The Antifraud Savings Clause of the National Securities Markets Improvement Act of 1996

Author:Evan J. Leitch
Position:J.D. Candidate, The University of Iowa College of Law, 2009; B.A., Middlebury College, 2006.

When Congress enacted the National Securities Markets Improvement Act of 1996, hopes were high that the Act would eliminate the additional costs of complying with the widely varying state securities laws for securities offerings that the Act "covered." A recent California appellate court decision highlights the inconsistency between the Act's attempts at federal preemption and its preservation of ... (see full summary)


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I Introduction

Imagine a stockbroker has an arrangement with a mutual fund. The arrangement provides that the mutual fund offers the stockbroker extra financial incentives to give the mutual fund's products heightened visibility and placement on the stockbroker's lists of recommended or preferred mutual funds. The arrangement has obvious benefits for both the broker and the mutual fund. The broker gets the financial incentives that the mutual fund offers, and the mutual fund gets more exposure to potential customers.

Such an arrangement raises the question: does the stockbroker have an ethical or a legal duty to disclose the arrangement to his clients? Resolving the ethical dilemma is best left to self-regulatory organizations ("SROs") or the depths of the human conscience. It suffices to say, though, that most stockbrokers do not seem too troubled resolving the ethical question in the negative.

Resolving the legal question, however, is this Note's raison d'etre. A stockbroker seeking to resolve the legal question might first look to the federal securities laws. There, the broker would find that he is not obligated to disclose the existence of the arrangement to his customers. 1 But the broker is not out of the woods quite yet. There are also state securities laws that may require the stockbroker to disclose the existence of the arrangement with the mutual fund.

Following the enactment of the National Securities Markets Improvement Act of 1996 ("NSMIA" or "the Act"), the stockbroker might have feltjustified in concluding that, as long as his disclosures complied with federal securities laws, he did not need to fear enforcement at the hands of state securities regulators. Two recent decisions in California bring this assumption into serious question. These two decisions force an examination of the NSMIA and whether or not the Act is achieving the goals to which it originally aspired.

This Note examines the NSMIA and its paradoxical construction, discusses recent developments in California courts, and-ultimately- prescribes a solution to the self-contradictory statute. This Note, more than offering potential solutions, highlights a drafting flaw in a law that gave so many cause to hope that the days of meeting the onerous burden of complying with state securities regulations were behind them. This Note explains why that hope may ultimately prove to be a false one and how the language of the Act is being used to erode its purpose. 2

To contextualize the NSMIA, Part II of this Note describes the evolution of state securities laws. It also explains the factors that led Congress to conclude that the pre-NSMIA system was "redundant, costly, and Page 1771 ineffective,"3 which, finally, led to the adoption of the NSMIA. Part III provides a detailed examination of the NSMIA's parts.4 Part IV calls attention to one of the aforementioned California cases that perfectly illustrates the contradictory language in the Act. This case shows how state securities regulators are likely to (and, in this instance, did) interpret the language in a manner that seems at odds with the spirit and the language of the NSMIA.5 Part V offers a potential solution-one that commentators have been urging ever since states began regulating securities.6

II Background

Government intervention in the U.S. securities markets7 officially began in 1911 when Kansas enacted what most commentators consider to be the first "blue-sky" law. 8 While origins of the term "blue sky" to describe securities regulation are not entirely settled, there are two prevailing and interesting potential explanations.

The first explanation is that the term "blue-sky law" derives from the 1911 Kansas law "aimed at promoters who 'would sell building lots in the blue sky in fee simple.'"9 The second explanation-given by the Supreme Court-is that "[t]he name that is given to the law indicates the evil at which it is aimed, that is . . . 'speculative schemes which have no more basis than so many feet of "blue sky."'"10 While some commentators have unearthed earlier examples of blue-sky regulation, most commentators seem content to Page 1772 start the historical timeline of blue-sky regulation in the united States at 1911 with the enactment of the Kansas law.11

Whatever the reason for its moniker or true origin, one thing is clear: blue-sky regulation rapidly expanded as a means for states to regulate securities offerings. After 1911, other states quickly followed Kansas's lead- twenty-three states had blue-sky laws within two years,12 thirty-seven had them by 1921,13 and "today every state has some form of blue sky act."14

Initially, courts-especially federal courts-were reluctant to recognize a state's right to regulate securities.15 However, in 1917, the Supreme Court decided, in the Blue Sky Cases, that the blue-sky laws of Michigan, Ohio, and South Dakota did not violate the Fourteenth Amendment or unduly burden interstate commerce.16 The Court bolstered its Blue Sky Cases decision in Hall Page 1773 v. Geiger-Jones Co. and enunciated some of the common justifications for securities regulation:

It will be observed, therefore, that the [blue-sky] law is a regulation of business, constrains conduct only to that end, the purpose being to protect the public against the imposition of unsubstantial schemes and the securities based upon them. Whatever prohibition there is, is a means to the same purpose, made necessary, it may be supposed, by the persistence of evil and its insidious forms and the experience of the inadequacy of penalties or other repressive measures. The name that is given to the law indicates the evil at which it is aimed, that to use the language of a cited case, "speculative schemes which have no more basis than so many feet of 'blue sky'"; or, as stated by counsel in another case, "to stop the sale of stock in fly-by-night concerns, visionary oil wells, distant gold mines and other fraudulent exploitations." Even if the descriptions be regarded as rhetorical, the existence of evil is indicated, and a belief of its detriment; and we shall not pause to do more than state that the prevention of deception is within the competency of government and that the appreciation of the consequences of it is not open for our review. 17

While courts have invalidated parts of blue-sky laws since the Supreme Court decided the Blue Sky Cases, the Constitution does not pose a barrier to blue-sky regulation generally.18

Blue-sky laws-which now exist in all fifty states, the District of Columbia, Guam, and Puerto Rico19-vary, by jurisdiction, in their substance.20 Studying the blue-sky laws in the 1950s, Professors Louis Loss and Edward M. Cowett found 2800 separate exemptions in their survey of the forty-seven statutes in existence at that time.21 They also found, however, that nearly every one of the acts had common provisions. 22 Examining these common provisions, they were able to sketch a rough outline of the general nature of blue-sky laws: "There are three distinct types of [blue-sky] Page 1774 regulatory devices: (1) anti-fraud provisions; (2) provisions requiring the registration or licensing of certain persons engaging in the securities business; and (3) provisions requiring the registration or licensing of securities."23 Considering that securities regulation involves a delicate balancing act between protecting investors and maintaining a marketplace with highly fluid and cheap capital, one can see that a regime with 2,800 different exemptions might be less than ideal, not to mention difficult and expensive to navigate.24 Indeed, as one author explained, engaging local counsel in every single jurisdiction where a company offers a security, to ensure that it complies with local laws, is an essential part of registering and offering a security. 25

To complicate matters even further, the federal government became involved in the regulation of securities as well. President Franklin Delano Roosevelt's New Deal, at the start of the Great Depression, included passing the Securities Act of 1933 (the "1933 Act").26 Shortly thereafter, Congress passed the Securities Exchange Act of 1934 (the "1934 Act"), which created the Securities and Exchange Commission ("SEC" or the "Commission").27The passage of these acts, coupled with the already existing blue-sky regulation, meant that "[s]ecurities offerings and the brokers and dealers engaged in securities transactions [were] all subject to a dual system of regulation that, in many instances, [was] redundant, costly, and ineffective."28 One prominent commentator, commenting specifically on the difficulties of broker-dealer registration, wrote that "state regulation of broker-dealers adds a superfluous layer of rules to an area that is already subject to extensive (some would say excessive) regulation at the federal level. The result is additional complexity and cost without any demonstrable increase in protection for the public."29

The duplicative nature of securities regulation, and blue-sky laws in particular, was not the legal community's only complaint with the pre- Page 1775 NSMIA securities-regulation regime. 30 Many academics and institutions found the state blue-sky laws inimical to the goals of securities regulation- investor protection and capital formation-in and of themselves. 31

Nearly as soon as the blue-sky laws came into vogue-recall that twenty-three states adopted them within two years of the 1911 Kansas law32-there were calls from various sectors for an over-arching federal scheme that...

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