Jul 16, 2020
On July 1, 2020, the U.S. Financial Industry Regulatory Authority, Inc. (FINRA) issued Regulatory Notice 20-21 (the “Regulatory Notice”), 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.
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.
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:
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.
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.
In the Regulatory Notice, FINRA underlined that communications prepared by third-parties may constitute firm communications and must comply with Rule 2210:
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.
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:
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.
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.
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:
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.
 FINRA Regulatory Notice 20-21.
 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).
 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).
 FINRA Regulatory Notice 10-22.
 For more information regarding Regulatory Notice 10-22, please see “FINRA Guidance: Member Firms’ Responsibilities in Regulation D Offerings” (June 3, 2010).
 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.
 For more information, please see “FINRA Proposes to Permit Use of Predictions/Projections of Investment Strategy Performance” (March 9, 2017).