Covered securities

What Are Covered Securities?

Covered securities are a specific classification of investment products that are exempt from certain state-level registration requirements under U.S. federal law. This designation falls under the broader category of securities regulation, aiming to reduce regulatory duplication between federal and state authorities. Essentially, if a security is "covered," it means that its offering and sale are primarily regulated at the federal level by the Securities and Exchange Commission (SEC), preempting most state blue sky laws that would otherwise require separate state registration or qualification. This framework for covered securities streamlines the process for issuers raising capital and facilitates more efficient capital markets.

History and Origin

The concept of covered securities emerged from a desire to harmonize the fragmented landscape of U.S. securities regulation. Prior to the mid-1990s, companies offering securities publicly often had to comply with both federal and individual state registration requirements, leading to significant compliance burdens and costs. State "blue sky" laws, enacted in the early 20th century, aimed to protect investors from fraudulent schemes and required registration or qualification of securities offerings within their borders. Meanwhile, the federal regulatory framework, established by the Securities Act of 1933 and the Securities Exchange Act of 1934, provided a separate layer of oversight¹³, ¹⁴, ¹⁵.

This dual system often resulted in inefficiencies, as a single offering could be subject to registration in all 50 states, each with its own specific requirements. To address these concerns and promote more efficient capital formation, Congress passed the National Securities Markets Improvement Act of 1996 (NSMIA). NSMIA significantly amended existing federal securities laws to preempt, or override, state regulatory authority over certain types of offerings and securities¹². It established the category of "covered securities," granting the SEC exclusive jurisdiction over their registration and effectively eliminating duplicative state review for these specific investments.

Key Takeaways

Covered securities are a class of investment products largely exempt from state-level registration requirements due to federal preemption.
The National Securities Markets Improvement Act of 1996 (NSMIA) created the concept of covered securities to reduce regulatory burdens and streamline capital markets.
Types of covered securities include nationally traded exchange-listed securities, certain mutual funds, and securities offered in specific federal private placements.
While exempt from state registration, covered securities generally remain subject to state anti-fraud provisions and notice filing requirements.
This designation primarily impacts the issuer's compliance obligations and the jurisdiction of state securities regulators.

Interpreting Covered Securities

The designation of a security as "covered" is critical for issuers and those involved in the distribution of financial products, such as a broker-dealer. It dictates which regulatory body holds primary jurisdiction over the offering and sale of that security. For a security classified as covered, the issuer is generally relieved from the complex and often costly process of registering or qualifying the offering in each state where it is sold. Instead, the focus shifts predominantly to compliance with federal regulation.

However, being a covered security does not imply a complete absence of state oversight. States typically retain their authority to investigate and prosecute fraud in connection with the offer or sale of any security, including covered securities. Additionally, states may still require issuers to file "notice filings" and pay filing fees, even if the security itself is exempt from full state registration. This allows states to track offerings within their borders and maintain some level of surveillance for potential fraudulent activities, despite the preemption of substantive review.

Hypothetical Example

Consider "InnovateCorp," a growing technology company seeking to raise capital by issuing new shares. InnovateCorp decides to list its shares on the New York Stock Exchange (NYSE) through an initial public offering. Since shares listed on a national securities exchange like the NYSE are defined as covered securities under NSMIA, InnovateCorp primarily focuses on complying with the SEC's federal registration requirements.

InnovateCorp prepares and files a detailed registration statement and prospectus with the SEC. Once the SEC declares the registration statement effective, InnovateCorp can offer and sell its shares across various states without needing to undergo separate, full registration processes with each state's securities regulator. While individual states might still require a notice filing and a fee payment to acknowledge the offering within their jurisdiction, they cannot impose their own substantive review on the fairness of the offering or demand additional disclosures beyond those required by the SEC. This streamlines InnovateCorp's ability to raise capital from a broad base of investors nationwide.

Practical Applications

Covered securities play a significant role across several areas of finance and investing:

Public Offerings: Securities listed or authorized for listing on national stock exchanges (such as the NYSE or Nasdaq) are the most common example of covered securities. This includes most publicly traded stocks and corporate bonds. The Investment Company Act of 1940 also designates certain registered investment company securities, like shares of open-end mutual funds, as covered securities.
Private Placements: Certain types of private placement offerings conducted under specific SEC exemptions, notably Rule 506 of Regulation D, are classified as covered securities. This means that companies raising capital privately under these rules are largely exempt from state blue sky registration requirements, though they must still file a "Form D" notice with the SEC⁹, ¹⁰, ¹¹. This facilitates capital raising for small and medium-sized businesses by reducing the multi-state compliance burden⁸.
Structured Products: Complex financial instruments, if they are listed on national exchanges or offered under certain federal exemptions, can also fall under the covered securities designation. This federal preemption ensures a consistent regulatory approach for these products across state lines.
Investment Advisers: While not directly securities, the NSMIA also redefined the regulatory authority over investment advisers, establishing federal registration for larger advisers and leaving state registration for smaller ones. This mirrors the dual-system streamlining applied to covered securities themselves.

The SEC's Regulation D provides a key framework for many private offerings that qualify as covered securities, streamlining the process for issuers seeking capital without the extensive requirements of a full public registration⁷.

Limitations and Criticisms

Despite the intended benefits of efficiency and reduced regulatory burden, the concept of covered securities and federal preemption is not without its limitations and criticisms.

One primary concern revolves around investor protection. Before NSMIA, state blue sky laws often included "merit review," where state regulators could assess the substantive fairness of an offering, not just the adequacy of disclosures⁶. The preemption of these state merit review powers for covered securities shifted the regulatory focus almost entirely to disclosure-based regulation at the federal level. Critics argue this might leave some investors, particularly those less sophisticated, vulnerable to offerings that are technically disclosed but may be inherently risky or unfair⁴, ⁵.

Additionally, while states cannot require full registration for covered securities, they can still mandate notice filings and collect fees. This has led to some debate regarding whether these "notice filings" still impose an undue burden on issuers, particularly smaller entities, without providing significant additional investor protection³. Some scholars argue that while federal preemption addressed some issues, the current system still presents challenges for small businesses seeking capital due to remaining complexities and costs associated with navigating state regulations, even if limited to notice filings and anti-fraud provisions¹, ². This ongoing tension between federal efficiency and state-level investor protection remains a point of discussion in securities regulation.

Covered Securities vs. Exempt Securities

The terms "covered securities" and "exempt securities" are often confused due to their shared characteristic of being free from certain registration requirements, but their basis for exemption differs significantly.

Covered Securities: These are securities that, by their nature or the manner of their offering, are primarily regulated at the federal level by the SEC. Their exemption from state registration is due to the federal preemption established by NSMIA. Examples include securities listed on national exchanges, certain mutual funds, and those offered under specific federal private placement rules like SEC Rule 506. The underlying principle is that federal oversight is deemed sufficient, rendering state registration redundant.
Exempt Securities: These securities are exempt from the federal registration requirements of the Securities Act of 1933 from the outset. Their exemption is based on the nature of the security itself or the type of transaction, deemed to either not need the full protection of federal registration or to be sufficiently regulated elsewhere. Examples include U.S. government bonds, municipal bonds, and commercial paper. While exempt federally, they may still be subject to state blue sky laws unless they also qualify as covered securities or are otherwise exempt under state law.

In essence, covered securities are generally subject to federal registration (or a federal exemption from registration that makes them covered), but are largely free from state registration. Exempt securities, conversely, are free from federal registration by default, and their state registration status depends on specific state laws.

FAQs

Q: Are all securities that are exempt from federal registration considered covered securities?
A: No. While some exempt securities, like those issued in certain federal private placements, can also be "covered," the terms are distinct. Covered securities are defined by federal preemption of state law, whereas exempt securities are defined by their exemption from federal registration requirements.

Q: Can states still investigate fraud related to covered securities?
A: Yes. The National Securities Markets Improvement Act of 1996 preserved the authority of state securities regulators to investigate and bring enforcement actions for fraud or deceit, even for covered securities. The preemption applies primarily to registration and qualification requirements, not anti-fraud provisions.

Q: What is the main benefit of a security being designated as "covered"?
A: The primary benefit is reduced regulatory burden for issuers. It streamlines the process of offering securities across multiple states by eliminating the need for separate, substantive blue sky laws registration processes in each state, thereby facilitating more efficient capital formation.

Q: Do covered securities still require any state-level filings?
A: In most cases, yes. While exempt from state registration, issuers of covered securities are often still required to make "notice filings" with state securities regulators and pay associated fees. These filings provide states with information about offerings within their jurisdiction.