FINRA Announces Effective Date of New Capital Acquisition Broker Rules

Adoption of CAB Rules

On October 17, FINRA published Regulatory Notice 16-37, announcing the adoption of the new Capital Acquisition Broker (CAB) rules, approved by the SEC on August 18 (Release No. 34-78617). CABs will be brokers with businesses limited to private placements and M&A transactions involving institutional investors, as defined in the FINRA rules, and qualified purchasers, as defined in Section 2(a)(51) of the Investment Company Act of 1940. They will also have other limitations on their activities, including a bar on participation in secondary sales. CABs will be registered with the SEC but subject to a reduced set of FINRA rules and compliance obligations. The CAB rules become effective on April 14, 2017; however, FINRA will accept applications for membership beginning January 3, 2017. Firms already registered as brokers may switch to a CAB membership beginning April 14 if they meet all of the conditions of the new CAB rules.

Following are answers to a few questions about CAB membership.

What is a CAB?

A capital acquisition broker is defined in CAB Rule 016(c) as a firm that is solely engaged in a limited range of activities, including advising companies on mergers and acquisitions, advising issuers on raising debt and equity capital in private placements with institutional investors, as well as acting as placement agent, and providing strategic and financial advisory services.

The definition does not include any broker or dealer that carries customer accounts or acts as an introducing broker with respect to customer accounts, holds or handles customers’ funds or securities, accepts orders from customers to purchase or sell securities either as principal or as agent for the customer (except as permitted in connection with its activities as a private placement agent or M&A broker), has investment discretion on behalf of any customer, engages in proprietary trading of securities or market-making activities, or participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A, or effects securities transactions that would require the broker or dealer to report the transaction under FINRA reporting rules.

A CAB may only act as placement agent in private offerings to institutional investors, which are defined in CAB Rule 016(i) to include:

• Any bank, savings and loan association, insurance company or registered investment company;
• Any governmental entity or subdivision of a governmental entity;
• Certain employee benefit, stock bonus or profit-sharing plans meeting the requirements of Section 403(b) or 457 of the Internal Revenue Code or Section 3(a)(12)(C) of the Exchange Act, and having at least 100 participants;
• Any other person (individual or entity) having total assets of at least $50 million; and
• Any “qualified purchaser” as defined in section 2(a)(51) of the Investment Company Act.

In reciting the elements of the definition of CAB in Regulatory Notice 16-37, FINRA bolded the word “solely,” in the phrase “solely engages in any one or more of the following activities.” In the absence of further guidance from FINRA, it would appear that a CAB may not engage in business activities unrelated to the securities business (for example, acting as an insurance agent or real estate agent), although such activities may be conducted out of an affiliated entity. It is reasonable to assume that a CAB may engage in the ordinary activities of a business acting on its own behalf, such as opening bank accounts, renting or owning its office space and entering into arrangements with various service providers. A CAB may, however, need to seek guidance from FINRA with respect to capital held in the form of securities, since one of the excluded activities is engaging in proprietary trading in securities. The distinction between trading and holding for investment will be key in this context.

Are there other limitations on the activities of a CAB?

There are three limitations that will significantly reduce the number of persons electing to register as CABs. The first, already mentioned, is the limitation that sales in private placements may only be made to institutional investors. While the inclusion of qualified purchasers in the definition of institutional investor will benefit brokers who act as placement agents for investment funds exempt from registration under Section 3(c)(7) of the Investment Company Act, there are other placement agents that market, or would like the flexibility to market, to accredited investors who do not qualify as institutional investors. Those placement agents will not be able to register as CABs.

The second limitation is that CABs may not act as brokers in secondary sales of securities, other than in connection with M&A transactions. Placement agents who market primary issuances of securities in private placements are in a good position to help holders of unregistered securities to find buyers for them. CABs will not be able to act as brokers in secondary sales by those holders. There is a question whether, given the limitation on private securities transactions discussed next, registered representatives of CABs would even be permitted to help holders of unregistered securities to find buyers as an accommodation, and without compensation.

The third limitation is the prohibition on private securities transactions as defined in FINRA Rule 3280(d): “any securities transaction outside the regular course or scope of an associated person’s employment with a member, including, but not limited to, new offerings of securities which are not registered with the SEC.” Excluded from the definition are securities transactions for the individual’s own account, transactions among immediate family members for which no associated person of a member receives selling compensation, and personal transactions in investment company and variable annuity securities. Associated persons of non-CAB FINRA members may engage in private securities transactions if they provide written notice to the member and, in the case of transactions for compensation, if the member approves the transaction, carries it on its books and records and supervises the associated person in connection with the transaction. An associated person of a CAB will not, however, be able to engage in private securities transactions by providing written notice to the CAB and obtaining approval, whether or not the person is compensated in connection with the transaction, because of the prohibition in CAB Rule 328. Absent further guidance from FINRA, an associated person of a CAB may need to avoid any involvement in facilitating a secondary trade in unregistered securities, even if not compensated.

This prohibition will also affect registered representatives and principals of CABs who act as investment advisers. FINRA Regulatory Notice 94-44 interprets “private securities transaction” to include the activities of associated persons of a broker who also act as investment advisers to the extent that they enter orders for securities trades with another broker or directly with a mutual fund or any other entity. Given the prohibition on private securities transactions in CAB Rule 328, individuals registered with a CAB will not be able to act as investment advisers to individuals or investment funds and place orders in securities. They may, however, provide investment advice without placing orders if they notify the CAB pursuant to CAB Rule 327 (Outside Business Activities of Registered Persons).

Are the compliance obligations of a CAB really reduced?

Good question. Many people who have been following the proposed and final rules think that the compliance obligations of CABs have not been reduced as much as they could be. FINRA has rightly pointed out, however, that it does not have the authority to alter or suspend SEC or FinCEN rules.

CABs will be subject to the FINRA By-Laws, some core FINRA rules and rules based on FINRA rules but tailored to address the business activities of CABs. Many of the eased compliance obligations of the CAB rules flow from the fact that CABs will be dealing solely with institutional customers. For example, the specific suitability determination requirement of CAB Rule 211 is akin to the suitability requirement applicable to recommendations to institutional investors in FINRA Rule 2111, but also applies to recommendations to qualified purchasers, which are not considered institutional investors under FINRA Rule 2111 unless they otherwise qualify.

The provisions of CAB Rule 221 (Communications with the Public) are substantially reduced from the requirements of FINRA Rule 2210 on communications with the public. CAB Rule 221 contains content standards only; there is no distinction among retail communications, institutional communications and correspondence, and there is no requirement to file advertising or sales literature with FINRA. The content standards of CAB Rule 221 generally require communications to be fair and accurate, and do not, among other things, permit communications to “imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast.” Significantly, CAB Rule 221 does not prohibit communications that predict or project performance, as FINRA Rule 2210 does. Institutional investors often expect forecasts and projections in offering material. While issuers and their investment advisers could provide forecasts and projections in offering materials, FINRA members are not able to present such information in their own communications. CABs will be able to do so.

CABs will have some reduced supervisory requirements. They will not be required to conduct annual meetings with each registered representative (as required by FINRA Rule 3110(a)(7)) or conduct internal inspections of their businesses, offices of supervisory jurisdiction and branch offices (FINRA Rule 3110(c)), and will need to provide for independent testing for AML compliance every two years, instead of every year (CAB Rule 331(c)).

How do I register as a CAB?

A non-member firm that wishes to become a CAB generally must follow the same registration and application procedures as any other broker-dealer applicant, by filing a Form BD with the SEC and a New Member Application Form (Form NMA) with FINRA. Form NMA requests various types of information and documentation, some of which are required of all applicants (e.g., business plan, business continuity plan, first year financials, information about supervisory principal qualifications) and some of which depend on the businesses that the broker will conduct. The Form NMA requirements for CABs will likely be more uniform, due to the limited nature of a CAB’s business activities. In its Form NMA, the CAB will be asked to indicate its intent to operate solely as a CAB pursuant to the CAB rules.

The CAB rules do not change the time frame for review of NMAs in NASD Rule 1014, which can extend up to six months after filing of the application. However, FINRA has recently been approving some NMAs for FINRA members on a fast-track time schedule, and may be able to review and approve CAB applications more efficiently as time goes on.

The CAB rules do not affect the need for CABs to be registered with the SEC and every state in which they do business, unless a state exemption is available. Many states have exemptions from registration for persons that do not have a place of business in the state and who engage in transactions exclusively with institutional investors. It should be noted that the list of persons who qualify as institutional investors varies from state to state.

If I’m already registered as a broker but can meet all the conditions of a CAB, how do I change my membership status to become a CAB?

A FINRA member firm will be able to convert to CAB membership status if the firm is already approved to engage in the activities that a CAB may engage in. The firm must file a request to amend its membership agreement or obtain a membership agreement, if none currently exists. In the membership agreement, the firm must represent that its activities will be limited to those permitted for CABs and that it agrees to comply with the CAB rules. There is no application fee associated with this request. The firm will also be required to amend its Form BD to reflect that it is now a CAB.

A member firm that is not already approved to engage in CAB activities, or that intends to change its ownership, control or business operations as described in NASD Rule 1017(a), must file a continuing membership application (CMA) in order to elect CAB status. There is a fee for filing a CMA and it is subject to review by FINRA.

What if I change my status to become a CAB but realize that I’ve made a mistake?

Good news: it is easy to change your mind within one year. FINRA has established streamlined procedures under CAB Rule 116(d) to permit a FINRA member that has converted to CAB status to return to its former status within a year. The firm must notify FINRA, but does not need to file a CMA for approval of a material change in business operations under NASD Rule 1017. The CAB need only file a request to amend its membership agreement in order to effect this change. In its membership agreement, the firm must agree that it will comply with all FINRA rules, and the membership agreement must impose the same limitations on the firm’s activities that existed before the firm converted to CAB status. The firm also would need to amend its Form BD to reflect that it no longer intends to operate as a CAB.

Beyond the one-year period following conversion to CAB status, in order for a CAB to return to the status of a full FINRA member broker-dealer, it must file a CMA with FINRA and execute an amended membership agreement to provide that it will comply with all FINRA rules.

Who should register as a CAB?

CAB membership may be an attractive option for small firms that limit their activities to private placements and M&A transactions. This would include persons who have previously been acting as unregistered finders or conducting business as M&A brokers under the SEC’s M&A Brokers no-action letter of January 31, 2014. SEC staff members have indicated informally that there may be more enforcement activity against unregistered finders after the CAB rules go into effect, since there will be a somewhat less burdensome registration available to them. The M&A Brokers no-action letter is currently still in effect, so persons who act exclusively as M&A brokers in accordance with the conditions of that letter may continue to conduct business without registration.

Managers and advisers to investment funds may also wish to consider establishing an affiliated CAB to house the sales personnel who market their fund interests. The safe harbor for associated persons of an issuer provided by SEC Rule 3a4-1, and the principles underlying it, continue to apply to the employees of managers and advisers to investment funds who, among other things, have substantial other duties besides marketing and are not paid special compensation for sales efforts. However, permitting employees to register with an affiliated CAB would provide more flexibility to pay sales compensation to those employees, and allow them to spend a greater percentage of their time in marketing activities.

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If you are considering registering as a CAB or have questions about the information in this client alert, please contact the author, Peter LaVigne, or the Goodwin attorney with whom you typically consult.