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Mar 08, 2017

FINRA Proposes to Permit Use of Predictions/Projections of Investment Strategy Performance

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Exception Proposed to FINRA Communication Rule’s Prohibition on Predictions or Projections of Performance

Introduction

In February, the US Financial Industry Regulatory Authority (“FINRA”) proposed amendments1 to its rule regarding communications with the public, Rule 2210, that would allow broker-dealers to distribute a customized hypothetical investment planning illustration that includes projected performance of an asset allocation or other investment strategy (but not with respect to an individual security).2 The amendments would be a carve-out from Rule 2210’s prohibition on predictions or projections of performance.

FINRA is currently soliciting comments to the proposal. All comments must be received by March 27, 2017.

Background: FINRA’s Communications Rule

Overview of Rule 2210 and Its Content Standards

Rule 2210 governs broker-dealer communications with the public. Rule 2210’s requirements include principal review, filing, and record-keeping requirements, certain disclosure requirements, as well as content standards discussed in greater detail below.

Under Rule 2210(d)(1), all communications with the public, including “institutional communications”—communications which are distributed to only institutional investors—must adhere to the following five content standards3:

  • All broker-dealer communications with the public must be based on principles of fair dealing and good faith, must be fair and balanced, and must provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service;

  • No broker-dealer may make any false, exaggerated, unwarranted or misleading statement or claim in any communication with the public. Information may be placed in a legend or foot-note only in the event that such placement would not inhibit an investor’s understanding of the communication;

  • If any testimonial in a communication with the public concerns a technical aspect of investing, then the person making the testimonial must have the knowledge and experience to form a valid opinion with respect to the applicable subject; and,

  • Communications with the public may not predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast, subject to limited exceptions. [emphasis added]

Rule 2210 Prohibition on Predictions and Projections of Performance

Rule 2210(d)(1)(F)’s broad prohibition on predictions or projections of performance is subject to four narrow exceptions: (i) investment analysis tools that comply with FINRA Rule 2214; (ii) price targets in research reports; (iii) certain projections concerning security futures and options; and (iv) hypothetical illustrations of mathematical principles. Notwithstanding the availability of these exceptions, the prohibition on prediction or projection of investment performance is a relatively rigid prohibition, and, as noted above, is not subject to an exemption for institutional investors.

This broad prohibition against predictions or projections of performance has historically presented an obstacle in the marketing and advertising efforts of broker-dealers, particularly for those broker-dealers engaged in institutional private placement activities, where institutional investors regularly insist on receiving both projections of performance and target return figures4, as well as the underlying data for such projections, in order to evaluate underlying assumptions and to make investment decisions. FINRA has been reluctant to provide exemptions beyond those enumerated in the rule.5

The Proposed Amendments

The proposed amendments would provide an exception to the prohibition of projections or predictions for distribution of a customized hypothetical investment planning illustration. In particular, the exception would cover illustrations that project the performance of an asset allocation or other investment strategy, but not those that project the performance of an individual security. The exception would be available for all firms, including firms that operate only an online platform, and could be relied upon with respect to communications with both current and prospective customers.

The proposed exception would require that there be a “reasonable basis” for all assumptions, conclusions and recommendations, and that there be clear and prominent disclosure of the fact that the illustration is hypothetical and that there is no assurance that any described investment performance or event will occur. All material assumptions and limitations applicable to the illustration would have to be disclosed.

FINRA stated that a “reasonable basis” might be established by reference to historical financial data, including data regarding historical performance and performance volatility of asset classes, the effects of macroeconomic factors, and the impact of fees, costs and taxes, etc. The proposal notes that an unreasonable emphasis on any one factor underlying a projection may cause such projection to be considered noncompliant. In addition, FINRA noted that basing a projection upon hypothetical back-tested performance or the past performance of particular investments by an asset manager would be per se unreasonable.

Finally, the proposal would establish specific supervisory requirements for the permitted illustrations. In general, permitted illustrations would require registered principal approval prior to use or distribution, although firms that utilize a template illustration would be allowed to obtain principal approval of the template in lieu of obtaining approval for each individual illustration.

Concluding Thoughts

The proposed amendments to Rule 2210 represents a significant, positive step in the harmonization between broker-dealer and investment advisory standards, and would simplify the compliance and oversight requirements for firms that are dual-registered as both broker-dealers and investment advisers. In addition, the relaxing of the prohibition on projections would allow broker-dealers to provide to their clients information that may be important to customers’ investment decision-making processes.

However, the relaxing of the prohibition on projections remains limited under the proposal, as the exception is limited to strategy planning asset allocation tools, and does not permit, for example, projections relating to prospective investment outcomes for pooled investment vehicles or any other individual security. Further, the data that broker-dealers are permitted to reference in order to form the “reasonable basis” for any projection is also subject to limitations that may constrain use of the exemption. 

With that said, steps in the direction of permitting prudent, professional use of predictions or projections of performance are most welcome.

Footnotes

[1]  FINRA’s proposal is made in Regulatory Notice 17-06, available at: http://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-17-06.pdf
[2]  For more information regarding FINRA regulation of broker-dealer communications with the public, please see: “New Rules Regarding Communications With the Public by Brokers and Dealers Take Effect” (November 1, 2003), currently available at: https://www.shearman.com/~/media/files/newsinsights/publications/2003/11/new-rules-regarding-communications-with-the-publ__/files/download-pdf-new-rules-regarding-communications-__/fileattachment/sd_1103.pd

[3]  For purposes of Rule 2210, an “institutional investor” means any: (A) (i) bank, savings and loan association, insurance company or registered investment company; (ii) an investment adviser registered either with the SEC under Section 203 of the Investment Advisers Act or with a state securities commission (or any agency or office performing like functions); (iii) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million; (B) governmental entity or subdivision thereof; (C) employee benefit plan, or multiple employee benefit plans offered to employees of the same employer, that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and in the aggregate have at least 100 participants, but does not include any participant of such plans; (D) qualified plan, as defined in Section 3(a)(12)(C) of the Securities Exchange Act of 1934, or multiple qualified plans offered to employees of the same employer, that in the aggregate have at least 100 participants, but does not include any participant of such plans; (E) FINRA member or registered person of such a member; and (F) person acting solely on behalf of any such institutional investor.

[4]  We note that target returns are, by definition, neither predictions nor projections of performance. However, our experience has been that FINRA will carefully review the use of target returns not only for consistency with the content standards described above, but also to see if, as used, they are de facto predictions or projections of performance. In the past, FINRA has brought enforcement action for use of target returns that FINRA believed to be inconsistent with the content standards described above.
[5]  See Interpretive Letter to W. Thomas Conner, National Association for Variable Annuities, granting the use of hypothetical illustrations in variable life insurance or annuity contracts only as they may be required pursuant to Part 51 of Title 11 of the Official Compilation of Codes, Rules and Regulations of the State of New York (“Regulation 60”). The letter is available at: http://www.finra.org/industry/interpretive-letters/february-5-1999-1200am. In contrast, see Interpretive Letter to Dawn Bond, FSC Securities Corporation, denying the use of investment projections with respect to financial plans used by a dual-registered broker-dealer/investment adviser to recommend a proposed portfolio to clients. The letter is available at: http://www.finra.org/industry/interpretive-letters/july-30-1998-1200am.

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Nathan Greene

Partner

Investment Funds

+1 212 848 4668

+1 212 848 4668

New York

Jennifer D. Morton

Counsel

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5187

+1 212 848 5187

New York

Steven Blau

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 8534

+1 212 848 8534

+1 416 360 2154

+1 416 360 2154

New York

Jenny Ding Jordan

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 5095

+1 212 848 5095

New York