Alert June 18, 2014

SEC Approval of Amendments to FINRA Corporate Financing Rules Will Reduce Burdens on Parties in Public Offerings


The SEC recently approved amendments to simplify and refine the scope of FINRA corporate financing and underwriter conflicts of interest rules. The amendments include modifications that will affect not only underwriters and issuers in public offerings, but investment banks acting as independent financial advisors to issuers, and investment funds and other investors that are significant stockholders in public companies.

The Securities and Exchange Commission (SEC) recently approved two proposals by the Financial Industry Regulatory Authority, Inc. (FINRA) to amend FINRA Rules 5110 (the Corporate Financing Rule) and 5121 (the Conflicts of Interest Rule). The amendments include modifications that will affect not only underwriters and issuers in public offerings, but investment banks acting as independent financial advisors to issuers, and investment funds and other investors that are significant stockholders in public companies.

The amendments modify the rules as follows:

  1. The Corporate Financing Rule definition of “participation or participating in a public offering” now excludes the activities of any FINRA member that acts exclusively as an “independent financial adviser”[1];
  2. The Corporate Financing Rule no longer requires disclosure of affiliations of officers, directors and beneficial owners of 5% the issuer’s securities with FINRA members that are not “participating” in the subject public offering;
  3. Engagement letters in connection with the public offering can now provide for participating FINRA members to receive termination fees or rights of first refusal (RoFRs) if the FINRA member is terminated before the public offering is completed, as long as those termination fees or RoFRs are subject to certain conditions, including the right of the company to terminate the FINRA member for cause, ending the FINRA member’s right to termination fees[2];
  4. The definition of “control” under the Conflicts of Interest Rule no longer includes beneficial ownership of 10 % or more of the outstanding subordinated debt of an entity[3];
  5. Shares that a FINRA member or its affiliate acquires from “acquisitions and conversions to prevent dilution,” which were already excluded from underwriter compensation, are now also exempt from the lock-up restrictions of the Corporate Financing Rule;
  6. The Corporate Financing Rule no longer requires filings with the FINRA Corporate Financing Department for certain exchange-traded funds (ETFs)[4].


The Corporate Financing Rule generally regulates underwriting compensation and prohibits unfair arrangements in connection with the public offering of securities. Among other provisions, Rule 5110 requires FINRA members to file with FINRA information about the securities offerings in which they participate and to disclose affiliations and other relationships that may indicate a conflict of interest.

Under the Conflicts of Interest Rule, the definition of “control” is considered in determining whether a FINRA member and an issuer are “affiliates” for purposes of both the conflicts of interest provisions of Rule 5121 and the informational and other requirements of Rule 5110.[5]

Summary of Key Changes

1.     Independent financial advisors and participation in a public offering. Rule 5110(a)(5) previously defined “participation in a public offering” to include participation in “any advisory or consulting capacity to the issuer related to the offering.”  Under the amended Rule, an “independent financial adviser” that only provides advisory or consulting services to an issuer would not be “participating in a public offering” as defined in Rule 5110(a)(5) and therefore would not be subject to the compensation limitations set forth in the Rule. As examples of advisory or consulting services, FINRA’s rule proposal noted that financial advisors may consult issuers regarding such matters as the options for financing that may be available to the issuer, the benefits and disadvantages of a public offering and the terms proposed by underwriters.[6]

However, the amendment specifically provides that if the independent financial adviser providing consulting services to an issuer is also engaged in the solicitation or distribution of the offering, or is affiliated with any entity that is engaged in the solicitation or distribution of the offering, all of the compensation received by that FINRA member, whether advisory-related or distribution-related, would be subject to the compensation limitations of Rule 5110.[7]

2.     Information requirements. Rule 5110(b)(6)(A)(iii) previously required filers to disclose to FINRA information about affiliations or associations between the officers, directors, and certain owners of the issuer and any FINRA member. As a companion to the change in the definition of “participation in a public offering,” the amendment narrows the scope of Rule 5110(b)(6)(A)(iii) to require disclosure only about the affiliation or association of the specified parties with “any participating member.”

3.     Termination fees and rights of first refusal. Under Rule 5110(f)(2), termination fees in the event of a failed offering were deemed unfair and unreasonable, and were prohibited except in limited circumstances.[8] Similarly, RoFRs were allowed only if an offering was successful.[9] FINRA has amended Rule 5110(f)(2) to allow terminations fees and RoFRs as long as the following conditions are met:

(a)    the agreement specifies that the issuer has a right of “termination for cause,” which shall include the participating FINRA member’s material failure to provide the underwriting services contemplated in the written agreement;

(b)    the issuer’s exercise of its right of “termination for cause” eliminates any obligations with respect to the payment of any termination fee or provision of any RoFR;

(c)    the amount of any specified termination fee must be reasonable in relation to the underwriting services contemplated in the agreement, and any fees arising from underwriting services provided under a RoFR must be customary for those types of services;

(d)    (for termination fees only): the issuer must not be responsible for paying the termination fee unless an offering or other type of transaction (as set forth in the agreement) is consummated within two years of the date the engagement is terminated by the issuer; and

(e)    (for RoFRs only): Rule 5110(f)(2)(E) continues to provide that the duration of any RoFR must not be in excess of three years from (i) the date of commencement of sales in the public offering or (ii) the date the issuer terminates the engagement. In either case, the agreement may not provide for more than one opportunity to waive or terminate the RoFR in consideration of any payment or fee.

Goodwin Procter LLP can assist investment banks in incorporating termination provisions and rights of first refusal into engagement letters in a way that will conform to the conditions of amended Rule 5110.

4.     Definition of “control.” Under Rule 5121, the definition of “control” is integral to determining whether a FINRA member and an issuer are deemed to be affiliated for purposes of the conflicts provisions of Rule 5121 and for provisions of Rule 5110 where references to affiliation are made. Amended Rule 5121 narrows the scope of the definition of “control” by deleting, from the list of factors in Rule 5121(f)(6) constituting control: “beneficial ownership of 10 % or more of the outstanding subordinated debt of an entity, including any right to receive such subordinated debt within 60 days of the FINRA member’s participation in the public offering.”  As a result, it will no longer be necessary for questionnaires to underwriters on FINRA matters to ask whether the underwriter or its affiliates own 10% or more of the subordinated debt of the issuer.

5.     Lock-up restrictions. Rule 5110(g)(1) imposes a lock-up restriction that generally prohibits any underwriter and related person from selling or otherwise transferring any unregistered equity securities of an issuer acquired during the 180-day period prior to the filing of the registration statement, or acquired after the required filing date of the registration statement. This prohibition extended to securities that FINRA excluded from underwriting compensation under subparagraphs (A)-(E) of Rule 5110(d)(5), including subparagraph (D), which excludes additional securities received in acquisitions and conversions by a FINRA member or an affiliate of the member to “prevent dilution” of the security holder’s investment as the result of (a) preemptive rights, (b) stock-splits or a pro-rata rights or similar offering, or (c) conversions of securities that have not been deemed by FINRA to be underwriting compensation.

For example, if a participating FINRA member or its affiliate (which might be an investment fund operated by the member or its affiliate) owns convertible preferred stock of the issuer and that stock is intended to be converted to common stock prior to the issuer's initial public offering, that common stock is not treated as underwriting compensation, despite being issued (as a result of the conversion) after the date that is 180 days before the initial filing of the offering with FINRA, because of the exclusion provided by Rule 5110(d)(5)(D). However, prior to the amendment, the shares would still be subject to the lock-up restrictions of Rule 5110(g), unless the holder was able to obtain a discretionary exemption from FINRA.

Amended Rule 5110(g)(1) eliminates the lock-up restrictions for securities excluded from underwriter compensation under Rule 5110(d)(5)(D), and allows shares received in an acquisition or conversion to prevent dilution to be treated in a manner consistent with the treatment provided for the securities on which their acquisition or conversion was based. Note that the other types of securities excluded from underwriting compensation under Rule 5110(d)(5)(A), (B), (C) and (E) remain subject to the lock-up restrictions of 5110(g)(1).

6.     Filing requirements for certain exchange-traded funds. Rule 5110(b)(8) (Exempt Offerings) generally provides an exemption for investment companies from all of the requirements of the Rule. ETFs whose assets are securities typically register as investment companies and qualify for the Rule 5110(b)(8) exemption. However, some ETFs that have assets other than securities (e.g., gold or other commodities) do not register as investment companies and did not qualify for the exemption. The newly approved amendments add an exemption for ETFs that are not included in the definition of an “investment company.” Specifically, the amended rule exempts offerings of securities issued by a pooled investment vehicle, whether formed as a trust, partnership, corporation, limited liability company or other collective investment vehicle, that is not registered as an investment company under the Investment Company Act and has a class of equity securities listed for trading on a national securities exchange, provided that such equity securities may be created or redeemed on any business day at the net asset value per share.



[1] Revised Rule 5110(a)(5)(B).

[2] Revised Rule 5110(f)(2)(D).

[3] Revised Rule 5121(f)(5).

[4] Revised Rule 5110(b)(7)(H).

[5] April 28 Order at p.4.

[6] Proposed Rule Change to Amend FINRA’s Corporate Financing Rules to Simplify and Refine the Scope of the Rules, Jan 9, 2014 (the “Simplification Proposal”)at p.5.

[7] Simplification Proposal at p.17.

[8] Proposed Rule Change Relating to Amendments to FINRA 5110 (Corporate Financing Rule—Underwriting Terms and Arrangements), Jan 24, 2014 (the “Termination Fee Proposal”) at p.5.

[9] Termination Fee Proposal at p.7.