State exemptions

In the previous two chapters, we discussed how a security can be registered with the state administrator. In this chapter, we’ll cover the various exemptions that allow issuers and other interested parties to avoid the securities registration process.

A security may avoid registration if:

• Considered an exempt security
• Sold in an exempt transaction

Exempt securities

An exempt security is one that avoids registration solely based upon what it is. The Uniform Securities Act (USA) explicitly names the following as securities exempt from state registration:

• US government securities
• Canadian government securities
• National foreign government securities
• Bank securities
• Insurance company securities
• Railroad, common carrier, and public utility securities
• Federal-covered securities
• Non-profit securities
• Promissory notes
• Employee benefit plans

The following descriptions of exempt securities will begin with direct quotes from the USA.

US government securities

Any security (including a revenue obligation) issued or guaranteed by the United States, any state, any political subdivision of a state, or any agency or corporate or other instrumentality of one or more of the foregoing

Any security issued by a government of the United States is considered exempt. As we’ve previously discussed, there are three layers of government securities to be aware of:

• Federal (Treasury)
• Mortgage agencies
• Municipal

Canadian government securities

Any security issued or guaranteed by Canada, any Canadian province, any political subdivision of any such province, any agency or corporate or other instrumentality of one or more of the foregoing

Just like US government securities, Canadian government securities of any form are exempt from registration. Federal (national), provincial, city, and local government securities all avoid registration.

National foreign government securities

Any other foreign government with which the United States currently maintains diplomatic relations, if the security is recognized as a valid obligation by the issuer or guarantor

Unlike Canada, exemptions for other foreign governments are limited to those of the national (federal) government. For example, a bond issued by the French government would be exempt, but a bond issued by the city of Paris would not be exempt. The US maintains diplomatic relations with countries, not local governments. Additionally, the US must be on “good terms” (diplomatic relations) with those foreign governments.

Bank securities

Any security issued by and representing an interest in or a debt of, or guaranteed by, any bank organized under the laws of the United States, or any bank, savings institution, or trust company organized and supervised under the laws of any state

Any security issued by and representing an interest in or a debt of, or guaranteed by, any federal savings and loan association, or any building and loan or similar association organized under the laws of any state and authorized to do business in this State

Any security issued or guaranteed by any federal credit union or any credit union, industrial loan association, or similar association organized and supervised under the laws of this state;

As we’ve seen several times throughout this material, banks (and most entities that sound like banks) are generally exempt or excluded from virtually every registration requirement. Their securities are additionally considered exempt from registration.

Any nationally regulated bank organization’s securities are exempt, but state-regulated organizations must be authorized to do business in a state in order to sell exempt securities. For example, let’s assume a bank is organized and regulated only by the banking regulators in the state of Kentucky. If this bank offered its securities in any other state, the exemption would not apply. However, a sale of their securities in Kentucky would be exempt.

Let’s summarize all the “banking” entities that qualify for this exemption:

• Banks
• Savings institutions
• Trust companies
• Federal savings and loan associations
• Building and loan associations
• Credit unions
• Industrial loan associations

Keep in mind this exemption does not apply to bank holding companies, which we discussed in an earlier chapter.

Insurance company securities

Any security issued by and representing an interest in or a debt of, or guaranteed by, any insurance company organized under the laws of any state and authorized to do business in this state; [but this exemption does not apply to an annuity contract, investment contract, or similar security under which the promised payments are not fixed in dollars but are substantially dependent upon the investment results of a segregated fund or account invested in securities]

Insurance company securities are generally exempt, except for any variable contract offered. While you don’t need to know the specifics, these are the three non-exempt insurance company securities to be aware of:

• Variable annuities
• Variable life insurance
• Universal variable life insurance

Keep this one simple! If it’s an insurance product with the word ‘variable’ in the name, it’s not exempt. Every other insurance company security is exempt as long as that insurance company is authorized to do business in that state (same concept as we discussed with banks).

Railroad, common carrier, and public utility securities

Any security issued or guaranteed by any railroad, other common carrier, public utility, or holding company

Definitions

Common carrier

A person or company that transports goods or passengers on regular routes at set rates

The first version of the USA was written in the 1930s, back when railroads (a type of common carrier) were very popular. That’s why they’re specifically mentioned in the law. Securities issued by public utility companies (e.g. your local electric provider) also fit into this exemption.

Federal-covered securities

We previously discussed federal-covered securities, which are subject to notice filing in every state they’re offered in. It’s a bit of a confusing topic, but federal-covered securities are subject to some filing requirements, but ultimately are considered exempt from full-on state registration. As a reminder, here are the three categories of federal-covered securities:

• Exchange-traded securities (and senior securities)
• Investment company securities
• Regulation D securities

Non-profit securities

Any security issued by any person organized and operated not for private profit but exclusively for religious, educational, benevolent, charitable, fraternal, social, athletic, or reformatory purposes, or as a chamber of commerce or trade or professional association

Securities issued by non-profits of many forms, including those issued by churches, universities, and charities, are considered exempt from registration. However, the USA provides the state administrator with the ability to remove the exemption should they suspect fraud or any other “sketchy” situation. This is for good reason; the North American Securities Administrators Association (NASAA) has witnessed numerous instances of affinity fraud over the years.

Definitions

Affinity fraud

A form of fraud that targets members of cultural, ethnic, or religious groups

Promissory notes

A promissory note, draft, bill of exchange or bankers’ acceptance that evidences an obligation to pay cash within 9 months after the date of issuance, exclusive of days of grace, is issued in denominations of at least $50,000, and receives a rating in one of the 3 highest rating categories from a nationally recognized statistical rating organization; or a renewal of such an obligation that is likewise limited, or a guarantee of such an obligation or of a renewal;

Promissory notes, also referred to as commercial paper are short-term corporate debt obligations. These securities are issued at a discount, pay no interest during the life of the security (zero coupon), and mature at par. As long as a promissory note does not exceed 9 months to maturity, is issued in at least $50,000 denominations*, and is rated one of the three highest debt ratings* (e.g. AAA, AA, A), it is considered an exempt security. Organizations like Moody’s and S&P Global Ratings (formerly Standard & Poors) commonly provide ratings on these securities.

*As we discussed earlier, federal exemptions only require these securities to be 9 months (technically 270 days) or less to maturity. There is no federal minimum denomination or debt rating minimum requirement. Many test takers forget the additional state requirements, and the test writers know this. Be sure to be aware of the differences between the federal and state exemption.

Employee benefit plans

Any investment contract issued in connection with an employees’ stock purchase, savings, pension, profit-sharing, or similar benefit plan

Many companies offer securities and other investment plans to their employees while avoiding registration. These offerings are not available to the general public, which is the primary reason for this exemption existing. Like non-profit securities, the USA provides the state administrator with the ability to strip this exemption should they suspect fraud or any other “sketchy” situation.

Exempt transactions

We’ll now discuss exempt transactions, which allow non-exempt securities to be offered without registration in a specific type of transaction. A non-exempt security is one that does not have an exemption based solely on what it is. Most securities, including the vast majority of stocks, are non-exempt.

These are the exempt transactions covered in the USA:

• Private placements
• Isolated non-issuer transactions
• Unsolicited non-issuer transactions
• Certain fiduciary transactions
• Debt-related transactions
• Transactions between issuers and underwriters
• Institutional transactions
• Offer of pre-organization certificates

Private placements

We discussed Regulation D in a previous chapter, which is the federal version of a private placement. As a reminder, a private placement is a non-public sale of a security to a small group of investors. The USA (state) has its own version of a private placement that applies if the transaction will take place intrastate (in one state only).

A security offered to no more than 10 non-institutional (retail) investors in the previous 12 months is eligible for the private placement exemption. Additionally, these investors must buy the security for investment purposes (not just to immediately resell it). Last, no commissions from retail investors* can be collected by the financial representatives facilitating the transactions.

*Commissions can be collected from private placement sales to institutional investors.

Let’s assume a local business in your state wants to raise capital by selling stock while also avoiding state registration of the security. The company offers the security to you, plus 9 other retail investors while taking no commission. You purchased the stock for investment purposes and now hold an unregistered, non-exempt security. The issuer was able to sell their stock without registering it because of the way it was sold (an exempt transaction).

You now hold a restricted security that cannot be sold in the public markets until it’s registered. This doesn’t mean you can’t sell the security, though. If you can claim an exempt transaction yourself (most likely one of the many transactions below), you can sell the security.

Isolated non-issuer transactions

As per the USA:

Any isolated non-issuer transaction, whether effected through a broker-dealer or not [is considered an exempt transaction]

The USA is fairly vague with this type of transaction, but let’s break down the terminology. Isolated means infrequent and non-recurring. You already know what an issuer is; an issuer transaction is one where the issuer receives the proceeds from a securities sale. The private placement example we discussed above was an issuer transaction. So, a non-issuer transaction is one where the issuer does not collect the proceeds from a sale.

In most scenarios, an isolated non-issuer transaction occurs between family members, friends, or colleagues. Let’s revisit the example discussed above where you purchased stock from a local business in a private placement. You could sell the non-exempt unregistered stock to a friend of yours and claim this exemption as long as it doesn’t become a frequent transaction. By doing so, you were able to legally sell the security without it being registered.

Unsolicited non-issuer transactions

What if you wanted to sell your non-exempt unregistered stock, but couldn’t find a friend or family member that was interested? You could contact your broker-dealer and ask for help selling the security as long as it was on an unsolicited basis. The broker-dealer cannot recommend the transaction in any way, plus they may also ask you to sign a non-solicitation letter (some state administrators require them for these transactions). This document would declare you were attempting to sell the security without the coercion of the broker-dealer.

Certain fiduciary transactions

A fiduciary is a person placed in charge of managing another person’s assets or belongings. There are numerous types of fiduciaries in the world, but the USA specifically identifies those that qualify for exempt transactions:

• Estate executors and administrators
• Sheriffs and marshals
• Receiver
• Trustee in bankruptcy
• Guardians and conservators

An estate executor or administrator is appointed to oversee the estate of a deceased person. If the deceased person owned a non-exempt unregistered security, the executor or administrator could sell it through this exemption.

Sheriffs and marshals are law enforcement officers that may take possession of the assets of those subject to criminal prosecution. If a judge mandates a convicted criminal to pay a fine to the state, a liquidation of a non-exempt unregistered security may occur through this exemption.

A receiver is a person appointed by a judge to take temporary possession of assets while a lawsuit is taking place. If a sale of a non-exempt unregistered security is required by the court, the receiver can perform the transaction legally through this exemption.

A trustee may be appointed to oversee a person’s bankruptcy. If the bankruptcy court orders the liquidation of the bankrupt person’s assets, a non-exempt unregistered security may be part of the order. This exemption would allow the trustee to sell the security legally without registering it.

Guardians and conservators are court-appointed fiduciaries tasked with overseeing the assets of a person incapable of doing so themselves, typically due to mental illness or incapacitation. If the person owns a non-exempt unregistered security and the conservator or guardian wants to sell it, they can do so through this exemption.

Debt-related transactions

Some loans are secured, or collateralized loans. For example, a mortgage is a secured loan; if the homeowner cannot make their required mortgage payments, the lender can repossess the property (collateral). It’s possible a person takes out a loan and pledges a non-exempt unregistered security as collateral. If the loan goes unpaid, the lender can sell the security through this exemption to recoup the borrowed money.

The USA sometimes makes reference to these loans being ‘bona fide,’ meaning they are legitimate loans. This would not be the case if a non-exempt unregistered security was pledged as collateral for a loan with an immediate intention of defaulting on it. It’s most likely a person doing this would only be taking the loan as a creative way to sell the security while falsely claiming this exemption.

Transactions between issuers and underwriters

Most public offerings of securities begin with a sale from the issuer to underwriters. As a reminder, an underwriter is a financial firm that sells securities on behalf of issuers. In a previous chapter, we discussed how Morgan Stanley and Goldman Sachs acted as co-lead underwriters on the AirBnB initial public offering (IPO). Prior to Morgan Stanley and Goldman Sachs selling AirBnB stock to the public, they first purchased the stock from Airbnb.

The sale of a security from an issuer to its underwriter(s) does not require a security to be registered. However, the subsequent sale from the underwriter to the general public does require registration (unless some other exemption exists).

Institutional transactions

As we’ve learned throughout this material, institutional investors don’t require many of the same protections offered to retail investors. This is why the USA allows a sale to virtually any institutional investor to occur without registration of that security. The following institutions are specifically mentioned:

• Banks
• Savings institutions
• Trust companies
• Insurance companies
• Investment companies
• Pensions
• Profit-sharing plans
• Financial institutions
• Broker-dealers

Offer of pre-organization certificates

A pre-organization certificate is a pledge by an investor to purchase a security in the future from an organization that has not yet been formed. Companies tend to use them as a way to ensure they have access to capital (money) once officially formed. As long as they’re offered to no more than 10 potential subscribers and no payment or commission is received, pre-organization certificates avoid registration requirements through this exemption.

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Let’s summarize a few things regarding the exemptions discussed in this and the previous chapter. Exempt securities avoid registration based solely on what they are, while exempt transactions allow the sale of non-exempt unregistered securities if a transaction occurs a specific way. It’s possible an exam question tests you on the difference. For example:

All of the following are exempt transactions according to the Uniform Securities Act, EXCEPT:

A) An offer of securities to 8 retail investors in a 12-month period
B) An offer of a Treasury bond to hundreds of retail investors
C) An offer of a pre-organization certificate to 9 potential subscribers
D) An offer of common stock to an institutional investor

Can you figure out the answer?

Many test takers remember exempt securities as nouns, while exempt transactions are verbs. An exempt security is exempt based on what it is (a noun), while an exempt transaction provides an exemption based on an action (a verb).

In the exempt securities section above, we learned how non-profit and employee benefit security exemptions can be removed by the state administrator if fraud or another “sketchy” situation is suspected. This same concept applies to all the exempt transactions discussed above.

Key points

State-exempt securities

• US government securities
• Canadian government securities
• National foreign government securities
• Bank securities
• Insurance company securities
• Railroad, common carrier, and public utility securities
• Federal-covered securities
• Non-profit securities
• Promissory notes
• Employee benefit plans

State-exempt transactions

• Private placements
  • Offer made to 10 or fewer retail investors
  • Purchase made for investment purposes
  • No commissions to be collected from retail investors
• Isolated non-issuer transactions
• Unsolicited non-issuer transactions
• Certain fiduciary transactions
  • Estate executors and administrators
  • Sheriffs and marshals
  • Receiver
  • Trustee in bankruptcy
  • Guardians and conservators
• Debt-related transactions (bona fide loans)
• Transactions between issuers and underwriters
• Institutional transactions
• Offer of pre-organization certificates
  • No more than 10 subscribers