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FINRA Proposes Amendments To The Corporate Financing Rules

On April 11, 2017, the Financial Industry Regulatory Authority (FINRA) released three regulatory notices requesting comment on rules related to corporate financing and capital formation. In particular, the regulatory notices propose changes to Rule 5110, which regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities; Rules 2241 and 2242, which regulate equity and debt research analysts and research reports; and Rule 2310, which relates to public offerings of direct participation programs and unlisted REIT’s.

The proposed changes come as part of the FINRA360 initiative announced several months ago. Under the 360 initiative, FINRA has committed to a complete self-evaluation and improvement. As part of FINRA360, the regulator has requested public comment on the effectiveness and efficiency of its rules, operations and administrative processes governing broker-dealer activities related to the capital-raising process and their impact on capital formation.

Regulatory Notice 17-14 – Request for Comment on Rules Impacting Capital Formation

Regulatory Notice 17-14 is a request for comment on FINRA rules impacting capital formation. In its opening FINRA notes that the ability of small and large businesses to raise capital efficiently is critical to job creation and economic growth and that broker-dealers play a vital role in assisting in that process. FINRA members act as underwriters for public offerings, advisors on capital raising and corporate restructuring, placement agents for private offerings, funding portals and research analysts. Furthermore, there have been significant changes in the capital-raising processes, such as securities-based crowdfunding and Regulation A+ both initiated from the JOBS Act.

FINRA itself has made changes to modernize its regulations such as through the creation of the new Capital Acquisition Broker (CAB) and funding portal rules for brokers engaged in a limited range of fundraising activities. For more information on the CAB rules, see HERE. FINRA also seeks comments on changes that may be helpful in both the CAB and funding portal rules.

Below is a brief summary of some, but not all, the rules highlighted in FINRA Regulatory Notice 17-14.

Rules 2241 and 2242

The Regulatory Notice seeks comment on any FINRA rules that may impact capital formation, but highlights and summarizes certain rules that have significant impact on the process. For example, FINRA highlights Rule 2241 (Research Analysts and Research Reports) and Rule 2242 (Debt Research Analysts and Debt Research Reports), both of which are subject to a separate Regulatory Notice discussed in this blog.

Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. In Regulatory Notice 17-16, FINRA proposes a safe harbor from Rule 2241 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report.

Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

Rule 2310

Rule 2310 addresses underwriting terms and arrangements in public offerings of direct participation programs (DPP’s) and unlisted real estate investment trusts (REIT’s). These investments tend to be complex and as such, the Rule regulates underwriter and placement agent compensation, requires due diligence and contains suitability guidelines.

The 5100 Series of Rules

The 5100 series of rules govern underwriting compensation and terms, underwriter conduct, conflicts of interest and related matters. Although there are nine rules in the 5100 Series, a few in particular most often affect the capital formation process.

Rule 5110 – Corporate Financing Rule – Underwriting Terms and Arrangements; Rule 5121 – Public Offerings of Securities with Conflicts of Interest

Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities. The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA. The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest. In addition, the Rule limits certain compensation such as termination or tail fees and rights of first refusal and imposes lock-up restrictions related to the sale or transfer of securities received as compensation. The lock-up restrictions apply to a period beginning six months prior to the initial filing of a registration statement with the SEC and end 90 days following the effectiveness of the registration statement.

Where Rule 5110 requires the disclosure of affiliations, Rule 5121 goes further and prevents member firms from participating in offerings where certain conflicts of interest exist. Member firms are prohibited from participating in a public offering where certain conflicts exist, including where the issuer is controlled by or under common control with the FINRA member firm or its associated persons.

For more information on Rules 5110 and 5121, see HERE.

Rule 5122 – Private Placement of Securities Issued by Members; Rule 5123 – Private Placement of Securities

Subject to certain exceptions, such as where an offering is limited to accredited investors, Rule 5123 requires member firms to file a copy of the private placement memorandum, term sheet or other disclosure document with FINRA, for all offerings in which they sell securities, within 15 calendar days of the first sale. FINRA enacted the rule in an effort to further police the private placement market and to ensure that members participating in these private offerings conduct sufficient due diligence on the securities and their issuers.

Rule 5122 requires members that offer or sell their own securities to file the private placement memorandum, term sheet or other offering document at or prior to the first time the documents are provided to any prospective investor. Rule 5122 also establishes standards on disclosure and the use of private placement proceeds.

Rule 6432 – Compliance with Rule 15c2-11

Rule 6432 generally requires that, prior to initiating or resuming quotations in a non-exchange-listed security in a quotation medium, such as OTC Markets, a member firm must demonstrate compliance with Rule 6432 which, in turn, requires that the member firm has the information set forth in Securities Act Rule 15c2-11. Under Rule 6432, a member complies by filing a FINRA Form 211 at least three business days before the member’s quotation is published or displayed in the quotation medium. In reality the processing of the Form 211 application takes much longer than three days, and often several months. Moreover, the information and review conducted by FINRA in this process can be arduous.

Regulatory 17-15 – Request for Comment on Amendments to the Corporate Financing Rule

As discussed above, Rule 5110 is the corporate financing rule regulating underwriting compensation and prohibiting unfair arrangements in connection with the public offerings of securities. Under Rule 5110, a member firm is required to submit its underwriting or other arrangements associated with a public offering and obtain a no-objection letter from FINRA before they can proceed. FINRA proposes substantial changes to modernize, simplify and clarify its provisions.

The proposed amendments will clarify what is included in determining underwriter compensation. The Rule will eliminate a limit that prevents a member and its affiliates from acquiring more than 25% of a company’s stock and increase the fraction of shares sold in a private placement that a syndicate of investors can buy from 20 percent to 40 percent. Currently, underwriting compensation is defined to include a laundry list of items. The proposed amendment would define “underwriting compensation” to mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would also include “finder fees and underwriter’s counsel fees, including expense reimbursements and securities.” The proposal would continue to provide two non-exhaustive lists of examples of payments or benefits that would be and would not be considered underwriting compensation.

The Rule would also allow members to use formulas other than those dictated by FINRA to calculate their underwriting compensation, extend certain filing deadlines, and clarify circumstances in which stock sale restrictions don’t apply.

The proposed Rule increases the filing deadline from one business day to three business days after the filing of the offering with the SEC. The Rule also reduces the number of documents that must be filed. Furthermore, if a member participating in the offering files with FINRA, other participating members will be not be required to do so.

The Rule governs all public offerings subject to exceptions. Moreover, certain offerings are not subject to the Rule, such as offerings exempt under Section 4(a)(1), 4(a)(2) or 4(a)(6) of the Securities Act.

Regulatory Notice 17-16 – Request for Comment on Proposed Safe Harbor from FINRA Equity and Debt Research Rules

As discussed above, Rule 2241 covers equity research reports and requires a separation between research and investment banking, regulates conflicts of interest and requires certain disclosures in reports and public appearances. Rule 2242 covers debt research reports and is similar to Rule 2241 with key differences reflecting the differences in trading of debt and equity.

FINRA proposes a safe harbor from Rule 2241 and 2242 for eligible desk commentary prepared by sales and trading or principal trading personnel that may rise to the level of a research report. In particular, the safe harbor would cover specified brief, written analysis distributed to eligible institutional investors that comes from sales and trading or principal trading personnel but that may rise to the level of a research report (i.e., desk commentary).

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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SEC Has Approved FINRA’s New Category Of Broker-Dealer For “Capital Acquisition Brokers”

Posted by Securities Attorney Laura Anthony | November 22, 2016 Tags: Application; Associated Person Registration; Supervision, CAB, CABs, Conduct Rules for CABs, Description of Capital Acquisition Broker (“CAB”), Financial and Operational Rules for CABs, FINRA Rule 2121, FINRA Rule 3110, FINRA rules, M&A deals

On August 18, 2016, the SEC approved FINRA’s rules implementing a new category of broker-dealer called “Capital Acquisition Brokers” (“CABs”), which limit their business to corporate financing transactions. FINRA first published proposed rules on CABs in December 2015. My blog on the proposed rules can be read HERE. In March and again in June 2016, FINRA published amendments to the proposed rules. The final rules enact the December proposed rules as modified by the subsequent amendments.

A CAB will generally be a broker-dealer that engages in M&A transactions, raising funds through private placements and evaluating strategic alternatives and that collects transaction-based compensation for such activities. A CAB will not handle customer funds or securities, manage customer accounts or engage in market making or proprietary trading.

Description of Capital Acquisition Broker (“CAB”)

There are currently FINRA-registered firms which limit their activities to advising on mergers and acquisitions, advising on raising debt and equity capital in private placements or advising on strategic and financial alternatives. Generally these firms register as a broker because they may receive transaction-based compensation as part of their services. However, they do not engage in typical broker-dealer activities, including carrying or acting as an introducing broker for customer accounts, accepting orders to purchase or sell securities either as principal or agent, exercising investment discretion over customer accounts or engaging in proprietary trading or market-making activities.

The proposed new rules will create a new category of broker-dealer called a Capital Acquisition Broker (“CAB”). A CAB will have its own set of FINRA rules but will be subject to the current FINRA bylaws and will be required to be a FINRA member. FINRA estimates that there are approximately 750 current member firms that would qualify as a CAB and that could immediately take advantage of the new rules.

FINRA is also hopeful that current firms that engage in the type of business that a CAB would, but that are not registered as they do not accept transaction-based compensation, would reconsider and register as a CAB with the new rules. In that regard, FINRA’s goal would be to increase its regulatory oversight in the industry as a whole. I think that on the one hand, many in the industry are looking for more precision in their allowable business activities and compensation structures, but on the other hand, the costs, regulatory burden, and a distrust of regulatory organizations will be a deterrent to registration. It is likely that businesses that firmly act within the purview of a CAB but for the transactional compensation and that intend to continue or expand in such business, will consider registration if they believe they are “leaving money on the table” as a result of not being registered. Of course, such a determination would include a cost-benefit analysis, including the application fees and ongoing legal and compliance costs of registration. In that regard, the industry, like all industries, is very small at its core. If firms register as a CAB and find the process and ongoing compliance reasonable, not overly burdensome and ultimately profitable, word will get out and others will follow suit. The contrary will happen as well if the program does not meet these business objectives.

A CAB will be defined as a broker that solely engages in one or more of the following activities:

Advising an issuer on its securities offerings or other capital-raising activities;

Advising a company regarding its purchase or sale of a business or assets or regarding a corporation restructuring, including going private transactions, divestitures and mergers;

Advising a company regarding its selection of an investment banker;

Assisting an issuer in the preparation of offering materials;

Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;

Qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in respect to the purchase or sale of newly issued unregistered securities (see below for the FINRA definition of institutional investor, which is much different and has a much higher standard than an accredited investor);

Qualifying, identifying, soliciting or acting as a placement agent or finder on behalf of an issuer or control person in connection with a change of control of a privately held company. For purposes of this section, a control person is defined as a person that has the power to direct the management or policies of a company through security ownership or otherwise. A person that has the power to direct the voting or sale of 24% or more of a class of securities is deemed to be a control person; and/or

Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters. For more information on this, see my blog HERE regarding the SEC no-action letter granting a broker registration exemption for certain M&A transactions.

Since placing securities in private offerings is limited to institutional investors, that definition is also very important. Moreover, FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. Under the proposed CAB rules, an institutional investor is defined to include any:

Bank, savings and loan association, insurance company or registered investment company;

Government entity or subdivision thereof;

Employee benefit plan that meets the requirements of Sections 403(b) or 457 of the Internal Revenue Code and that has a minimum of 100 participants;

Qualified employee plans as defined in Section 3(a)(12)(C) of the Exchange Act and that have a minimum of 100 participants;

Any person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million;

Persons acting solely on behalf of any such institutional investor; or

Any person meeting the definition of a “qualified purchaser” as defined in Section 2(a)(51) of the Investment Company Act of 1940 (i.e., any natural person that owns at least $5 million in investments; family offices with at least $5 million in investments; trusts with at least $5 million in investments; or any person acting on their own or as a representative with discretionary authority, that owns at least $25 million in investments).

A CAB will not include any broker that does any of the following:

Carries 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 agent for the customer;

Has investment discretion on behalf of any customer;

Produces research for the investing public;

Engages in proprietary trading or market making; or

Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act (interesting that FINRA would include Regulation A in this, as currently no license is required at all to maintain such a platform – only platforms for Regulation Crowdfunding require such a license).

Application; Associated Person Registration; Supervision

A CAB firm will generally be subject to the current member application rules and will follow the same procedures for membership as any other FINRA applicant, with four main differences. In particular: (i) the application has to state that the applicant will solely operate as a CAB; (ii) the FINRA review will consider whether the proposed activities are limited to CAB activities; (iii) FINRA has set out procedures for an existing member to change to a CAB; and (iv) FINRA has set out procedures for a CAB to change its status to regular full-service FINRA member firm.

The CAB rules also set out registration and qualification of principals and representatives, which incorporate by reference to existing NASD rules, including the registration and examination requirements for principals and registered representatives. CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs will also be subject to current rules regarding Operations Professional registration.

CABs would have a limited set of supervisory rules, although they will need to certify a chief compliance officer and have a written anti-money laundering (AML) program. In particular, the CAB rules model some, but not all, of current FINRA Rule 3110 related to supervision. CABs will be able to create their own supervisory procedures tailored to their business model. CABs will not be required to hold annual compliance meetings with their staff. CABs are also not subject to the Rule 3110 requirements for principals to review all investment banking transactions or prohibiting supervisors from supervising their own activities.

CABs would be subject to FINRA Rule 3220 – Influencing or Rewarding Employees of Others, Rule 3240 – Borrowing form or Lending to Customers, and Rule 3270 – Outside Activities of Registered Persons.

Conduct Rules for CABs

The proposed CAB rules include a streamlined set of conduct rules. This is a brief summary of some of the conduct rules related to CABs. CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Rules 2080 and 2081 regarding expungement of customer disputes; and the FINRA arbitration requirements in Rules 2263 and 2268. CABs will also be subject to know-your-customer and suitability obligations similar to current FINRA rules for full-service member firms, and likewise will be subject to the FINRA exception to that rule for institutional investors. CABs will be subject to abbreviated rules governing communications with the public and, of course, prohibitions against false and misleading statements.

CABs are specifically not subject to FINRA rules related to transactions not within the purview of allowable CAB activities. For example, CABs are not subject to FINRA Rule 2121 related to fair prices and commissions. Rule 2121 requires a fair price for buy or sell transactions where a member firm acts as principal and a fair commission or service charge where a firm acts as an agent in a transaction. Although a CAB could act as an agent in a buy or sell transaction where a counter-party is an institutional investor or where it arranges securities transactions in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the SEC rules, rule interpretations and no-action letters on such M&A deals, FINRA believes these transactions are outside the standard securities transactions that typically raise issues under Rule 2121.

Financial and Operational Rules for CABs

CABs would be subject to a streamlined set of financial and operational obligations. CABs would be subject to certain existing FINRA rules including, for example, audit requirement, maintenance of books and records, preparation of FOCUS reports and similar matters.

CABs would also have net capital requirements and be subject to suspension for noncompliance. CABs will be subject to the current net capital requirements set out by Exchange Act Rule 15c3-1.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
LAnthony@LegalAndCompliance.com

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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