SEC Proposes Federal Preemption of State Merit Review for Nontraded REITs and BDCs
The U.S. Securities and Exchange Commission has proposed treating all securities sold in SEC-registered offerings as “covered securities” under Section 18 of the Securities Act of 1933, a change that would eliminate state-by-state merit review for nontraded real estate investment trusts, nontraded business development companies, and similar publicly registered programs.
The SEC described the proposal as the most significant modernization of the registered offering framework in more than 20 years.
The proposal, if adopted, would extend to nontraded REITs and BDCs the same federal preemption that Congress granted to exchange-listed securities and registered investment companies under the National Securities Markets Improvement Act of 1996. Nontraded REITs and BDCs were not included in that legislation — in part because they were a small and nascent corner of the market at the time. Today these issuers file the same kind of SEC-registered prospectus that Apple, Microsoft, and every mutual fund family file, while also clearing merit review in at least 34 states.
Anya Coverman, president and chief executive officer of the Institute for Portfolio Alternatives, said the commission is moving to “close the last gap in federal preemption that has forced publicly registered, federally regulated offerings to navigate a patchwork of state-level review.”
Currently, state merit review allows state securities regulators to block or condition the sale of securities within their borders based on their assessment of whether an offering is “fair, just, or equitable” — a standard that substitutes the regulator’s judgment for the investor’s. The Massachusetts Securities Division’s 1980 decision to block the sale of Apple’s IPO is the most frequently cited example of that authority in practice.
“Federal securities regulation rests on disclosure and ensures that investors who receive full, fair, and complete information about a public offering should be free to make their own decision,” Coverman added.
What Changes for Alternative Investment Issuers
For sponsors of nontraded REITs and BDCs, the practical consequences of preemption would be significant. Issuers currently must clear merit review in each state where they intend to sell, a process that adds cost and time to offerings and imposes state-specific conditions — on fees, leverage, conflicts of interest, and other terms — that vary by jurisdiction. Those costs have historically been passed to retail investors in the form of higher offering expenses, at least theoretically.
Federal preemption would also remove state-level barriers to distribution through self-directed brokerage accounts at custodians such as Schwab and Fidelity, where state approval requirements have complicated or prevented access for retail investors. Comparable federally regulated offerings — mutual funds, exchange-traded funds, and listed REITs — do not face equivalent restrictions.
“The state preemption provision in the registered offering reform proposal is directly relevant to our members, and frankly, the dual-review burden on registered nontraded REITs and BDCs has been a long-standing friction point for sponsors and distributors alike,” said Jade Miller, chief executive officer for the Alternative & Direct Investment Securities Association, known as ADISA.
The proposal would not affect state authority over anti-fraud enforcement or notice-filing requirements. States would retain full power to pursue fraud claims and require issuers to file notices of sale within their borders — the change is limited to merit-based approval authority.
The alternatives industry has grown substantially since 1996. Nontraded REITs and BDCs today file detailed SEC-registered prospectuses subject to full SEC review. Industry trade groups, including IPA, have argued that the continued application of state merit review to these products represents a regulatory asymmetry that no longer reflects the maturity of the category or the federal oversight already in place.
The SEC’s registered offering proposal is one of two rulemakings the commission advanced Tuesday. The second would extend disclosure accommodations and reporting deadlines currently available to smaller and emerging public companies to approximately 81% of all current public companies, and would raise the threshold for large, accelerated filer status from $700 million to $2 billion in public float.
Securities and Exchange Commission Chair Paul S. Atkins said in a statement that the proposals “serve as the foundation for my agenda to Make IPOs Great Again” and are “among the first important steps toward transforming the SEC’s regulatory framework for public companies.”
The public comment period for both proposals will remain open for 60 days following publication in the Federal Register.
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