In Regulatory Notice 23-09, FINRA provides an update on actions it currently has under way to promote capital formation and the capital-raising process. FINRA also requests comment regarding whether there are other changes to FINRA rules, operations, or administrative processes that would similarly improve capital formation. The request for comment is general in nature, inviting observations on five topics, described below. Of particular interest to fund managers and placement agents who sell fund interests are proposed changes to the prohibition in Rule 2210 on the use of forecasts and projections in sales material.
Actions Currently Under Way
FINRA lists several rule amendments it is working on:
- Capital Acquisition Broker (CAB) Rules — FINRA proposed amendments to the CAB rules in response to comments from members on Regulatory Notice 20-04, which would:
- allow CABs to register as investment advisers provided that the firm’s advisory clients are solely institutional investors.
- broaden the definition of institutional investor to include “knowledgeable employees.”
- permit CABs to act as intermediaries in connection with a secondary transaction involving unregistered securities, provided the transaction is not considered a distribution of securities under the Securities Act of 1933, and both the seller and the purchaser are institutional investors as defined by the CAB rules. We have requested this change in several meetings with FINRA staff. In the fund context, a CAB acting as placement agent is likely to be in the best position to find a buyer for an interest holder who wants to sell, something not currently permitted by the rules.
- codify a staff interpretation that CABs may be compensated in the form of securities issued by a privately held CAB client under certain conditions.
- confirm that associated persons of CABs may invest in unregistered securities, provided that the associated person reports such investments to his or her employer CAB firm. Under FINRA Rule 3280, applicable to regular member brokers, an associated person is not permitted to engage in a private securities transaction (PST) without permission from the broker. A PST includes a transaction in which an associated person purchases securities in a private offering for his or her own account. Under CAB rules, currently, associated persons of a CAB are strictly prohibited from engaging in PSTs regardless of whether they obtain supervisory approval. This is a long-overdue and much-appreciated change.
- Proposed Amendments to FINRA Rule 2210 (Communications with the Public) Regarding Performance Projections — For many years, placement agents have asked FINRA to confirm that certain projections or estimates of performance can appear in the marketing materials they distribute, particularly with respect to institutional communications. The SEC’s December 2020 marketing rules for registered investment advisers permit them to use key projections and estimates in their marketing materials. FINRA has not confirmed, however, that Rule 2210 permits placement agents to distribute materials containing identical information. This has forced many advisers to create special versions of their marketing materials for FINRA members and, in some cases, put placement agents and their affiliates at a competitive disadvantage. FINRA describes its contemplated amendments as intended to help “improve the flow of information, which would help enhance capital formation.” This may indicate that some relief for placement agents is finally on the horizon. That said, it remains unclear when FINRA will issue its proposal and whether the proposal will still conflict with the SEC rules applicable to advisers.
- Regulation A and FINRA Rule 5110 — FINRA published Reg. Notice 15-32 (FINRA Filing Requirements and Review of Regulation A Offerings) and regularly updates the Regulation A Frequently Asked Questions section on its Public Offerings page. However, FINRA states that it would like to better understand, through comments received in response to this Notice and a series of planned roundtable discussions, whether additional guidance or changes could help improve the Regulation A filing process. We anticipate that this topic will yield considerable attention from the increased number of issuers who rely on Regulation A as a result of the SEC’s amendments to the regulation in 2015 and 2020.
- Fixed Income Roundtables — FINRA is considering feedback received from minority, women, disabled, and veteran-owned firms in the securities industry during the Municipal Securities Rulemaking Board/FINRA Partnership Roundtables regarding economic obstacles, regulatory challenges, and potential remedies.
Open Request for Comment on Capital Formation Rules
FINRA has also requested comment more generally in five areas in order to better understand where additional rulemaking or guidance may be helpful:
- Whether there are any FINRA rules, operations or administrative processes that should be updated or amended to better facilitate capital raising in a manner that preserves investor protection.
- Whether FINRA’s rules covering the capital-raising process have effectively responded to the problem(s) they were intended to address.
- The economic impacts arising from FINRA’s rules on the capital-raising process, including the degree to which they differ by business attributes (e.g., size of the broker-dealer, differences in business models) and related quantitative information.
- Whether specific FINRA rules related to the capital-raising process are particularly effective, and whether there are any other rules or applications where a similar approach might be taken to enhance capital formation.
- Whether members have experienced any unintended consequences as a result of FINRA’s rules related to the capital-raising process (e.g., changes in business models and practices).
One area calling for comment in response to at least two of the requests above involves the obligation of fund managers to obtain questionnaires from investors in order to satisfy the requirements applicable to investment banks under Rules 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings) and 5131 (New Issue Allocations and Distributions). Since investment funds are “accounts” of their beneficial owners, investment banks may not sell to investment funds if more than a de minimis amount of interest is held by restricted persons under Rule 5130 or covered persons under Rule 5131. This creates an obligation of fund managers to obtain information from fund investors, which may themselves be investment funds. This imposes a substantial unnecessary cost on persons who are not regulated by FINRA, solely so that they can invest in “new issues” (generally, securities sold in initial public offerings). Investment banks should be permitted to rely on information provided by fund managers on knowledge and belief, taking into account circumstances where the likelihood of ownership by restricted and covered persons is low. Commenters could provide suggestions concerning, for example, what information gathering and analysis standards could apply in lieu of the current use of questionnaires.
We would be happy to answer questions about any of the regulatory proposals discussed in this Notice and to assist in preparing comment letters on the proposals or on other ways FINRA rules relating to capital formation may be improved.