many feet of ‘blue sky’…to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other like fraudulent exploitations."
While most blue sky acts address similar core concepts, individual states’ statutes are widely divergent. This creates a patchwork of differing rules and regulations around the country, creating difficulties for broker-dealers and other financial institutions which increasingly offer services on a national basis.
Over the past few years, the states’ role in securities regulation has become increasingly important. Fraud often takes place at a level that does not attract the attention of federal regulators. In addition, not all securities are regulated under the federal scheme. Indeed, both Congress and the SEC have recently acknowledged that federal regulators simply cannot cope with all the enforcement that needs to be done. Local schemes to defraud investors—such as Ponzi schemes and other scams—would often go unregulated if it were not for state blue sky acts and the civil and criminal enforcement mechanisms provided by the state courts.
The Uniform Securities Act of 2002
The National Conference of Commissioners on Uniform State Laws (NCCUSL) drafted a uniform securities act in 1930, 1956, 1985, and 2002. The 1956 act was the most widely adopted, having been enacted in 37 states.
There were many changes in both the legal and regulatory landscape after 1985. The National Securities Markets Improvement Act of 1996 (NSMIA), for example, changed the dynamic between state and federal regulation of the securities industry tremendously. NSMIA preempted state registration of securities listed on a major exchange, traded on NASDAQ, or issued by registered investment companies, such as mutual funds. The states’ regulation of investment advisers also changed significantly during this period. Regulation of larger investment advisory firms, defined as those with more than $25 million in assets under management, is undertaken by the SEC. Smaller firm regulation had been left to the state in which the firm is located, or where its agents maintain a place of business.
In light of NSMIA and other new federal law, as well as significant technological advancements in securities trading and regulation, and the increasingly national and international scope of securities transactions, the Uniform Law Commissioners organized a committee in 1998 and began the process of reworking the Uniform Securities Act. The committee obtained the input of key industry groups, including the American Bar Association, the American Bankers Association, the American Council of Life Insurers, the Certified Financial Planner Board of Standards, the Financial Planning Association, the Investment Company Institute, the National Association of Securities Dealers, Inc., the New York Stock Exchange, the North American Securities Administrators Association, the Securities and Exchange Commission, and the group formerly known as the Securities Industry Association. After four years of work, the National Conference of Commissioners on Uniform State Laws (NCCUSL) completed the Uniform Securities Act of 2002. All of the groups that gave their input have endorsed the final product.
Here are some of the most important issues those in the securities and financial services industries need to know when doing business in the 13 jurisdictions that have adopted the USA.
Banks No Longer Given Blanket Exemption
In the past, banks were exempt from the definition of broker-dealer under most state statutes, and were therefore exempt from registration and enforcement. No more. Consistent with the 1999 Gramm-Leach-Bliley Act, the USA adopts a functional regulatory approach towards banks. In general terms, if a bank is engaged in the business of buying and selling securities on behalf of others, it is treated like any other broker-dealer, must register as such and is subject to enforcement by the state.
Qualified Immunity for Termination Form Disclosures
When a stock broker’s employment is terminated, the NASD requires the employing firm to submit a termination form, or Form U-5, stating the reasons for the termination, regardless of the cause of the termination. The purpose of this requirement is to protect the investing public. For instance, if a broker is fired for illegal or fraudulent behavior, presumably another brokerage firm considering hiring that broker will be dissuaded from doing so by the prior firm’s U-5 disclosure.
Negative disclosures on this termination form often function as a bar to future employment. As a result, brokers often sue their firms when there are negative disclosures, alleging defamation, slander, and so forth. Some courts have held that the brokerage firm’s disclosures on this termination form are entitled to absolute immunity, essentially barring lawsuits brought on the basis of such disclosures. Other courts have held that termination form disclosures are protected by qualified immunity, barring a lawsuit only if the disclosures were not made with malice and an intent to smear the employee.
Under the USA and in the states that have adopted it, brokerage firms’ termination disclosures are protected by qualified immunity.
Enhanced State Enforcement Powers
Most broker-dealers must register with the NASD and are regulated by it and the SEC. Those broker-dealers who do business in USA states, as well as their agents, must also register with each state in which they do business. These entities are then subject to regulation by the state, which has broadened and enhanced enforcement powers.
Under the USA, states have the power to issue cease and desist orders for violations of the USA, and courts will have the power to enforce these orders. The states also have the authority to conduct investigations, issue subpoenas, and assist securities regulators from other jurisdictions in their investigations and enforcement actions. These broad powers will significantly enhance a state’s ability to investigate securities fraud and take enforcement action.
Antifraud Provisions
The antifraud provisions of the USA have been updated to bring them in line with federal statutes. One interesting change is the explicit inclusion of viatical settlements or similar agreements in the definition of a security. Viatical settlements allow individuals to invest in another person’s life insurance policy. A broker ordinarily facilitates the transaction, for a fee, in which one person purchases the insurance policy of another at a price that is less than the death benefit. When the seller dies, the purchaser collects the death benefit. The return depends on the seller’s life expectancy and the actual date she dies. In many states, it has been unclear whether viatical settlements were securities under state law and therefore subject to state enforcement and regulation. Under the USA, viatical settlements or similar agreements are explicitly included in the definition of a security.
A second interesting twist relates to annuity contracts, specifically variable annuities. In early drafts of the USA, variable annuities were specifically included in the definition of a security to give state securities regulators enforcement powers over brokers and others selling these products. A compromise in the final version of the USA gives the states the option of including or excluding variable annuities from the definition of a security. Every state that has adopted the USA thus far has determined to exclude variable annuities from the definition of a security.
Many believe that the question of whether to include or exclude variable annuities in the definition of securities is the primary reason the USA has not been adopted in more states. By all accounts, this was the most contentious issue encountered during the drafting process, causing political infighting between securities industry groups charged with representing the interests of investors, such as the NASD, and the organizations representing the insurance industry, such as the American Council of Life Insurers.
Individual Liability and Damages
Overall, criminal and civil penalties under the USA for those engaged in fraud are fairly consistent with most states’ existing laws. The USA does, however, broaden coverage and liability for investment advisers and their representatives based on the increasingly significant role of investment advisers in the securities industry. The USA goes even one step further, creating liability under certain circumstances for anyone who provides fraudulent advice regarding securities in exchange for compensation, regardless of whether that individual is a registered investment adviser or an adviser representative.
Criminal liability under the USA is largely unchanged. The measure of actual damages for violation of the act in most civil cases is based upon tendering the stock or returning it to the seller. In other words, actual damages are calculated as the amount that would be recoverable upon tender, minus the value of the security when the purchaser disposed of it, plus interest, costs, and reasonable attorneys fees. The courts in many states have previously utilized various other measures for determining damages, and in those states, this will be a significant change.
Statute of Limitations
The USA makes the statute of limitations consistent with federal law, lengthening the limitations period in most states. Under the USA, claims must be brought no later than two years from the discovery of the violation, but in no event more than five years from the date of the transaction.
Conclusion
The overarching goals of the Uniform Securities Act of 2002 are to increase coordination between the state and federal regulatory agencies and to provide uniformity in state securities regulatory schemes around the country. While the USA is largely successful in achieving these goals on its face, the true test of its success lies in the number of states that choose to adopt it. With 13 jurisdictions already in the fold, the USA appears to be well on its way to broader success.
The material contained in this communication is informational, general in nature and does not constitute legal advice. The material contained in this communication should not be relied upon or used without consulting a lawyer to consider your specific circumstances. This communication was published on the date specified and may not include any changes in the topics, laws, rules or regulations covered. Receipt of this communication does not establish an attorney-client relationship. In some jurisdictions, this communication may be considered attorney advertising.