Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving Proposed Rule Change, as Modified by Amendment No. 1, to FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities) That Would Require Members To File Retail Communications Concerning Private Placement Offerings That Are Subject to Those Rules' Filing Requirements

I. Introduction

On October 28, 2020, the Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) and Rule 19b-4 thereunder, a proposed rule change to amend FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities) that would require members to file certain retail communications concerning private placements.

The proposed rule change was published for comment in the Federal Register on November 6, 2020. On December 11, 2020, FINRA consented to an extension of the time period in which the Commission must approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether to approve or disapprove the proposed rule change to February 4, 2021. On January 12, 2021, FINRA responded to five comment letters received in response to the Notice and filed an amendment to the proposed rule change (“Amendment No. 1”). On January 29, 2021, FINRA responded to a sixth comment letter received in response to the Notice. On February 4, 2021, the Commission filed an Order Instituting Proceedings to determine whether to approve or disapprove the proposed rule change, as modified by Amendment No. 1. The Commission received no comments in response to the OIP. On April 12, 2021, FINRA responded to a seventh comment letter received in response to the Notice. On May 4, 2021, FINRA consented to an extension of the time period in which the Commission must approve or disapprove the proposed rule change to May 26, 2021. On May 25, 2021, FINRA consented to an extension of the time period in which the Commission must approve or disapprove the proposed rule change to June 9, 2021. This order approves the proposed rule change, as modified by Amendment No. 1.

II. Description of the Proposed Rule Change

For certain private placements of unregistered securities issued by a FINRA member or a control entity (“member private placements”), FINRA Rule 5122 requires the member or control entity to provide prospective investors with a private placement memorandum (“PPM”), term sheet or other offering document that discloses the intended use of the offering proceeds, the offering expenses, and the amount of selling compensation that will be paid to the member and its associated persons. Among other things, the current rule also requires a member to file the PPM, term sheet or other offering document with FINRA's Corporate Financing Department at or prior to the first time the document is provided to any prospective investor, and to file any amendments to such documents within 10 days of being provided to any investor or prospective investor. Similarly, for certain private placements of unregistered securities issued by a non-member, FINRA Rule 5123 requires members or control persons to file with FINRA's Corporate Financing Department any PPM, term sheet or other offering document, including any material amended versions thereof, used in connection with an offering within 15 calendar days of the date of first sale.

Separately, FINRA also requires broker-dealers to file with FINRA's Advertising Regulation Department certain written communications that they distribute or make available to retail customers to review those written communications for compliance with the content requirements of FINRA Rule 2210 (Communications with the Public). For example, retail communications are required to comply with the general, fair and balanced standards in FINRA Rule 2210. Despite these existing obligations, FINRA has found a comparatively high rate of non-compliance with Rule 2210 of retail communications concerning private placements. Currently, some broker-dealers submit retail communications as part of their Rules 5122 and 5123 filings either voluntarily or as new members. In a 2018 spot check of these filings, FINRA found that 76% of retail communications filed during the spot check review period involved significant violations of Rule 2210. Further, FINRA stated that since January 1, 2014, it has initiated 49 disciplinary actions related to non-compliant retail communications concerning private placements. This number represents 21% of all actions involving private placements. According to FINRA, these communications often present false or misleading information regarding the underlying offering, which could result in significant losses to investors and could undermine public trust in the private placement markets.

To address this area of regulatory concern, FINRA proposed amendments to Rules 5122 and 5123 that would require members or control persons to file retail communications that “promote or recommend” a private placement with FINRA's Corporate Financing Department, in addition to the currently required PPMs, term sheets, and other offering documents. The rules' requirements that material amendments to offering documents must be filed also would apply to any material amendments to retail communications concerning private placements. The proposed rule change would provide FINRA with a more timely opportunity to review retail communications concerning private placements for compliance with its rules. Other than those documents filed pursuant to Rule 2210, FINRA's review of such documents is currently limited to its cycle and spot exams of its members.

The proposed rule change would not, however, broaden the application of the rules to capture those offerings that are currently exempt from filing. The proposed rule change also would not impose new filing fees on broker-dealers.

In addition, the proposed rule change would neither amend Rule 2210 nor, as FINRA states, alter FINRA's interpretation of the application of that rule's requirements. Thus, if written communications qualify as retail communications pursuant to FINRA Rule 2210, those retail communications would be subject to the proposed rule changes.

III. Discussion and Commission Findings

A. Discussion

After careful review of the proposed rule change, as modified by Amendment No. 1, the comment letters, and FINRA's responses to the comments, the Commission finds that the proposed rule change, as modified by Amendment No. 1, is consistent with the requirements of the Exchange Act and the rules and regulations thereunder that are applicable to a national securities association. Specifically, the Commission finds that the proposed rule change, as modified by Amendment No. 1, is consistent with Section 15A(b)(6) of the Exchange Act, which requires, among other things, that FINRA rules 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.

Four commenters supported the proposed rule change. Two of these commenters stated that the proposed rule change would establish necessary investor protections in light of regulatory changes that have expanded the marketplace for private placements. Specifically, one stated that its state securities administrator members have observed significant, recurring problems with private placements and that, “[w]ith the SEC's recent regulatory changes to the private [placement] marketplace, . . . the need for increased regulatory scrutiny of private placement advertisements is even more acute.” One other supportive commenter stated that, because the number of persons who can invest in private placements has increased substantially over the last several decades, “FINRA must keep an eye [on] private placement sales abuses.” One of the other supportive commenters stated that FINRA and Commission rules already require members to keep detailed records on marketing materials, which are routinely requested during cycle examinations, and that the proposed rule changes could facilitate this review process. The fourth supportive commenter stated that the proposed rule changes are justified because they would help FINRA “better ensure that retail communications used by broker-dealers in retail private placements are fair, balanced and not misleading.”

1. Requests for Guidance Under FINRA Rule 2210 (Communications With the Public)

a. Issuer-Prepared Material

A supportive commenter requested that the Commission use this opportunity to provide “definitive guidance” to members with respect to the applicability of Rule 2210 to materials prepared and disseminated by an issuer to the public, without the involvement of a member firm or its registered representatives. In response, FINRA stated that it has already addressed the applicability of Rule 2210 to issuer-prepared communications. In particular, FINRA has previously stated that “[a member] that assists in the preparation of a private placement memorandum or other offering document should expect that it will be considered a communication with the public by that [member] for purposes of . . . Rule 2210, FINRA's advertising rule.” Similarly, FINRA has stated that sales literature concerning a private placement that a member distributes will be deemed to constitute a communication by that member with the public, whether or not the member assisted in its preparation. Therefore, regardless of whether a member distributes a retail communication that is attached to a PPM or as a standalone document, it constitutes a member communication subject to Rule 2210.

FINRA's proposed rule change does not amend the definition of “retail communications” or change the scope of communications captured within the definition of the term. Thus, the Commission believes that interpretations of the definition of “retail communications” are outside the scope of the proposed rule change. However, FINRA stated that it has issued guidance on retail communications concerning private placements, stating that, in general, if a member distributes sales literature concerning a private placement it will be deemed a communication by that member with the public subject to Rule 2210. In addition, Rule 2210 prohibits members from publishing, circulating, or distributing “any communication that the member knows or has reason to know contains any untrue statement of a material fact or is otherwise false or misleading” regardless of its origin.

b. Performance Projections

Three commenters sought guidance regarding the application of FINRA Rule 2210 to performance projections. A supportive commenter requested that the Commission provide interpretive guidance under Exchange Act Rule 10b-5 concerning the inclusion of performance return objectives in private placement sales materials. Specifically, the commenter believes that because of Rule 2210's restrictions on predicting or projecting performance, broker-dealers are placed at a competitive disadvantage relative to private placements that do not involve a broker-dealer (to which Rule 2010 would not apply), and that the Commission should “level the playing field.”

In response, FINRA stated that, in general, Rule 2210(d)(1)(F) prohibits member communications from predicting or projecting performance or making any exaggerated or unwarranted claim, opinion or forecast. More specifically, FINRA stated that retail communications concerning private placements may not project or predict returns to investors such as yields, income, dividends, capital appreciation percentages or any other future investment performance. However, FINRA also clarified that despite its prohibition on certain types of performance predictions, its rules permit retail communications concerning private placements to include reasonable forecasts of issuer operating metrics (e.g., forecasted sales, revenues or customer acquisition numbers) that may convey important information regarding the issuer's plans and financial position. FINRA stated that these presentations should provide a sound basis for evaluating the facts, such as clear explanations of the key assumptions underlying the forecasted issuer operating metrics and the key risks that may impede achievement of the forecasted metrics.

One commenter recommended that FINRA “clarify the application of its principles-based advertising rules to retail communications concerning private placement[s].” In particular, the commenter recommended that FINRA provide interpretive guidance on the term “performance projection” to help members comply with FINRA Rule 2210(d)(1)(F). FINRA responded that the proposed rule change would not amend or provide guidance on Rule 2210. Accordingly, FINRA believes that the commenter's recommendation is outside the scope of the proposed rule change.

Another commenter described its experience evaluating the features and risks of alternative investments marketed through private placements and has found, like FINRA, many instances in which a sponsor's offering promotional materials did not comply with FINRA Rule 2210. Thus, the commenter asked FINRA to further clarify Regulatory Notice 20-21 to: (1) Explain what types of information constitute an issuer's “operating metrics” and (2) clarify when members may present information about “distribution rates” within retail communications.

In response, FINRA stated that the commenter's concerns regard the application of FINRA Rule 2210 rather than the filing requirements in the proposed rule changes to Rules 5122 and 5123 that are the subject of the rule filing. FINRA reiterated its guidance under Regulatory Notice 20-21 but stated that it is willing to further discuss with its members issues regarding particular retail communications that are filed with FINRA, both before and after a communication is filed.

Given that the proposed rule change does not change the interpretation of retail communications, the Commission believes that interpretations of the definition of “retail communications” are outside the scope of the proposed rule change. However, FINRA stated that it has existing guidance regarding the type of performance projections a member can include, and is prohibited from including, in its retail communications.

2. Other Suggested Rule Changes

One of the four commenters supporting the proposed rule change suggested three additional changes “to protect retail investors in the private placement market.” First, the commenter recommended that FINRA combine Rules 5122 and 5123 into a single rule and that the combined new rule should require (as does Rule 5122) disclosure about the use of offering proceeds, offering expenses and selling compensation, suggesting that providing investors these key pieces of information about an offering is justified given the history of problems in the private placement market. Third, the commenter recommended that FINRA amend Rule 2210 so that it applies to PPMs, term sheets, and other offering documents in retail private placements, arguing that in the absence of a legal definition of “private placement memorandum” it is difficult to distinguish a PPM from other retail communications and it may be difficult to determine if a member assisted in its preparation. Accordingly, the commenter recommended that such offering documents be subject to the general content standards of Rule 2210(d)(1).

In response, FINRA stated that the commenter's suggestions were beyond the scope of the proposed rule change and could not be adopted as part of this filing. The Commission agrees with FINRA that the commenter's suggestions raise issues that go beyond the subject matter of this proposal and therefore are beyond the scope of the proposed rule change.

3. Non-Promotional Communications

One commenter expressed concern with the breadth of the communications that would be required to be filed. The commenter believes that requiring a member to file all “retail communications concerning a private placement” could result in members being required to file communications that are administrative in nature, such as confirmations that a signature was received or reminders of actions that investors still need to take. Instead, the commenter recommended that FINRA narrow the scope of the filing requirement to capture only “those types of communications on which investors are likely to base an investment decision,” such as pitch decks or slide shows.

In response, FINRA noted that the examples of administrative communications that the commenter identified likely would be directed to a single or small group of investors, and thus would be correspondence (which is not subject to filing) rather than retail communications. Nevertheless, FINRA recognized that some of these administrative and non-promotional communications may fall within the definition of retail communication because they are distributed to more than 25 retail investors within a 30-day period. Accordingly, FINRA amended the proposed rule change to narrow the filing requirement to any retail communication that “promotes or recommends” a member private placement (Rule 5122) or other private placement (Rule 5123), rather than a retail communication “concerning” such offerings.

The Commission believes that the proposed rule change in Amendment No. 1 to apply the filing requirement only to a retail communication that “promotes or recommends” a member private placement is designed to protect investors and the public interest by appropriately narrowing the filing requirement to those communications that pose the greatest regulatory concern, and therefore improving the timeliness of FINRA's review of private placement communications that might influence investors' transaction decisions.

B. Commission Findings

Under Rules 5122 and 5123, broker-dealers are required to file with FINRA's Corporate Financing Department any PPM, term sheet, or other offering document used in connection with private placements, but these rules do not currently require retail communications governed by Rule 2210 to be filed. Similarly, Rule 2210 generally does not require broker-dealers to file with FINRA's Advertising Regulation Department the materials they use to communicate with retail investors concerning private placements. Accordingly, firms currently have no regulatory obligation to submit retail communications concerning private placements for review by FINRA. Currently, some broker-dealers submit retail communications as part of their Rules 5122 and 5123 filings either voluntarily or as new members. Given the comparatively high rate of non-compliance with Rule 2210 in these private placement retail communications, and the increased risk of investor harm associated with those communications, FINRA proposed to amend Rules 5122 and 5123 to make such submissions mandatory, in addition to the currently required PPMs, term sheets, and other offering documents. The proposed rule change would not amend Rule 2210 or change FINRA's interpretations of the rule.

The Commission believes that the proposed rule change to require members to file retail communications concerning private placements would help prevent fraudulent and manipulative acts and practices by facilitating FINRA's review of information about private placements being disclosed to retail customers in those communications. Requiring members to file retail communications concerning private placements with FINRA's Corporate Financing Department would allow FINRA to review the documents more efficiently and timely than it could by relying on cycle reviews of its members. Through its reviews of the these retail communications, FINRA would be able to more efficiently identify retail communications about private placements that may not be fair and balanced as required by FINRA Rule 2210, thereby reducing the potential risk of customer harm from investing on the basis of misleading communications. Moreover, given the high rate of non-compliance with this fundamental communications standard, FINRA's increased ability to review retail communications concerning private placements pursuant to this proposed rule change would likely incentivize broker-dealers to distribute those types of retail communications that are fair and balanced in compliance with Rule 2210 and deter them from presenting information in a manner that may cause investor harm. The Commission believes that these changes are particularly important in light of the expanded retail investor participation in the market for private placements. The proposed rule change would help encourage the use of fair and balanced communications to investors making investment decisions.

Although some commenters requested clarification of specific aspects of the application of FINRA Rule 2210, such as broker-dealers' use of performance projections in their retail communications, and in some cases sought guidance on specific factual scenarios, FINRA has previously provided guidance on these issues and has offered to continue to provide guidance as necessary. Moreover, the Commission believes that these comments are beyond the scope of this proposed rule change. Notably, the proposed rule change does not modify Rule 2210, does not change its application, nor does it subject any additional communications to 2210's requirements.

In sum, the Commission believes that the proposed rule change addresses a problem identified by FINRA regarding the comparatively high rate of non-compliance with Rule 2210 of retail communications concerning private placements. The Commission believes that FINRA's proposed rule change would improve the quality of information available to retail investors about private placement securities offered by FINRA members and strengthen FINRA's ability to monitor these communications for potential violations of its rules thereby improving prospective investors' confidence in these communications. FINRA has taken a number of steps to narrowly tailor this proposed rule change in some key respects: The proposed rule change would apply to types of retail communications that have been found to have a high rate of noncompliance with FINRA's fair and balanced standards; broker-dealers would not have to pay a filing fee for their submissions; and the proposed filing requirement has been narrowed to apply only to retail communications concerning private placements that “promote or recommend” a private placement security. Thus, for the reasons stated above, we believe that the proposed rule change, as modified by Amendment No. 1, is consistent with the provisions of Section 15A(b)(6) of the Exchange Act because it is 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.

IV. Conclusion

It is therefore ordered pursuant to Section 19(b)(2) of the Exchange Act that the proposed rule change (SR-FINRA-2020-038), as modified by Amendment No. 1, be, and hereby is, approved.