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Jul 16, 2020

FINRA Releases New Guidance on Retail Communications Concerning Private Placement Offerings

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FINRA RELEASES NEW GUIDANCE ON RETAIL COMMUNICATIONS CONCERNING PRIVATE PLACEMENT OFFERINGS

I. Introduction

On July 1, 2020, the U.S. Financial Industry Regulatory Authority, Inc. (FINRA) issued Regulatory Notice 20-21 (the “Regulatory Notice”)[1], which provides guidance to broker-dealers on compliance with FINRA Rule 2210 (Communications with the Public) in the context of private placement offerings with respect to several issues identified by FINRA.[2]

The principal topics addressed in the Regulatory Notice are (i) compliance with Rule 2210 with respect to third-party prepared materials, (ii) balanced presentation of risks and investment benefits, (iii) use of forecasts of issuer operating metrics, (iv) use of distribution rates, and (vand use of internal rates of return. This note will consider each of the foregoing in turn.

II. Rule 2210 Background

FINRA Rule 2210 regulates broker-dealer communications with the public. The rule includes both (i) content standards to which all broker-dealer communications with the public must adhere, and (ii) prior review, filing requirements and record-keeping requirements for certain types of communications.

FINRA Rule 2210(a)(5) defines “retail communication” to mean any written or electronic communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period. FINRA found that many private placement offerings to retail investors include communications that meet this definition.

2.1 Content Standards

Under Rule 2210(d)(1), all communications with the public must adhere to certain content standards, including the following:

  • 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 regarding 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 footnote 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.

2.2 Principal Approval Requirements

Under Rule 2210, each retail communication must be reviewed by an appropriately qualified principal of the firm before the earlier of its use or filing with FINRA. The rule provides several exceptions for the principal pre-use approval requirement for retail communications, including the following: advertisements that another firm has already filed with and had approved by FINRA; retail communications posted on an online interactive electronic forum; and any retail communication that does not make any financial or investment recommendation or otherwise promote a product or service of the firm.[3]

2.3 Retail Communication Filing Requirements

Under Rule 2210, certain retail communications must be filed with FINRA. While institutional communications and correspondence do not need to be filed with FINRA, Rule 2210(c)(7) also excludes certain retail communications from the filing requirements. Prospectuses, preliminary prospectuses, fund profiles, offering circulars, annual and semi-annual reports and similar documents filed with the SEC or any state in compliance with applicable requirements, and offering documents concerning securities exempt from such filing or registration, including free writing prospectuses exempt from filing with the SEC, do not need to be filed with FINRA.

Certain retail communications must be filed with FINRA at least ten business days prior to first use or publication, such as retail communications that include rankings or performance comparison information that is not generally published or that is created by the investment company. Certain other retail communications must be filed with FINRA within ten business days of use, including registered investment company retail communications that promote or recommend a specific registered investment company or family of registered investment companies.

III. Third-Party Prepared Materials

In the Regulatory Notice, FINRA underlined that communications prepared by third-parties may constitute firm communications and must comply with Rule 2210:

  • In the Regulatory Notice, FINRA reminds members that FINRA Regulatory Notice 10-22[4] provided that a broker-dealer that assists in preparing an offering document should expect that it will be considered a firm communication with the public for purposes of FINRA Rule 2210, and therefore must be fair and balanced.
  • Further, FINRA Regulatory Notice 10-22 states that sales literature concerning a private placement that a broker-dealer will generally constitute a communication with the public, regardless of whether the broker-dealer assisted in its preparation of such sales literature.[5] With respect to third-party sales literature, the guidance set forth in the Regulatory Notice may represent a tightening of FINRA’s expectations, although this point will ultimately be borne out in upcoming FINRA examinations.
  • FINRA expands on these principles in the Regulatory Notice, noting that some issuer-prepared PPMs are presented as a single electronic file with other documents that are distinguishable by their marketing or promotional content from the factual descriptions and financial information about the issuer generally disclosed in PPMs. FINRA noted that these documents constitute a communication of the member subject to Rule 2210 notwithstanding that they may be attached to a PPM.[6]

IV. Presentation of Risks and Investment Benefits

Under Rule 2210, a broker-dealer must ensure that its communications are clear and not misleading within the context in which they are made, and that they provide balanced treatment of risks and potential benefits. FINRA notes that, as such, retail communications that discuss the benefits of investing in a private placement should balance this disclosure with a discussion of their risks, such as lack of liquidity.

The Regulatory Notice reminds that providing risk disclosure in a separate document, such as a private placement memorandum, is not enough to comply with the rule’s content standards, and that disclosure of the risks of investing in a private placement must be in the same retail communication that discusses the potential benefits.

V. Forecasts of Issuer Operating Metrics

FINRA Rule 2210(d)(1)(F) provides that communications may not predict or project performance, imply that past performance will recur, or make any exaggerated or unwarranted claim, opinion or forecast. However, the rule’s text provides exemptions for: (i) a hypothetical illustration of mathematical principles, provided that it does not predict or project the performance of an investment or investment strategy, (ii) an investment analysis tool, or a written report produced by an investment analysis tool that meets the requirements of FINRA Rule 2214, or (iii) a price target contained in a research report on debt or equity securities, subject to certain conditions.

The Regulatory Notice provides that although retail communications concerning private placements must not project or predict returns to investors, FINRA would not consider 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 positions” [emphasis in the original] as a prohibited prediction or projection of performance.

If a communication will include issuer operating metrics, broker-dealers should ensure that the communication includes a sound basis for evaluating the facts as required by Rule 2210(d)(1)(A). As such, the communication should include an explanation of the underlying assumptions of the metrics and the key risks that may impede achievement of the forecasted metrics. Firms should consider:

  • the time period forecasted (generally a time period in excess of five years would be unreasonable);
  • whether growth rate assumptions are commensurate with the nature and scale of the business;
  • whether forecasted gross margins are commensurate with industry averages; and
  • whether sales and customer acquisition forecasts are reasonable in relation to the overall market for the issuer’s products or services.

FINRA noted that communications may not characterize specific revenue or cash flow as guaranteed or certain, and may not project or depict specific investment returns to an investor.

VI. Distribution Rates

The Regulatory Notice also addresses programs whereby issuers fund a portion of their distribution through return of principal or loan proceeds. The Regulatory Notice notes that, for example, a portion of a newer program’s distributions might include a return of principal until its assets are generating significant cash flows from operations. FINRA states that, per FINRA Rule 2210(d)(1)(B)’s prohibition of false, exaggerated, unwarranted, promissory or misleading claims, broker-dealers must not misrepresent the amount or composition of such distributions, and retail communications may not state or imply that a distribution rate is a yield or that their investments are comparable to a fixed income investment. Retail communications may include an annualized distribution rate only if the program has paid distributions that are, on an annualized basis, at a minimum equal to that rate for at least two consecutive full quarterly periods.

The Regulatory Notice provides guidelines for including distribution rates in retail communications, and notes that communications should disclose that distribution payments are not guaranteed and may be modified, among other disclosures.

VII. Internal Rate of Return

Internal Rate of Return (IRR) is a measure of performance that shows a return earned by investors over a particular period of time, calculated on the basis of cash flows to and from investors. Potential investors in private equity funds and real estate funds often specifically request such information. With respect to the prohibition on communications that predict or project performance, set forth in Rule 2210(d)(1)(F), the Regulatory Notice provides guidance on use of IRR in certain scenarios:

  • For investment programs that do not have operations or that operate as a blind pool, FINRA states that use of IRR would be inconsistent with the rule’s prohibition on unwarranted forecasts or projections.[7]
  • However, retail communications may include IRR for completed investment programs or for a specific investment in a portfolio, as long as the IRR represents the actual performance of that holding.
  • Where an investment program with ongoing operations has a combination of realized investments and unrealized holdings, it is permissible to include the IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investor.

VIII. Conclusion

Communications relating to private placements, including private placements of many investment funds, have raised compliance issues under Rule 2210 for years, not least because investors in such investment opportunities often specifically request forward-looking data. The Regulatory Notice underscores some of the challenges in providing those data, but also gives new information that will be helpful to firms seeking to comply with the Rule. Our team at Shearman & Sterling LLP would be happy to answer any questions you may have.

Footnotes

[1] FINRA Regulatory Notice 20-21.
[2] For more information regarding FINRA regulation of broker-dealer communications with the public, you may wish to refer to: “FINRA Releases New Guidance Regarding Social Media and Digital Communications” (June 26, 2017), “FINRA Proposes to Permit Use of Predictions/Projections of Investment Strategy Performance” (March 9, 2017), and “New Rules Regarding Communications With the Public by Brokers and Dealers Take Effect” (November 1, 2003).
[3] For more information regarding FINRA Rule 2210, please see Private Banking and Wealth Management by Andrew J. (Buddy) Donohue and Russell D. Sacks (2018), and “Exception Proposed to FINRA Communication Rule’s Prohibition on Predictions or Projections of Performance” (Mar. 08, 2017).
[4] FINRA Regulatory Notice 10-22.
[5] For more information regarding Regulatory Notice 10-22, please see “FINRA Guidance: Member Firms’ Responsibilities in Regulation D Offerings” (June 3, 2010).
[6] PPMs do not constitute communications of the member even if distributed by the broker-dealer, unless, as noted above, the broker-dealer has assisted in preparing the offering document as set forth in Regulatory Notice 10-22.
[7] For more information, please see “FINRA Proposes to Permit Use of Predictions/Projections of Investment Strategy Performance” (March 9, 2017).

Authors and Contributors

Russell Sacks

Partner

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7585

+1 212 848 7585

New York

Jennifer D. Morton

Partner

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

P. Sean Kelly

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7312

+1 212 848 7312

New York

Taylor Pugliese

Associate

Financial Institutions Advisory & Financial Regulatory

+1 212 848 7294

+1 212 848 7294

New York