February 28, 2024

FINRA Proposes to Add ‘Knowledgeable Employees’ to Category of Persons Who May Receive Projections and Targeted Returns Under Rule 2210

This amendment builds on FINRA’s recent willingness to relax the prohibition on the use of projections and targeted returns in the marketing materials broker-dealers deliver to institutional investors and qualified purchasers, but the amendment does not otherwise expand the exception for use with retail investors generally. The accompanying response to comments also provides useful clarification on the presentation of IRR on unrealized properties if the proposal is adopted. 

In December 2023, we wrote that the Financial Industry Regulatory Authority (FINRA) had filed with the Securities Exchange Commission (SEC)  a proposed amendment to FINRA Rule 2210, Communications with the Public. The amendment would permit FINRA members, subject to certain conditions, to project performance of or provide targeted returns for a security, asset allocation, or other investment strategy in (1) an institutional communication or (2) a communication to qualified purchasers — as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940 — that promotes or recommends an investment in certain types of nonpublic offerings exempt from FINRA Rules 5122 and 5123 (qualified private offerings).

FINRA has now filed Partial Amendment No. 1, adding “knowledgeable employees,” as defined in SEC Rule 3c-5 under the Investment Company Act, to the category of persons who may be given projected performance or target returns in materials that promote or recommend an investment in qualified private offerings. FINRA also filed a response to comments on the original proposal.

The addition of knowledgeable employees to the proposal is not a surprising development and is likely the correction of a prior oversight. Qualified purchasers are investors who are qualified, by the amount of investments they own, to purchase interests in funds exempt under Section 3(c)(7) from registration as an investment company. Rule 3c-5 permits knowledgeable employees of 3(c)(7) funds to purchase interests in the funds with which they are associated, even if they do not meet the requirements to be a qualified purchaser. Knowledgeable employees include officers, directors, trustees, general partners and advisory board members of the fund or certain of its affiliates, and other employees who participate in the investment activities of the fund or affiliates. FINRA noted that knowledgeable employees typically have sufficient knowledge of the operations of the private funds with which they are associated and that they are “less likely not to understand the risks and limitations of projections or targeted returns associated with such funds.” We would also point out that it is less likely that knowledgeable employees will rely on information from sales material provided by placement agents in deciding whether to purchase. At the same time, it would be awkward to prohibit placement agents from letting knowledgeable employees see such material, because knowledgeable employees will surely be involved in both creating and reviewing it.    

Response to Comments

FINRA’s letter responding to comments on the original proposal contains some useful clarifications, along with further explanations for its decision not to expand the rule in other ways requested by commenters. Here are a few highlights:

  • Use of Internal Rates of Return (IRR). Fund managers and placement agents want to present, and institutional investors want to see, IRR information on the performance of portfolio assets. FINRA permits IRR on realized performance (i.e., an asset that has been sold at a known price); however, it considers IRR on unrealized performance to be a projection because the disposition price of the asset is projected. In Regulatory Notice 20-21, FINRA permitted IRR on unrealized performance to be used if it had been calculated in a manner consistent with the Global Investment Performance Standards (GIPS). Those standards require uniform methodology and prominent disclosure of the additional metrics required by GIPS. In response to comments, FINRA stated that in communications to institutional investors, qualified purchasers, and knowledgeable employees, the proposed rule change would permit the use of IRR for new private funds and for unrealized holdings within a fund without the requirement that the information be compliant with GIPS. The guidance in Regulatory Notice 20-21, including the need for compliance with GIPS, would continue to apply to communications with retail investors ineligible to receive projections under the amended rule.
  • Extension to Other Retail Investors. Other than the inclusion of knowledgeable employees in the category of investors who may receive projected performance and targeted returns in communications about qualified private funds, FINRA declined to further expand the rule to cover communications with other retail investors, such as accredited investors.
  • Reasonable-Basis Requirement. Commenters asked whether members would be required to make an independent determination that they have a reasonable basis for the projected performance or targeted returns used in sales material if the material was prepared by the issuer or fund manager. FINRA reiterated that members must do their own due diligence and make a reasonable-basis determination, noting that “members have flexibility to determine what is reasonable based upon the particular facts and circumstances.”  
  • Written Policies and Procedures. The proposed exception for the use of projections and targeted returns with institutional investors and, with respect to investments in qualified private funds, qualified purchasers, would require the member to adopt and implement written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication. Written policies and procedures must also ensure compliance with all applicable requirements and obligations. Commenters noted that member firms have an independent obligation under Regulation Best Interest and the FINRA suitability rule to ensure that recommendations are suitable for the investor receiving them. In addition, commenters asked whether firms would be required to determine if projections and targeted returns are relevant to the financial situation and investment objectives of each person receiving the information, and they asked if there could be situations in which the information could be provided only to some qualified purchasers and not to others. FINRA responded that it continues to believe firms should have policies and procedures on this point but noted that by using the word “likely” in the phrase “likely financial situation and investment objectives of the investor receiving the communication,” it intended to indicate that a member “is not required to know the actual financial situation or investment objectives of each investor that receives the communication.” Members would be permitted to comply with this condition by grouping investors into categories or types.   

Comments are due on the proposed rule, as amended by Amendment No. 1, 21 days after publication in the Federal Register.