California’s blue sky laws, codified in the Corporate Securities Law of 1968, require every offer or sale of a security in the state to be qualified with the Department of Financial Protection and Innovation (DFPI) unless the security or the transaction falls into a specific exemption or is preempted by federal law.1California Department of Financial Protection and Innovation. About the Corporate Securities Law of 1968 Willful fraud can bring fines up to $10 million and five years in prison, and defrauded investors can sue to rescind the deal or recover damages.
What the Law Requires
The default rule is simple. If you want to offer or sell a security in California, you either qualify it with the DFPI or you fit an exemption. There is no third option.
What sets California apart from the federal Securities Act of 1933 is how the regulator reviews qualification applications. Federal law works on disclosure: if the issuer tells investors enough about the risks, the SEC generally stays out of whether the deal is a good one. California uses merit review. The DFPI can deny or suspend qualification if it finds the offering is “not fair, just, or equitable,” the issuer doesn’t intend to run the business honestly, or the securities would work a fraud on buyers.2California Legislative Information. California Corporations Code 25140 Complete disclosure isn’t enough on its own; the DFPI can still reject a deal it considers unfair to investors.
Alongside the qualification rules, California’s anti-fraud provision bars any offer or sale of a security made through a communication that contains a material misstatement or leaves out a material fact.3California Legislative Information. California Code CORP 25401 That rule reaches written and spoken communications and applies whether or not the security itself needed to be qualified.
Securities That Bypass California Qualification: Federal Preemption
The National Securities Markets Improvement Act of 1996 (NSMIA) bars states from imposing their own registration or qualification requirements on “covered securities.”4Office of the Law Revision Counsel. 15 U.S. Code 77r – Exemption From State Regulation of Securities If a security is covered, California cannot subject it to merit review. The DFPI still keeps authority to investigate and prosecute fraud, and the state can still require a notice filing and a fee.
The most common categories of covered securities:
- Stocks listed or authorized for listing on the New York Stock Exchange, the Nasdaq Global Select Market, or other exchanges with comparable listing standards designated by the SEC.
- Shares issued by mutual funds and other investment companies registered under the federal Investment Company Act of 1940.
- Securities sold under Rule 506 of Regulation D, the most widely used federal private placement exemption.
- Offerings limited to buyers who meet the SEC’s “qualified purchaser” criteria.
Regulation Crowdfunding offerings under SEC rules also benefit from federal preemption. An issuer can raise up to $5 million in a rolling 12-month period through Reg CF, subject to California’s notice-filing and anti-fraud rules.
California’s Own Exemptions
Even when a security is not federally preempted, California exempts a range of securities and transactions from qualification. Government-issued securities such as U.S. Treasury bonds and municipal bonds are exempt because they’re backed by the issuing government’s taxing authority. Securities issued by banks, savings and loan associations, credit unions, and insurance companies regulated under state or federal law are also outside the qualification requirement.
Nonprofits get their own exemption under Section 25100(j). It covers securities issued by organizations formed exclusively for educational, charitable, religious, fraternal, or similar purposes, so long as none of the organization’s net earnings benefits any private individual. The exemption disappears if a promoter expects to profit from a business associated with the nonprofit’s operations.5California Legislative Information. California Corporations Code 25100
The Section 25102(f) Private Placement Exemption
This is the exemption most startups and early-stage companies use. Under Section 25102(f), an issuer can sell securities without qualification if the sales go to no more than 35 people total, including buyers outside California.6California Department of Financial Protection and Innovation. California Corporations Code Section 25102(f) Every buyer must either have a pre-existing personal or business relationship with the issuer or its officers, or have enough financial sophistication to evaluate the investment on their own.
Two things regularly trip issuers up. The 35-person cap counts all purchasers, not just those in California. And the issuer must file a Limited Offering Exemption Notice (LOEN) with the DFPI within 15 calendar days after the first sale of a security in California.7California Department of Financial Protection and Innovation. Securities – Frequently Asked Questions and Answers Missing the deadline doesn’t void the exemption, but the DFPI can demand the notice and charge a fee equal to what full qualification would have cost.
How to Qualify a Security
When a security is neither exempt nor preempted, the issuer must qualify it with the DFPI before making any offer or sale in California.8California Department of Financial Protection and Innovation. California Corporations Code Section 25110 – Issuer Transactions There are three routes.
Qualification by coordination is the fastest for issuers already registering federally. The issuer files a copy of its SEC registration statement with the DFPI within five business days of the federal filing. Qualification takes effect the moment the federal registration becomes effective, provided no DFPI stop order is pending and the application has been on file for at least 10 days.9California Legislative Information. California Corporations Code 25111
Qualification by notification is open to issuers that already have a class of securities registered under the Securities Exchange Act of 1934, or to investment companies registered under the federal Investment Company Act. Qualification becomes effective automatically at noon on the 10th business day after filing unless the DFPI intervenes.10California Legislative Information. California Corporations Code 25112
Qualification by permit is the broadest and most involved method, available for any security. The DFPI applies the merit standard and will refuse a permit unless it finds the business plan and proposed issuance fair and equitable and the securities not fraudulent. Small companies meeting certain criteria can use a streamlined application if the offering stays within $1 million over 12 months.11California Legislative Information. California Code CORP 25113
Who Else Has to Register
The law reaches beyond issuers. Broker-dealers must register with both the SEC and the DFPI, and their individual agents must pass FINRA qualification exams before conducting securities transactions in California.12Financial Industry Regulatory Authority. Series 7 – General Securities Representative Exam13Financial Industry Regulatory Authority. Series 63 – Uniform Securities Agent State Law Exam
Investment advisers split between state and federal registration based on assets under management. Firms managing less than $100 million generally register with the DFPI. At $100 million, a firm becomes eligible for SEC registration, and above $110 million SEC registration becomes mandatory.14California Department of Financial Protection and Innovation. State Licensed Investment Adviser A federally registered adviser whose AUM drops below $90 million has 180 days to move down to state registration.
What Happens for a Violation
DFPI Enforcement
The DFPI can go to superior court to seek an injunction, appoint a receiver over the violator’s assets, and obtain restitution or disgorgement for injured investors. It can assess civil penalties of up to $25,000 per violation through an action brought in the name of the people of California.15California Legislative Information. California Code CORP 25535 It can also issue stop orders halting a pending qualification, effectively killing an offering before it reaches investors.2California Legislative Information. California Corporations Code 25140 Serious cases can be referred to the California Attorney General or local prosecutors.
Criminal Penalties
Criminal liability under Corporations Code Section 25540 requires a willful violation and splits into tiers based on what was violated:
- Willfully violating any provision of the Corporate Securities Law or any DFPI rule or order: fines up to $1 million, imprisonment up to one year in county jail (or state prison under Penal Code Section 1170(h)), or both.16California Legislative Information. California Corporations Code 25540
- Willfully violating Sections 25400, 25401, or 25402 (fraud, market manipulation, or insider trading): fines up to $10 million and imprisonment for two, three, or five years.16California Legislative Information. California Corporations Code 25540
- An issuer as defined in the Sarbanes-Oxley Act that willfully commits fraud: fines up to $25 million and imprisonment for two, three, or five years.16California Legislative Information. California Corporations Code 25540
Private Lawsuits by Investors
Investors who buy through misleading communications don’t have to wait for the DFPI. Section 25501 gives them a private right of action and a choice of remedy.17California Legislative Information. California Corporations Code 25501 Rescission unwinds the transaction: the investor returns the security and recovers the purchase price plus interest at the legal rate, minus any income received on the security while holding it. Damages, available when the investor has already sold, equal the difference between the purchase price plus interest and the value of the security at disposal, again accounting for income received.
The seller has two defenses: proving the buyer actually knew about the misstatement or omission, or proving the seller exercised reasonable care and neither knew nor could have known about the problem with reasonable care.17California Legislative Information. California Corporations Code 25501 Liability can extend beyond the issuer to broker-dealers, corporate officers, and others involved in the transaction.
Deadlines matter. An investor must file suit within five years of the act constituting the violation or within two years of discovering it, whichever expires first.18California Legislative Information. California Corporations Code 25506 The outer five-year cap is absolute. An investor who discovers a fraud six years after the sale has no remedy under Section 25501, no matter when the truth came to light.