Legal Definitions - merit regulation

Merit regulation refers to a specific approach used by state securities regulators, primarily under what are known as "blue-sky laws," to oversee investment offerings. Unlike regulations that only require companies to fully disclose all relevant information to potential investors, merit regulation goes a step further.

Under merit regulation, state authorities evaluate the fundamental fairness, justice, and equity of a securities offering itself. This means regulators don't just check if all facts are disclosed; they also assess whether the investment is inherently sound, reasonable, and not unduly risky or exploitative for the average investor. If an offering is deemed to have terms that are unfair, unjust, or too speculative, even if fully disclosed, a state with merit regulation can prevent or modify the offering to protect its residents.

• Example 1: Startup Stock Offering

  Imagine a new technology startup wants to sell shares to the public in a state that employs merit regulation. The company provides all required disclosures, including its business plan, financial projections, and the risks involved. However, during the regulatory review, state officials discover that the company's founders are retaining an overwhelmingly large percentage of voting rights for themselves while offering public investors shares with very limited influence. Furthermore, the price at which the public is asked to buy shares is significantly higher than the price paid by early investors, without a clear justification for the disparity.

  How it illustrates merit regulation: In this scenario, a merit regulation state might deem the offering "unfair" or "inequitable" to public investors, despite the full disclosure of these terms. The regulator could demand changes to the voting structure or the pricing before allowing the offering to proceed, focusing on the substantive fairness of the deal rather than just its transparency.

• Example 2: Real Estate Investment Fund

  Consider a company proposing to launch a new real estate investment fund, structured as a limited partnership, and offering units to investors in a merit regulation state. The company provides a comprehensive prospectus detailing the properties, management team, potential returns, and all associated fees. Upon review, the state regulator notes that the proposed management fees are exceptionally high, and the fund's profit-sharing agreement heavily favors the fund managers (the general partners) even if the fund's performance is mediocre, leaving a disproportionately small share for the limited partners (the investors).

  How it illustrates merit regulation: Here, the regulator isn't just confirming that the high fees and skewed profit-sharing are disclosed. Instead, they are evaluating the *merit* of these terms. They might conclude that the fee structure and profit distribution are "unjust" or "unreasonable" for investors and require the company to modify these terms to be more equitable before the fund can be offered for sale in that state.