Federal Covered Security

An agent tells a client that shares of a large exchange-listed company are "federal covered securities, which means they are not securities under state law at all, so the State Administrator has no role." Under the Uniform Securities Act and NSMIA, this statement is:

1. A.Incorrect, but only because the state may still require the issuer to register the offering.Incorrect. The state may not require registration of a federal covered security; the error lies elsewhere in the statement.
2. B.Correct, because NSMIA transferred all authority over exchange-listed securities to the SEC.Incorrect. States retain antifraud authority over offers and sales within the state.
3. C.Incorrect, because a federal covered security is still a security and the state retains antifraud jurisdiction.Correct. Preemption reaches state registration, not the definition or the antifraud provisions.
4. D.Correct, because federal covered securities are excluded from the definition of a security under state law.Incorrect. There is no such exclusion from the definition.

Why: A federal covered security is still a security. The federal covered designation preempts STATE REGISTRATION of the offering, leaving the state to notice filings and fees where permitted, but the state retains full antifraud jurisdiction over offers and sales of those securities within the state.

Fallbrook Analytics is conducting an offering to accredited investors under Rule 506 of Regulation D and will sell to residents of State N. The State N Administrator writes demanding that the company register the offering in the state and submit to a merit review of the terms. What is the correct position?

1. A.The Administrator is correct, because a state may always require registration of any offering sold to its own residents.Incorrect. NSMIA makes Rule 506 securities covered securities and preempts state registration and merit review of the offering.
2. B.The Administrator may not require registration or merit review of a Rule 506 covered security, but may require a notice filing and a fee and retains full antifraud enforcement authority.Correct. Preemption is limited to registration and merit review; notice filings, fees and antifraud jurisdiction survive.
3. C.The state has no authority of any kind over the offering, so it may not require a notice filing, charge a fee or investigate fraud.Incorrect. It overstates preemption. Notice filings, fees and antifraud authority are expressly preserved to the states.
4. D.The Administrator may not require registration, but only because the purchasers are accredited investors rather than because the security is covered.Incorrect reasoning. Preemption follows from the securities being covered securities under NSMIA, not from the status of the purchasers.

Why: Securities sold in a Rule 506 offering are covered securities under the National Securities Markets Improvement Act. Congress made federal regulation exclusive for that category, so a state may NOT require registration of the offering or subject its terms to a merit review. The Administrator demand is therefore beyond his authority as stated. States are not, however, cut out entirely. They retain three specific powers over covered securities. They may require a NOTICE FILING, typically a copy of the Form D filed with the SEC together with a consent to service of process, they may charge a filing FEE, and they retain full authority to investigate and bring enforcement actions for FRAUD or deceit in connection with the offering. Preemption is therefore about registration and merit review only; it is not a general immunity from state law. Separately, the persons selling the offering may still need to be registered in the state as broker-dealers or agents unless an exclusion applies to them.

An issuer sells stock in a private placement conducted under SEC Rule 506 of Regulation D, making it a federal covered security. Five purchasers reside in State W. Regarding State W's authority over this offering:

1. A.State W may require full registration by qualification because the purchasers are its residentsRegistration of a federal covered security is precisely what is preempted, regardless of where purchasers reside.
2. B.State W may require a notice filing and fee and may pursue fraud, but may not require registration of the securitiesCorrect. Federal covered status preempts state registration and merit review while preserving notice filings, fees, and the state's antifraud authority.
3. C.State W has no authority whatsoever over the offering or the persons who sell itPreemption is partial. Notice filings, fees, and antifraud enforcement all survive.
4. D.State W may review the merits of the offering but may not charge a filing feeThis inverts both points. Merit review is preempted; a filing fee is expressly permitted.

Why: A Rule 506 offering produces a federal covered security, so State W cannot require registration of the securities or review the offering's merits. The state may still require a notice filing (typically a copy of the federal Form D), collect a filing fee, and require a consent to service of process. It also retains full authority to investigate and act against fraud in connection with the offering. The clue is that the offering is federal covered - that word divides substantive registration authority from the state's remaining notice and antifraud powers. Review the topic on federal covered securities and state authority.

Ilkeswold Pharmaceuticals common stock is listed on the New York Stock Exchange. The company now offers, in State G, a new issue of senior preferred stock that ranks ahead of the listed common. The State G Administrator informs Ilkeswold that the preferred must be registered in State G by qualification and undergo merit review. Under the Uniform Securities Act as amended by federal law, the Administrator position is:

1. A.wrong, because a security senior in rank to a listed security is itself a federal covered security and states may not require its registrationCorrect. The equal or senior rank rule makes the preferred federal covered, so state registration and merit review are preempted.
2. B.correct, because preferred stock is never eligible for federal covered treatmentThere is no instrument-type exclusion. Rank relative to a listed security is the test.
3. C.correct, because only the security actually listed on the exchange qualifies as federal coveredThe definition extends to securities of the same issuer equal in rank or senior to the listed security.
4. D.wrong, because federal covered status also strips the Administrator of any authority to investigate fraud in the offeringPreemption reaches registration and merit review. Antifraud investigation and enforcement authority is expressly preserved.

Why: A security listed on the New York Stock Exchange is a federal covered security, and so is a security of the same issuer that is equal in rank or senior to a listed security. The senior preferred therefore qualifies as a federal covered security in its own right. States are preempted from requiring registration or applying merit review to a federal covered security, although they keep authority to investigate and bring enforcement actions for fraud or deceit.