All fund compliance has risen to elevated levels within fund boards, and a recent hot topic has become state compliance, also known as blue sky laws. This is due to obvious reasons- fees and penalties. But let's break down this monster to understand what this compliance represents and try to answer the question - is blue sky compliance more like the SEC or the IRS?
Back in 1911, Kansas created the first blue sky laws to protect its citizens from con men disguised as investment professionals. Under these state laws, securities needed to be registered with the state prior to sale. The states would review the prospectus and in some cases request changes if the state examiner determined information was unclear or misleading. Once the state examiner determined the security met the standards for the state, registration was granted. There were fees associated with this initial examination and fees to renew the registrations. Many of these state blue sky laws were originally enacted prior to the creation of the Securities and Exchange Commission, which also functions to protect investors.
This duplication of efforts between state and federal law was rectified in the National Securities Markets Improvement Act of 1996. This amendment to federal securities law preempted states securities regulations. Translation: federally covered securities, like mutual funds, could no longer be registered at the state level. Sounds like a free pass, right? Wrong. Here is where the IRS comparison comes in.
The states were allowed to require a notice filing, which means you are not actually registering, but giving notice of intent to sell in the state. So the state can no longer examine your filing to determine your qualification to register, which is done at the SEC, but they can require you to give notice-and pay a fee to do so. By removing the state regulatory requirement of examination to determine suitability and investor protections and keeping the fee structure, funds are paying what some may say sounds like a tax to sell in the states. In fact, many states contribute millions of dollars to state revenue from their Securities Divisions fee collections.
In another twist, certain alternative products, like hedge funds can be exempt from registering with the SEC under Regulation D of Rule 506. So this would make most alternative products exempt from state blue sky laws, right? Unfortunately, no. The states require notification of the Regulation D exemption when the product sells in the jurisdiction. And yes, there is a fee to let them know the product is exempt.
These types of products are a regulatory concern for the states since they have minimal scrutiny under the SEC Rule 506, so they have built an Electronic Filing Depository (EFD) and require filers to use the system to submit the exemptions. The states EFD System is also linked to the Federal SEC EDGAR filing system, which gives the states capability to track new products filed with the SEC and with other states.
Is Blue Sky more like the SEC or the IRS? It's a blend of both. Perhaps the most important takeaway - blue sky statutes are different in each state and are open to interpretation, so there is no way to completely avoid fees; however, with planning there may be opportunities to lower them. The key to a robust state compliance program is to determine your level of risk, understand the sources of your sales, research your exemption criteria, and document your findings.
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Alternative Investments, Regulation
Regulation , SEC , compliance , blue sky