|August 5, 2011|
Previously published on August 3, 2011
On July 28, 2011, the SEC published a proposed rule change from FINRA to adopt new rules governing communications with the public (the “Proposal” or “Rule Filing”).1 The Proposal would replace current NASD Rules 2210 and 2211, together with certain of the Interpretative Materials that follow NASD Rule 2210 and portions of Incorporated NYSE Rule 472, with new FINRA Rule 2210. The remaining Interpretative Materials that follow NASD Rule 2210 would be replaced by new FINRA Rules 2212 through 2216. FINRA first proposed these rules on September 14, 2009,2 and received a substantial number of comments, some of which are reflected in the Proposal.
The Proposal modifies the current communications rules in important respects, while retaining many of the familiar requirements relating to pre-use principal approval and filing. In particular, the new rule would create three categories of communications, as opposed to the six currently defined communications categories. One of these new categories is “retail communications.” The Proposal would substantially broaden the filing and review requirements as it relates to retail communications.
The Proposal was published in the Federal Register on August 3, 2011 and comments must be submitted to the SEC on or before August 24, 2011. Certain aspects of the Proposal filed with the SEC are new, as we note below. Therefore, while FINRA members should begin to consider how they will adapt their review, approval and filing procedures in anticipation of the Commission’s final approval of the rules in the Proposal, they also should consider commenting on new aspects of the Proposal.
I. Three Categories of Communications
Over the years, broker-dealers have been accustomed to applying the rules governing communications with the public within six general categories: advertisements, sales literature, correspondence, institutional sales material, independently prepared reprints and public appearances. Although each of the former categories remain subject to certain approval, filing and content standards under new FINRA Rule 2210, the Proposal reduces the number of current categories from six to three.
Under FINRA Rule 2210, the communication categories would be as follows:
A. Institutional Communications
This category includes communications that currently fall within the definition of institutional sales material under the current NASD Rules, i.e., written (including electronic) communications that are distributed or made available only to institutional investors.
Notably, FINRA seeks to modify the definition of institutional investor to clarify that the term includes multiple employee benefit plans and multiple qualified plans offered to employees of the same employer, provided the plans in the aggregate have at least 100 participants. The definition of institutional investor would otherwise remain as presently defined under NASD Rule 2211(a)(3).
FINRA also includes new Supplementary Material to further clarify 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 considered institutional communications under the proposed rule. As a result, these communications would be subject to the filing/approval, content standards and recordkeeping requirements under FINRA Rule 2210 (as well as NASD Rule 3010(d) (Review of Transactions and Correspondence)).
We draw readers’ attention to this proposed Supplemental Material because it could significantly impact firms’ current practices and has not been articulated previously by FINRA other than in isolated settled enforcement proceedings.
B. Retail Communications
This category includes any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30-calendar-day period.
A retail investor, under the Proposal, is any person other than an institutional investor, regardless of whether the person has an account with the member. Although the separate categories of advertisements, sales literature, public appearances and independently prepared reprints no longer exist under the Proposal, FINRA notes that advertisements, sales literature and public appearances will generally fall within the definition of retail communications. With respect to independently prepared reprints, to the extent a firm distributes or makes available a communication that currently qualifies as an independently prepared reprint to more than 25 retail investors within a 30-calendar-day period, the communication would fall under the definition of retail communication.
This category includes any written (including electronic) communication that is distributed or made available to 25 or fewer retail investors within any 30-calendar-day period. Generally, communications that currently qualify as correspondence would continue to fall within the definition under the proposed rule. Currently, under NASD Rule 2211, correspondence includes market letters as well as written letters and electronic mail messages that are sent to one or more existing retail customers and fewer than 25 prospective retail customers within a 30-calendar-day period. Under the proposed definition of correspondence, the term “market letter” is excluded. Instead of defining market letters as correspondence, FINRA revised the principal approval requirements to allow firms to supervise any retail communication that is excepted from the definition of research report pursuant to NASD Rule 2711(a)(9)(A) in the same manner as correspondence.
Despite comments from firms, FINRA did not include a fourth category for “interactive electronic communications.” However, the Proposal does incorporate the guidance about social media contained in FINRA Notice 10-06.
II. Approval, Review and Recordkeeping Requirements
A. Communications Subject to Pre-Use Principal Approval
Under Proposed Rule 2210(b), the pre-use principal approval requirement would apply generally to “retail communications,” as opposed to only advertisements, sales literature and independently prepared reprints, as the current rule provides. However, the Proposal also generally incorporates the current exceptions to the principal approval requirement. Thus, principal approval would not be required for retail communications that: 1) are excepted from the definition of research report under NASD Rule 2711(a)(9)(A); 2) are posted on an online interactive electronic forum;3 or 3) do not make any financial or investment recommendation or promote a product or service of the member.
The latter exception requires members to make the same type of determination that is currently required under NASD Rule 2211 with respect to correspondence that is sent to 25 or more retail investors. The Proposal indicates that this exception is for communications that are “administrative or informational,” such as notices telling customers that their account statements are available online. Importantly, communications that “are intended to educate” investors about products or services do not fall within the exception — regardless of whether they constitute a “recommendation” or “promote” a product or service.
The proposed rule adds a provision allowing FINRA to grant an exemption from the pre-use principal approval requirement for “good cause shown.” According to the Proposal, FINRA wants this exemptive authority in order to respond to “the rapid changes to technology used to communicate with customers.”
Consistent with current rules, “correspondence” and “institutional communications” would not require pre-use principal approval, but would be subject to the current supervision and review requirements.
B. Appropriately Qualified Registered Principal
The Proposal provides for an “appropriately qualified registered principal” to conduct the principal review. FINRA rejected suggestions that the rule provide more specific guidance as to which principal registration categories are appropriate for various types of communications, indicating instead that firms should determine the appropriate principal for a given communication by reference to the current registration rules for principals and supervisors. As FINRA notes in the release, it has separately proposed rules that would allow general securities sales supervisors, who are currently not qualified to approve advertisements, to approve both correspondence and the new category of “retail communications,” which includes advertisements. In addition, the Proposal would continue to permit a Series 16 supervisory analyst to approve research reports on debt and equity securities.
The proposal generally applies to “retail communications” and “institutional communications” the same recordkeeping requirements that now apply to advertisements, sales literature and independently prepared reprints, while adding an explicit reference to the retention, medium and format requirements of SEC Rule 17a-4. As to “correspondence,” the proposed rule cross-references the requirements of NASD Rule 3010(d)(3) and Rule 4511.
III. Filing Requirements
A. Pre-Use Filing of Certain Retail Communications
Proposed Rule 2210(c)(2) expands the pre-use filing requirement, which currently applies to advertisements and/or sales literature concerning certain types of securities or issuers, to apply generally to “retail communications” concerning those same securities or issuers. Thus, for retail communications concerning any registered investment company security that includes self-created rankings and retail communications that contain mutual bond fund volatility ratings, the Proposal would require pre-use filing (at least 10 business days prior to first use or publication). All other retail communications relating to investment company securities would require post-use filing (within 10 business days of first use). With respect to security futures, pre-use filing would be required for all retail communications except for those “in which the only reference to security futures is contained in a listing of the services of the member.” Also, while current NASD Rule 2210(c)(4) requires pre-use filing of “advertisements” concerning CMOs, the Proposal requires post-use filing of all “retail communications” concerning CMOs.
B. Pre-Use Filing by New Members
NASD Rule 2210(c)(5) currently requires firms to file advertisements prior to use beginning with their initial advertisement and for the next year. The Proposal, in contrast, imposes this one-year filing requirement on new members beginning on the date that the firm’s membership becomes effective. The requirement would, in effect, apply only to communications that are currently defined as advertisements, e.g., communications published or used in “public media,” such as newspapers or generally accessible websites. However, FINRA could impose more sweeping pre-use filing requirements on new members that it judges have departed from the standards of the Proposal.
C. Post-Use Filing Requirements
The Proposal generally incorporates the current post-use filing requirements of Rule 2210(c), but adds to them in important respects. While the current post-use filing requirement covers only advertisements or sales literature concerning certain types of issuers and products (for instance, communications concerning mutual funds not covered by the pre-use filing requirement, public direct participation programs and government securities), the Proposal requires filing of all “retail communications” concerning generally the same types of issuers and products within 10 business days of first use or publication.
In addition, the Proposal would require post-use filing of all retail communications concerning closed-end funds, not only those made during the fund’s IPO period. The proposal also for the first time requires filing of retail communications concerning publicly offered structured products. The Proposal does not use the term “structured products,” but rather requires post-use filing of retail communications concerning “any security that is registered under the Securities Act and that is derived from or based on a single security, a basket of securities, an index, a commodity, a debt issuance or a foreign currency.” FINRA specifically declined a suggestion to list the types of products subject to the filing requirement based on its view that “firms frequently develop new types of retail structured products that would not be included in any list that FINRA created today.” Members should carefully consider whether a communication fits this broad definition given FINRA’s apparently expansive approach and the fact that structured products have been one of its enforcement priorities.
D. Exclusions From Filing Requirements
The Proposal generally incorporates the current exclusions to filing requirements, such as the exclusion for materials that have previously been filed and are being used without material changes, and codifies the exclusion for previously-filed templates limited to updates of more recent statistical or other non-narrative information. The Proposal also continues to exclude prospectuses and other similar documents filed with the SEC, but codifies FINRA’s position that free-writing prospectuses are subject to the filing requirements if there is “broad unrestricted dissemination” of the free-writing prospectus.4 Correspondence and institutional communications would be excluded from filing requirements. As with the principal approval requirements, the Proposal permits FINRA to grant exemptions from the filing requirements on a showing of good cause.
IV. Content Standards
The Proposal retains all of the existing content standards, but rather than distributing them in a series of Interpretive Memos (of which the existing rule has eight), they have been codified in the rule itself and in several adjacent proposed rules. The Proposal does, however, make 10 substantive changes to the existing content standards:
1. Ban on Promissory Statements. Proposed Rule 2210(d)(1)(B) retains the language of NASD Rule 2210(d)(1)(B), which prohibits members from making “any false, exaggerated, unwarranted or misleading statement,” but adds “promissory” to this list. As the Rule Filing notes, interpretations of the existing rule already prohibit promissory statements and they are expressly prohibited by NYSE Rule 472(i), which the Proposal will replace.
2. Predictions and Projections. Proposed Rule 2210(d)(1)(F) retains the language of NASD Rule 2210(d)(1)(D), which prohibits the use of performance predictions and projections. To the current rule’s exception for a “hypothetical illustration of mathematical principles,” the Proposed Rule expressly adds that “projections of performance in reports produced by investment analysis tools” (that meet the requirements of Proposed Rule 2214, the successor to IM-2210-6) are allowed. The proposed rule also expressly allows firms to provide price targets in research reports, as long as there is a reasonable basis for the price target, the valuation method used is disclosed, and the risks that may “impede achievement of the price target” are explained.
3. Use of the Member’s Name. Proposed Rule 2210(d)(3) retains, with minor modifications, the existing requirements that members disclose their name on advertisement and sales literature (“retail communications” under the new rule). The Proposed Rule would, however, extend these same requirements to the member’s correspondence.
4. Comparisons of Taxable and Tax-Deferred Investments. Proposed Rule 2210(d)(4)(C) expands substantially the language of the existing IM, providing express requirements regarding the use of illustrations that compare tax-deferral to taxable investing. As FINRA describes it, the proposal incorporates much of the existing guidance into the rule itself. In the proposal, FINRA lists seven changes in this area:
(a) the illustration must depict both the taxable and tax-deferred investment using the same investment amounts and gross rates of return, which must be less than 10 percent per year;
(b) the illustration must use actual federal tax rates;
(c) the illustration may reflect an actual state tax rate if it also discloses that it is only applicable to investors in the identified state;
(d) if the illustration is directed to a target audience, the tax rate(s) used must reasonably reflect the tax bracket(s) and tax character (ordinary income or capital gains) of that group;
(e) if an investment payout period is included, the effect of taxes in that period must be addressed;
(f) the illustration may not “assume an unreasonable period of tax deferral;” and
(g) the illustration must, as applicable, make six specific disclosures, including (i) the risk associated with the assumed return; (ii) the effect of losses on the advantage of taxable versus tax-deferred investing; (iii) the “extent to which tax rates on capital gains and dividends would affect the taxable investment’s return;” (iv) “[i]ts underlying assumptions;” (v) the impact of tax penalties, if any; and (vi) that “an investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision. . .”
5. Customer Testimonials. Proposed Rule 2210(d)(2)(A) adopts the content of NASD Rule 2210(d)(2)(A) regulating the use of customer testimonials. Substantively, the proposed rule changes the existing one by quantifying the term “nominal sum” in the existing rule by requiring disclosure of payments more than $100.
6. Recommendations. Proposed Rule 2210(d)(7) incorporates the requirements currently in NASD IM-2210-1(6) regarding recommendations, with several substantive changes. First, while the existing IM applies to advertisements and sales literature (“retail communications” under the new rule), the Proposal would also apply to public appearances. Second, while the Proposal retains all three required disclosures (market making in the security, officers or partners with a financial interest in the security, whether the member managed or co-managed a public offering of the security), it narrows the scope of the disclosure regarding ownership interests in the security being recommended. Instead of all the firm’s officers and partners, the proposal requires disclosures only from any associated person “with the ability to influence the content of the communication,” which FINRA asserts will often be a smaller (if less well-defined) group. Third, the Proposal would change slightly some of the requirements when the communication discusses past profitable recommendations in communications, including requiring a specific warning against assuming that future recommendations will also be profitable.
7. Public Appearances. Although eliminated as a formal category of communications with the public, public appearances are addressed in Proposed Rule 2210(f). The Proposal expressly makes public appearances subject to the proposed rule’s general content standards, but also, for the first time, applies all of the requirements regarding recommendations to public appearances. The Proposal also expressly adds a requirement that firms adopt written policies and procedures to supervise public appearances, including training, surveillance, and maintaining records of these efforts. Finally, the Proposal states that materials used in public appearances (e.g., slides, handouts, scripts) are themselves communications within the meaning of the rule.
8. Investment Company Rankings. Proposed Rule 2112 incorporates the requirements of NASD IM-2210-3, regarding use of investment company rankings, with one material change. When a ranking includes more than one class of investment company securities, under the Proposal, the communication must expressly disclose that the classes have different expense structures.
9. Investment Analysis Tools. Proposed Rule 2214, and its supplementary materials and footnotes, addresses investment analysis tools, incorporating the guidance currently in NASD IM-2210-6, with some minor changes. First the rule would change the filing and access requirements from within 10 days of first use to within 10 business days of first use. Second, the proposed rule would narrow the required disclosures in communications that describe a tool, but do not provide access to it (requiring only a disclosure that results may vary and the mandatory warning that performance is hypothetical and not a guarantee). Finally the Proposal, in Supplementary Material .07, clarifies and expands the types of financial arrangements with issuers that may need to be disclosed.
10. Securities Futures. Proposed Rule 2215 replaces NASD IM-2210-7 regarding communications about securities futures. The Proposal makes four noteworthy changes. First, although the current IM applies only to advertisements, the proposed rule would apply to the entire new category of retail communications. Second, the Proposal amends the filing requirement from “10 days prior to use” to “10 business days prior to first use.” Third, the Proposal expands the requirement that communication be accompanied or preceded by the securities futures risk disclosure document to include any communications that names specific securities. Finally, the Proposal clarifies that communications, including historical performance, must disclose all relevant costs, which must also be reflected in the performance.
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While the comment period for the Proposal is brief (21 days), we expect FINRA to provide some lead-in time prior to the effectiveness of the new rules once the SEC approves them. Nevertheless, we recommend that broker-dealers begin their review of the Proposal so they fully understand the new approach to categories of communications, and review, approval and filings of communications, in order to consider any necessary changes to current compliance and supervision programs.
1Notice of Filing of Proposed Rule Change to Adopt FINRA Rules 2210 (Communications with the Public), 2212 (Use of Investment Companies Rankings in Retail Communications), 2213 (Requirements for the Use of Bond Mutual Fund Volatility Ratings), 2214 (Requirements for the Use of Investment Analysis Tools), 2215 (Communications with the Public Regarding Security Futures), and 2216 (Communications with the Public About Collateralized Mortgage Obligations (CMOs)) in the Consolidated FINRA Rulebook, Exchange Act Release No. 64984, 76 Fed. Reg. 46870 (Aug. 3, 2011).
2 Bingham Alert, Oct. 5, 2009, “FINRA Proposes New Rules Governing Communications With the Public.”
3 This exception is consistent with the guidance provided in Regulatory Notice 10-06 (Jan. 2010) concerning “interactive electronic forums.”
4 See FINRA Regulatory Notice 10-52 (Oct. 2010).