|November 18, 2011|
Previously published on November 15, 2011
The long path to a new Financial Industry Regulatory Authority (FINRA) rule governing communications with the public moved haltingly closer to completion on Oct. 31, 2011, when FINRA filed with the Securities and Exchange Commission (SEC) a response to public comments it had received on the proposal it filed on July 14, 2011, and an amended proposed version of the rule.1 The SEC could have approved the rule as amended, but instead it issued a release on Nov. 1, 2011 calling for additional public comment and took the highly unusual step of instituting proceedings pursuant to Section 19(b)(2)(B) of the Securities Exchange Act of 1934 (the“Exchange Act”) to determine whether to approve the rule.2 The proceedings were announced in the Federal Register on Nov. 7, 2011.3
FINRA’s Oct. 31, 2011, amendments include important revisions to the way it proposes to handle certain kinds of research reports, retail communications about government securities, communications about tax treatment, disclosure of conflict of interest and certain materials also required to be filed with the SEC.
FINRA stood by its previous proposed rule in many key respects, including the scope of the definition of “institutional investor” and its proposed addition of “Supplementary Material 2210.01,” which make clear that “internal written (including electronic) communications that are intended to educate or train registered persons about the products or services offered by a member” are “institutional communications” under the new rule.
The practical effect of the SEC’s action is to provide another opportunity for member firms to be heard, not only on the parts of the proposed rule that FINRA modified, but on a range of other issues that are outlined in the SEC release. The deadline for submitting written comments expires on Dec. 7, 2011. The proceedings must be completed within 180 days of the date the proceedings were announced in the Federal Register, but can be extended further by the SEC for good cause.
One of the significant changes introduced in the July 2011 version of the proposed rule is the addition of Supplementary Material 2210.01, which states that “a member’s internal written (including electronic) communications that are intended to educate or train registered persons about the products or services offered by a member” are “institutional communications.” As a result, those internal communications are subject not only to the content standards of Rule 2210(d)(1), but also the review, recordkeeping and supervision requirements that apply to institutional communications. The interpretation would apply to communications that are never shared with anyone outside a member firm.
Supplementary Material 2210.01 represents FINRA’s current interpretation of the definition of “institutional investor ” in Rule 2211 - an interpretation that until now has been advanced primarily through enforcement actions. Supplementary Material 2210.01 was not part of the initial proposal in 2009, but was added in the July 2011 proposal. Despite the receipt of a number of comments related to this provision of the proposed rule,4 FINRA steadfastly refused to change its position in its response letter. Indeed, FINRA’s justification is that the treatment in the Supplementary Material is already part of the rule. Given this clear expectation, member firms should examine their policies and procedures to include a review of internal material provided to their registered persons for compliance with the advertising rules.
Supplementary Material 2210.01 applies only to communications intended to educate or train registered persons, and, according to FINRA’s response letter, “that are used in the sales process.” Communications with unregistered employees would, therefore, not be covered, but member firms will need to consider how they will make a distinction as part of the procedures that govern internal communications. Traditionally, firms have handled these issues as part of their training or supervisory programs, not as part of their obligation under the advertising rules.
FINRA’s Revisions to the Proposed Adverting Rule
FINRA’s revised proposal, titled Partial Amendment No. 1, makes substantive changes in five areas, in response to comments from the public and the SEC staff.
- Principal Pre-Approval of Retail Communications Excepted From Definition of “Research Report” Under NASD Rule 2711
In response to comments from the SEC staff, FINRA clarified that an appropriately qualified registered principal must pre-approve retail communications that are excepted from the definition of “research report” under NASD Rule 2711(a)(9)(A) if the communication makes “any financial or investment recommendation.”
Under NASD Rule 2711, a number of broad categories of communications are specifically excluded from the definition of “research report,” including “discussions of broad-based indices” and “commentaries on economic, political or market conditions.”5 Under the new advertising rules, these kinds of communications may be supervised and reviewed in the same manner as correspondence but (under the revised proposal) if the communication makes “any financial or investment recommendation” then it must be subject to supervisory pre-review like other retail communications.
FINRA eliminated its proposal to require the filing of retail communications concerning government securities as defined in Section 3(a)(42) of the Exchange Act. In its filings, FINRA states that this requirement has generated relatively few filings over the years and the SEC staff has found relatively few problems with the advertisements filed. FINRA, however, reminded firms that it still retains the ability to review such communications through other means, such as spot-checks or targeted examinations and to take appropriate actions against firms for violations of FINRA rules.
- Illustrations of Tax Impact
The rule proposed in 2009 contains a new section in the portion of the rule discussing “Content Standards” that requires certain disclosures about how tax features are discussed in retail communications and correspondence. In response to comments from the SEC staff, FINRA has proposed adding new language to that section addressing, in particular, comparative illustrations of the mathematical principles of tax-deferred versus taxable compounding. The new language requires that illustrations must disclose that ordinary tax rates will apply to withdrawals from a tax-deferred investment.
- Greater Disclosure of Financial Interest In Recommended Securities
Partial Amendment No. 1 contains several changes that relate to disclosure requirements for retail communications and public appearances that include a recommendation of securities.
One revision broadens the category of a person whose financial interest must be disclosed. In the July filing, the disclosure was limited to the interests of the “member or any associated person with the ability to influence the content of the communication.” Under the new proposal, a retail communication that includes a securities recommendation would be required to be disclosed if “the member or any associated person that is directly and materially involved in the preparation of the content of the communication” has a financial interest in any of the securities of the issuer whose securities are recommended, unless the interest is “nominal.” The disclosure must describe the nature of the financial interest.
A second revision is a technical amendment to the language of paragraph (d)(7)(A)(iii) of the proposed rule to make it consistent with paragraph (d)(7)(A)(ii).
The third set of amendments make it clear that the disclosure requirements in proposed Rule 2210(d)(7)(A) and 2210(d)(7)(C) do not apply to communications that recommend only registered investment companies or variable insurance products, although those communications must still have a sound basis for the recommendation and the member must provide certain information supporting the recommendation upon request, pursuant to proposed paragraph (d)(7)(B).
A fourth revision relates to the disclosure standards for public appearances that include securities recommendations. Under the amended proposal, associated persons making a public appearance would have to disclose their own financial interests in any of the securities of the issuer and the nature of that interest, as well as “any other actual, material conflicts with the issuer of the associated person or member of which the associated persons know or has reason to know at the time of the public appearance.” These rules would not apply to research analysts for purposes of NASD Rule 2711. They also would not apply to recommendations of investment company securities or variable insurance products, although the associated person must have a reasonable basis for making recommendations of those products in a public appearance.
Materials already filed with the SEC.
Partial Amendment No. 1 explicitly clarifies that prospectuses, preliminary prospectuses, fund profiles and similar documents that have been filed with the SEC are not subject to the content standards of proposed Rule 2210(d). However, the content standards continue to apply to Securities Act Rule 482 prospectuses and free-writing prospectuses filed with the SEC under Securities Act Rule 433.
The SEC has solicited public comment not only about FINRA’s recent amendments, but the proposed rule as a whole. The Nov. 1, 2011 release asks commenters to address:
1) The changes that FINRA proposes in Partial Amendment No. 1
2) The comments received on the Notice of Filing
3) FINRA’s Oct. 31, 2011 response letter
4) “Any other comments they may wish to submit about the proposed rule change”
The staff has specifically asked for comments on six topics:
The scope of the definition of “institutional investor” for purposes of [Rule 2210]
The “reason to believe” standard under Proposed Rule 2210(a)(4)(F)
The requirements applicable to internal communications, public appearances and postings in online interactive fora
The requirements applicable to communications prepared by research department personnel
The scope of the category of associated persons who financial interests would have to be disclosed in a retail communication that includes a recommendation of securities
The scope of the proposed exclusion from the content standards as set forth in proposed paragraph 2210(d)(8)
Written comments are due on Dec. 7, 2011. Although the SEC seems to believe the proceedings can be completed based on written submissions, the commission will consider, pursuant to Rule 19b-4, any request for an opportunity to make an oral presentation.
1 FINRA first proposed creating a new advertising rule in September 2009. See Bingham ’s Client Alerts dated Oct. 5, 2009 (“FINRA Proposed New Rules Governing Communications with the Public”) and Aug. 3, 2011 (“SEC Publishes FINRA Proposal for Complete Rewrite of Communications with the Public Rules”).
2 See SEC Release No. 34-65663 (Nov. 1, 2011).
3 76 Fed. Reg. 215 (Nov.7, 2011). The SEC’s decision to initiate proceedings under Section 19(b)(2) of the Exchange Act is part of a recent trend in the way it handles proposed SRO rule changes, prompted in part by recent procedural amendments required under Section 916 of the Dodd-Frank Wall Street Reform and Consumer Protection Act. See 76 Fed. Reg. 15 (Jan. 24, 2011). According to the SEC’s January 2011 release announcing the new procedural rules, the most recent proceeding was in 1984. Under the new rules, SRO member firms may have greater opportunity for comment, and an opportunity to request an oral presentation of its views to the commission on proposed rules.
4 The proposal was published in the Federal Register on Aug. 3, 2011; public comments were due by Aug. 24, 2011. Four of nine public comment letters opposed or made comment on the implementation of Supplementary Material 2210.01.
5 NASD Rule 2711(a)(9).
6 See proposed FINRA Rule 2210(d)(4), “Tax Considerations.”
7 See proposed FINRA Rule 2210(d)(4)(c)(vii).