Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of Proposed Rule Change and Amendment No. 2 Thereto Relating to Private Placements of Securities Issued by Members

Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act” or “Exchange Act”) and Rule 19b-4 thereunder, notice is hereby given that on September 11, 2008, Financial Industry Regulatory Authority, Inc. (“FINRA”) (f/k/a National Association of Securities Dealers, Inc. (“NASD”)) filed with the Securities and Exchange Commission (“SEC” or “Commission”), and amended on January 7, 2009, the proposed rule change as described in Items I, II, and III below, which Items have been substantially prepared by FINRA. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

FINRA is proposing to adopt new FINRA Rule 5122 (“Rule”). This proposed rule change would require a member that engages in a private placement of unregistered securities issued by the member or a control entity to (1) Disclose to investors in a private placement memorandum, term sheet or other offering document the intended use of offering proceeds and the offering expenses, (2) file such offering document with FINRA, and (3) commit that at least 85 percent of the offering proceeds will be used for business purposes, which shall not include offering costs, discounts, commissions and any other cash or non-cash sales incentives.

Amendment No. 2 to SR-FINRA-2008-020 makes minor changes to the original filing filed on September 11, 2008. The proposed rule change replaces and supersedes the proposed rule change filed on September 11, 2008 in its entirety, except with regard to Exhibit 2, NASD Notice to Members 07-27 and comments received in response to NASD Notice to Members 07-27.

The text of the proposed rule change is available on FINRA's Web site at http://www.finra.org,, at the principal office of FINRA and at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, FINRA included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. FINRA has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

Background and Discussion

FINRA is proposing new FINRA Rule 5122 in response to problems identified in connection with private placements by members of their own securities or those of a control entity (referred to as “Member Private Offerings” or “MPOs”). In recent years, FINRA has investigated and brought numerous enforcement cases concerning abuses in connection with MPOs. Among the allegations in these cases were that members failed to provide written offering documents to investors, or provided offering documents that contained misleading, incorrect or selective disclosure, such as omissions and misrepresentations regarding selling compensation and the use of offering proceeds. In addition, as part of its examination program, FINRA conducted a non-public sweep of firms that had engaged in MPOs and found widespread problems. The MPO sweep revealed that in some cases, offering proceeds were used for individual bonuses, sales contest awards, commissions in excess of 20 percent, or other undisclosed compensation.

Inasmuch as MPOs are private placements, they are not subject to existing FINRA rules governing underwriting terms and arrangements and conflicts of interest by members in public offerings. This proposed rule change is intended to provide investor protections for MPOs that are similar to the protections provided by NASD Rule 2720 for public offerings by members.

In response to concerns about MPOs, in June 2007, FINRA issued Notice to Members 07-27 (“NTM 07-27”) soliciting comment on a proposed new rule regarding MPOs (then numbered Proposed Rule 2721). FINRA received sixteen comment letters in response to NTM 07-27. The comments were varied. Some commenters expressed support for the intent of the proposed rule, but voiced concerns about its breadth and scope; others questioned the benefit or necessity of the proposed rule. Most comment letters also suggested edits to the proposed rule. In the discussion below, FINRA discusses the comments and note areas that differ significantly from the Rule as previously proposed in NTM 07-27.

Definitions

The proposed rule change states that no member or associated person may offer or sell any security in a MPO unless certain conditions are met. The proposed rule change uses the term “MPO” as “a private placement of unregistered securities issued by a member or control entity.” The proposed rule further defines two of the terms in the definition of MPO: “private placement” and “control entity.” In response to one comment, FINRA has defined the term “private placement” to be “a non-public offering of securities conducted in reliance on an available exemption from registration under the Securities Act.”

The proposed rule change defines the term “control entity” as “any entity that controls or is under common control with a member, or that is controlled by a member or its associated persons.” The term “control” is defined as “a beneficial interest, as defined in Rule 5130(i)(1), of more than 50 percent of the outstanding voting securities of a corporation, or the right to more than 50 percent of the distributable profits or losses of a partnership or other non-corporate legal entity.” The power to direct the management or policies of a corporation or partnership alone (e.g., a general partner)—absent meeting the majority ownership or right to the majority of profits—would not constitute “control” as defined in proposed FINRA Rule 5122. For purposes of this definition, entities may calculate the percentage of control using a “flow through” concept, by looking through ownership levels to calculate the total percentage of control. For example, if broker-dealer ABC owns 50 percent of corporation DEF that in turn holds a 60 percent interest in corporation GHI, and ABC is engaged in a private offering of GHI, ABC would have a 30 percent interest in GHI (50 percent of 60 percent), and thus GHI would not be considered a control entity under this definition.

FINRA also reaffirms, as stated in NTM 07-27, that performance and management fees earned by a general partner would not be included in the determination of partnership profit or loss percentages. However, if such performance and management fees are subsequently re-invested in the partnership, thereby increasing the general partner's ownership interest, then such interests would be considered in determining whether the partnership is a control entity.

In response to several comments advocating that the timing for determining control take place at the conclusion rather than the commencement of an offering, FINRA has revised the definition of control to be determined immediately after the closing of an offering. The definition also clarifies that, in the case of multiple closings, control will be determined immediately after each closing. If an offering is intended to raise sufficient funds such that the member would not control the entity under the control standard, but fails to raise sufficient funds, the member must promptly come into compliance with the Rule, including providing the required disclosures to investors and filings with FINRA's Corporate Financing Department (“Department”).

Disclosure Requirements

The proposed rule change would require that a member provide a written offering document to each prospective investor in an MPO, whether accredited or not, and that the offering document disclose the intended use of offering proceeds as well as offering expenses and selling compensation. If the offering has a private placement memorandum or term sheet, then such memorandum or term sheet must be provided to each prospective investor and must contain these disclosures. If the offering does not have a private placement memorandum or term sheet, then the member must prepare an offering document that discloses the intended use of offering proceeds as well as offering expenses and selling compensation. The Rule is not meant to require a particular form of disclosure; to emphasize this point, FINRA proposes to issue Supplemental Material 5122.01, which would note that nothing in the Rule shall require a member to prepare a private placement memorandum that meets the additional requirements of Securities Act Rule 502.

FINRA believes that every investor in an MPO should receive basic information concerning the offering. FINRA also believes that none of the disclosures required in the proposed rule change would conflict with requirements under federal or state securities laws.

In response to comments, the proposed rule change eliminates the previously proposed requirements to disclose risk factors and “any other information necessary to ensure that required information is not misleading.” One commenter was concerned that requiring disclosure of these items could lead to an inconsistent scheme of regulation in interpreting the application of the federal securities laws to private placements if FINRA's expectation of what should be disclosed differed from the expectations of the SEC and the courts. While FINRA has omitted these disclosures from the proposed rule change, they specifically request comment on their decision to exclude such disclosures.

Filing Requirements

The proposed rule change would require that a member file a private placement memorandum, term sheet or other offering document with the Department at or prior to the first time such document is provided to any prospective investor. Any amendments or exhibits to the offering document also must be filed by the member with the Department within ten days of being provided to any investor or prospective investor. The filing requirement is intended to allow the Department to identify those offering documents that are deficient “on their face” from the other requirements of the proposed rule change. Notably, the filing requirement in the proposed rule change differs from that in Rule 5110 (Corporate Financing Rule) in that the Department would not review the offering and issue a “no-objections” letter before a member may commence the offering.

FINRA affirms, in response to concerns raised in the comment letters, that information filed with the Department pursuant to FINRA Rule 5122 would be subject to confidential treatment. FINRA has included a provision in the proposed rule change explicitly clarifying this position. The Department plans to develop a Web-based filing system that would allow for the filing to be deemed filed upon submission. In addition, the proposed rule change would not impose any additional requirements regarding filing of advertisements or sales materials, which would continue to be governed by NASD Rule 2210.

One commenter suggested that a member's filing of Form D pursuant to Securities Act Regulation D should provide sufficient information to FINRA. FINRA staff disagrees. For example, FINRA notes that the information in Form D does not include information on a wide variety of expenses or applications of proceeds, nor does Form D require that such information is contained in the offering documents.

Use of Offering Proceeds

Proposed Rule 5122(b)(3) would require that each time an MPO is closed at least 85 percent of the offering proceeds raised be used for business purposes, which would not include offering costs, discounts, commissions or any other cash or non-cash sales incentives. The use of offering proceeds also must be consistent with the disclosures to investors, as described above. This requirement was created to address the abuses where members or control entities used substantial amounts of offering proceeds for selling compensation and related party benefits, rather than business purposes. The proposed rule change does not limit the total amount of underwriting compensation. Rather, under the proposed rule change, offering and other expenses of the MPO could exceed a value greater than 15 percent of the offering proceeds, but no more than 15 percent of the money raised from investors in the private placement could be used to pay these expenses. FINRA notes the 15 percent figure is consistent with the limitation of offering fees and expenses, including compensation, in NASD Rule 2810 (Direct Participation Programs), and the North American Securities Administrators Association (“NASAA”) guidelines with respect to public offerings subject to state regulation.

Some commenters expressed concern that the 85 percent limit was arbitrary or unnecessary and should be reduced or eliminated to allow flexibility for management in MPOs. FINRA believes that when a member engages in a private placement of its own securities or those of a control entity, investors should be assured that, at a minimum, 85 percent of the proceeds of the offering are dedicated to business purposes. FINRA recognizes that changing the business purpose or use of proceeds in an offering may in some instances benefit investors, and remind members that the member may change its use of proceeds, provided it makes appropriate disclosure to investors and files the amended offering document with the Department.

One commenter requested that, when an issuer plans a series of MPOs, the issuer should be allowed to calculate the 85 percent limit at the end of the series. FINRA believes, however, that the limit should apply to each MPO in order to assure investors that at least 85 percent of each offering in a series is dedicated to the business purposes described in that offering's offering document. As a result, FINRA has clarified that the 85 percent limit applies to each MPO.

Proposed Exemptions

Proposed Rule 5122 would include a number of exemptions for sales to institutional purchasers because the staff's findings did not reveal abuse vis-à-vis such purchasers, who are generally sophisticated and able to conduct appropriate due diligence prior to making an investment. Specifically, the proposed Rule would exempt MPOs sold solely to the following:

• Institutional accounts, as defined in NASD Rule 3110(c)(4);
• Qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
• Qualified institutional buyers, as defined in Securities Act Rule 144A;
• Investment companies, as defined in Section 3 of the Investment Company Act;
• An entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A; and
• Banks, as defined in Section 3(a)(2) of the Securities Act.

In addition, the proposed rule change excludes the following types of offerings, which do not raise the concerns identified in the sweep or enforcement actions:

• Offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
• Offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;
• Offerings in which a member acts primarily in a wholesaling capacity (i.e., it intends, as evidenced by a selling agreement, to sell through its affiliate broker-dealers, less than 20% of the securities in the offering);
• Offerings of exempted securities with short term maturities under Section 3(a)(3) of the Securities Act;
• Offerings of subordinated loans under SEA Rule 15c3-1, Appendix D;

• Offerings of “variable contracts,” as defined in NASD Rule 2820(b)(2);
• Offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referred to in Rule 5110(b)(8)(E);
• Offerings of securities of a commodity pool operated by a commodity pool operator, as defined under Section 1a(5) of the Commodity Exchange Act;
• Offerings of equity and credit derivatives, including OTC options, provided that the derivative is not based principally on the member or any of its control entities; and
• Offerings filed with the Department under Rule 5110 or NASD Rules 2720 or 2810.

Finally, the proposed rule change also would exempt MPOs in which investors would be expected to have access to sufficient information about the issuer and its securities in addition to the information provided by the member conducting the MPO. These exemptions include:

• Offerings of unregistered investment grade rated debt and preferred securities;
• Offerings to employees and affiliates of the issuer or its control entities; and
• Offerings of securities issued in conversions, stock splits and restructuring transactions executed by an already existing investor without the need for additional consideration or investments on the part of the investor.

This list of exemptions is largely based on the exemptions previously proposed in NTM 07-27, with a few additions and clarifications in response to comments. FINRA clarified that exempted securities, as defined by Section 3(a)(12) of the Exchange Act, would not be subject to the Rule. In addition, FINRA proposes an exemption for commodity pools in view of the oversight and regulation performed by the National Futures Association and the Commodity Futures Trading Commission. FINRA also clarified that variable contracts and other life insurance products would be excluded, because the offer and sale of these types of offerings are already subject to existing FINRA rules. FINRA also proposes an exemption for member private offerings that are filed with the Department under Rule 5110 or NASD Rules 2720 or 2810.

In addition, FINRA clarified aspects of other previously proposed exemptions. FINRA clarified that their intent regarding the exemption for wholesalers is to provide an exemption for those that do not primarily engage in direct selling to investors. FINRA also clarified that offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already-existing investor without the need for additional consideration or investment on the part of the investor would be exempt.

FINRA also noted that equity and credit derivatives, such as OTC options, would be exempt, provided that the derivative is not based principally on the member or any of its control entities. As a technical matter, the issuer of an equity or credit derivative is the member firm, and thus would make such offering an MPO. However, where the security offered is not based principally on the member or any of its control entities (e.g., an OTC option on MSFT), FINRA does not believe such sale should be subject to the provisions of the proposed rule change. On the other hand, if the derivative is based principally on the member or a control entity (e.g., an OTC option overlying the member), then the sale of such security should be treated as an MPO and subject to the requirements of the proposed rule change.

Finally, FINRA clarified that the exemption for employees and affiliates of issuers would apply to employees and affiliates of control entities as well, because these persons are expected to have access to a level of information about the securities of the issuer similar to employees and affiliates of the issuer itself.

Based on the comment letters, FINRA also reconsidered whether offerings to accredited investors should be exempt. However, FINRA continues to believe that an exemption for offerings made to accredited investors would not be in the public interest due to the generally low thresholds for meeting the definition of the term “accredited investor.” FINRA notes that the SEC has recently proposed clarifying and modernizing its “accredited investor” standard due to concerns that the definition is overbroad.

Additionally, it is FINRA's view that financial products offered by a public reporting company, an investment fund or a state or federal bank affiliate of a FINRA member should not be excluded based solely on their status as a reporting company, a fund or a bank. FINRA's belief is that, as a general matter, exemptions are best tailored based on the type of securities offered or the type (and sophistication) of the purchaser rather than the type of offeror. FINRA also declines to exempt offerings that contribute below a specified level of a member's net worth (e.g., 5%), to create a categorical exemption for all exempted securities under Section 3(a) of the Securities Act, or to expand the exemption for securities with short term maturities under Section 3(a)(3) of the Securities Act to include all securities with a maturity of nine months or less. As a practical matter, however, many of these products would be exempt because they meet one of the other exemptions enumerated in the Rule.

Implementation and Compliance

FINRA will announce the implementation date of the proposed rule change in a Regulatory Notice to be published no later than 60 days following Commission approval. The implementation date will be 30 days following publication of the Regulatory Notice announcing Commission approval, but will not apply retroactively to any offerings that have already commenced selling efforts.

2. Statutory Basis

FINRA believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) of the Act, which requires, among other things, that FINRA rules must be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest. FINRA believes the proposed rule change will provide important investor protections in connection with private placements of securities by members and control entities.

B. Self-Regulatory Organization's Statement on Burden on Competition

FINRA does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

The proposed rule change was published in Notice to Members 07-27 (June 2007). Sixteen comments were received in response to Notice to Members 07-27. A copy of Notice to Members 07-27 is attached as Exhibit 2a to this rule filing. A list of the comment letters received in response to Notice to Members 07-27 is attached as Exhibit 2b to this rule filing. Copies of the comment letters received in response to Notice to Members 07-27 are attached as Exhibit 2c to this rule filing. The comments are summarized above.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 35 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:

(A) by order approve such proposed rule change, or

(B) institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form ( http://www.sec.gov/rules/sro.shtml ); or
• Send an e-mail to rule-comments@sec.gov. Please include File Number SR-FINRA-2008-020 on the subject line.

Paper Comments

• Send paper comments in triplicate to Elizabeth M. Murphy, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2008-020. This file number should be included on the subject line if e-mail is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site ( http://www.sec.gov/rules/sro.shtml ). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Copies of such filing also will be available for inspection and copying at the principal office of FINRA. All comments received will be posted without change; the Commission does not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-FINRA-2008-020 and should be submitted on or before February 17, 2009.