• FINRA Revises Proposed Rule on Private Placements
  • October 12, 2011 | Authors: Timothy I. Kahler; Eric A. Koontz; Vincent J. Pisano
  • Law Firms: Troutman Sanders LLP - New York Office ; Troutman Sanders LLP - Atlanta Office ; Troutman Sanders LLP - New York Office
  • On October 4, 2011, the Financial Industry Regulatory Association (FINRA) filed its anticipated revised private placement rule - Rule 5123 - with the Securities and Exchange Commission. This advisory provides background on the rule change and answers key questions about the parameters of the new rule.

    Rule 5123 will apply when a FINRA member firm participates in a private placement of securities of any issuer other than the member or its affiliates.  FINRA’s existing Rule 5122, which has been in effect since March 2009, applies to private placements by a member of its own securities or securities of its affiliates.

    Background.  Rule 5123 replaces FINRA’s January 2011 proposal, reported by us February 4, 2011, which would have extended Rule 5122 to cover substantially all private placements. That proposal, published as FINRA Regulatory Notice 11-04 (the “11-04 Proposal”), was criticized as over-reaching and an unnecessary burden on private fundraising. Instead of expanding the reach of Rule 5122, FINRA now proposes to adopt new Rule 5123 for private placements of securities of non-members; and, in response to critics, FINRA has made significant changes to the Rule and has removed the most pernicious aspects of the 11-04 Proposal.

    General Parameters of Rule 5123. Rule 5123 will prohibit member firms and their associated persons from being involved in a private placement unless written information about the private placement is provided to investors and filed with FINRA. Key aspects of the Rule are as follows:

    • When will the Rule apply? Rule 5123 will apply when a FINRA member or a person associated with a FINRA member offers or sells a security in a private placement or participates in the preparation of a private placement memorandum, term sheet or other disclosure document in connection with a private placement.

    • What private placements are subject to the Rule? Under Rule 5123, a “private placement” is any securities offering under an available exemption from registration under the Securities Act of 1933. While certain private placements are exempt from the Rule, an offering made only to accredited investors is not exempt (unless other aspects of the transaction place it within one of the specified exemptions of the Rule).

    • What must be provided to investors, and when? Member firms and their associated persons will be required to provide to each investor, prior to any sale, a private placement memorandum or term sheet that discloses “the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of compensation provided or to be provided to sponsors, finders, consultants, and members and their associated persons in connection with the offering.” The Rule requires the FINRA member or associated person to prepare the disclosure document if such a document does not otherwise exist.

    • What must be filed with FINRA, and when? The private placement memorandum, term sheet or other disclosure document, and any exhibits thereto, must be filed with FINRA no later than 15 days after the first sale. Any material amendments to the information furnished to investors, or any amendments (apparently without regard to materiality) to the disclosures required under the Rule, must be filed with FINRA no later than 15 calendar days after the date the document is provided to any investor or prospective investor.

    • Who must file? Under Rule 5123, FINRA filings will be the responsibility of every member firm involved in a private placement by making offers or sales, or by participating in the preparation of disclosure materials. Where multiple firms are involved in the same private placement, each firm would be expected to make its own filing.

    • What are the exemptions from the Rule? Rule 5123 would exempt most of the private placements that are currently exempt from Rule 5122. These include exemptions for private placements to certain types of investors, including qualified institutional buyers (QIBs), investment companies and banks (but notably, as mentioned above, private placements offered only to accredited investors are not automatically exempt unless within another exemption), and of certain types of securities. In addition, FINRA may exempt a member or associated person from Rule 5123 “for good cause shown.”

    • Will information be held confidential by FINRA? Yes. The Rule states that confidential treatment will be given to information filed and that FINRA shall utilize the information only to determine compliance with FINRA rules or for other regulatory purposes.

    FINRA’s Stated Goals for Rule 5123. In its filing with the SEC, FINRA contends that Rule 5123 is consistent with the goals of preventing fraud and protecting investors without unduly restricting capital formation. FINRA also states that the Rule will provide FINRA better information about the private placement activities of member firms and assist FINRA in identifying “problematic terms and conditions” in private placements, thereby helping to detect and prevent fraud.

    FINRA May Impose Numerical Limits on Private Placements. The 11-04 Proposal would have prohibited FINRA members from participating in private placements of non-member securities unless at least 85% of the offering proceeds are used for the business purposes described in the disclosure document. Rule 5122 currently imposes such a requirement on member firms when offering their own securities in private placements. While a numerical limit on the use of proceeds was strongly criticized, and has been deleted from Rule 5123, FINRA has stated that it will reconsider imposition of numerical limitations in Rule 5123 if reasonable limits on the use of proceeds are not achieved through the “rigorous application” of member firms’ due diligence and suitability obligations.

    Assessment of Rule 5123. Several aspects of Rule 5123 may need further clarification. For example:

    • What is the relevance of “participating” in the preparation of a disclosure document under the Rule? The Rule will prohibit members and their associated persons from “participation” in the preparation of a disclosure document unless the specified disclosures are delivered to each investor and filed with FINRA. Do these delivery and filing obligations apply to a FINRA member or an associated person retained by an issuer only for the purpose of preparing a disclosure document, or where all sales are made by an unaffiliated FINRA member?

    • What level of detail will be required? The Rule does not specify the level of detail required in the disclosure document. The commentary accompanying the rule filing states that the Rule requires “detailed” disclosures; however, the Rule’s language is somewhat general in describing the required disclosures. In addition, the Rule requires that the disclosures include “the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of compensation . . . .” By applying the adjective “anticipated” only to “offering proceeds,” is FINRA implying that higher standards of disclosure and accuracy will apply with respect to offering expenses and compensation? FINRA members may benefit from additional guidance in this area.

    • Which amendments must be filed with FINRA? The Rule provides that amendments to disclosure materials must be filed with FINRA no later than 15 days after the amendments are provided to investors or prospective investors. However, the original disclosure materials must be filed with FINRA only after the first sale. FINRA may wish to clarify that the requirement to file amended materials applies only to amendments made after the first sale in a private placement. Otherwise, the requirement to file amendments could arise prior in time to the requirement to file the original disclosures.

    Procedural Status. Public comments on Rule 5123 must be submitted within 21 days after its publication in the Federal Register. FINRA intends to announce the implementation date of Rule 5123 within 90 days after SEC approval, and implement the new Rule within 180 days after SEC approval.