PUBLICATIONS
Publications
Publications

A Publication of Pepper Hamilton LLP

Funds Services Alert

FINRA Rule 5123: A New FINRA Member Broker-Dealer Compliance Requirement When Selling Private Placements

Friday, June 22, 2012

On June 7, 2012, the Securities and Exchange Commission (SEC) issued an order approving a new FINRA Rule 5123.1 The rule is still open for comment until July 5, 2012 and will not become effective until FINRA formally promulgates the official final text of the rule and specifies the effective date.

The new rule requires a FINRA member broker-dealer that sells private placement securities2 to:

(i) send FINRA (or have submitted on its behalf) a copy of any private placement memorandum, term sheet or other offering document (including any materially amended versions) used in connection with a sale of such a security within 15 calendar days after the date of the first sale by that broker;3 or

(ii) indicate in a notice filing to FINRA (the specifics of how notice filings will be made have not yet been announced) that no such offering documents were used in connection with the broker-dealer’s sale of the privately placed securities. Rule 5123 also requires broker-dealers to file any “materially amended versions” of offering documents used in connection with a sale.

All documents and information filed under new Rule 5123 will be afforded confidential treatment and, as per FINRA, used only to assess the broker-dealer’s compliance with applicable FINRA rules and regulatory requirements.

Pepper Point: Issuers will want to ensure that only the most current versions of selling materials are sent to FINRA by their placement agents. While offering documents can be updated anytime – and must be updated for material changes – it is customary for a selling document to be in use for quite some time for consistency in the offering. Whenever there is a material supplement or addendum, it is expected that the rule will require the selling broker to file the amendment or supplement with FINRA to the extent that sales by the broker covered by Rule 5123 occur after the date of the amendment or supplement. We expect issues relating to the obligation to file amendments to be clarified by FINRA before the effective date of the new rule. For private equity funds, Rule 5123 is unlikely to represent a significant consideration since fundraising periods are finite (though they may not feel that way) and have relatively few amendments and supplements. For broker-dealer-sold hedge funds and funds of funds that engage in ongoing, open-ended offerings, brokers are likely to require periodic updates of offering materials that are still being used and to submit those amendments to FINRA. In this regard, the rule breaks no new ground (other than the filing/notice requirement) because issuers were always required to ensure that their offering materials were up-to-date and not materially misleading.

FINRA Rule 5123, in its current state, is narrower and less onerous than as originally proposed, no doubt due to the numerous industry comments that had urged its narrowing. Gone are proposed requirements for a use of proceeds schedule and similar disclosures.

FINRA Rule 5123 exempts various types of offerings and offerings sold to certain categories of purchasers from its notice filing requirements. Key exemptions include offerings sold by a FINRA member solely to any one or more of the following purchasers:

  • institutional accounts (as defined in FINRA Rule 4512(c))
  • accredited investors as defined in Rule 501(a)(1) (banks, brokers, insurance companies, etc.), (2) (private business development companies), (3) (corporations, business trusts, partnerships and 501(c)(3) organizations, in each case not formed for the specific purpose of acquiring the securities offered and with total assets in excess of $5 million) or (7) (trusts with total assets in excess of $5 million, not formed for the specific purpose of acquiring the securities offered) under the Securities Act4
  • qualified purchasers
  • qualified institutional buyers
  • an entity composed exclusively of qualified institutional buyers
  • investment companies
  • banks
  • issuer employees and affiliates, as defined in FINRA Rule 5121
  • knowledgeable employees as defined in Investment Company Act Rule 3c-5, and
  • eligible contract participants, as defined in Section 3(a)(65) of the Exchange Act (which has the same meaning as in Section 1a of the Commodity Exchange Act).5

Pepper Point: Natural persons who are accredited investors must meet an exception other than the “accredited investor” exception that is part of Rule 5123 (such as the qualified purchaser exception or knowledgeable employee exception) for sales to such persons not to trigger the requirements of Rule 5123.

The following types of offerings are also excluded from Rule 5123’s notice filing requirements:

  • offerings made pursuant to Securities Act Rule 144A or SEC Regulation S
  • offerings of registered investment companies
  • 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 investments on the part of the investor
  • business combination transactions as defined in Securities Act Rule 165(f)
  • standardized options, as defined in Securities Act Rule 238
  • offerings filed with FINRA under FINRA Rule 2310 (direct participation programs), 5110 (certain corporate financings), 5121 (concerning public offerings of securities with conflicts of interest) and 5122 (private placements of securities issued by FINRA members), or exempt from filing thereunder in accordance with FINRA Rule 5110(b)(7)
  • offerings of securities of a commodity pool operated by a commodity pool operator
  • offerings of exempt securities with short-term maturities under Section 3(a)(3) of the Securities Act and debt securities sold by members pursuant to Section 4(2) of the Securities Act so long as the maturity does not exceed 397 days and the securities are issued in minimum denominations of $150,000 (or the equivalent thereof in another currency)
  • offerings of “variable contracts,” as defined in FINRA Rule 2320(b)(2)
  • offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in FINRA Rule 5110(b)(8)(E)
  • offerings of non-convertible debt or preferred securities that meet the transaction eligibility criteria for registering primary offerings of non-convertible securities on Forms S-3 and F-3
  • offerings of subordinated loans under Securities Exchange Act (Exchange Act) Rule 15c3-1, Appendix D, and
  • offerings of exempted securities, as defined in Section 3(a)(12) of the Exchange Act (U.S. Government securities, municipal securities, etc.).

As noted above, the SEC comment period on FINRA Rule 5123 is open through July 5, 2012. FINRA rules are implemented through a “Regulatory Notice” process where, following SEC approval, FINRA issues a Regulatory Notice that announces the SEC’s approval of a FINRA rule change, generally summarizes the rule, and also announces the effective date of the rule.6 Generally, the effective date of a new FINRA rule is no less than 30 days after the date the Regulatory Notice is published and is often two to six months after the date the Regulatory Notice is published. We consider it unlikely that FINRA will publish a notice announcing the future effective date of Rule 5123 until sometime after the legally required comment period on Rule 5123 has passed and the SEC approval of the rule change can be fully consummated. Bottom Line: Rule 5123 is not yet effective and is very unlikely to become effective before early August (barring some extraordinary action by FINRA).

Pepper Point: While FINRA does not currently have the staffing to review all of the private placement material likely to be submitted under Rule 5123, it will have the practical ability to spot-check materials and FINRA examination staff is likely to review materials prior to broker-dealer office inspection and/or should complaints or problems arise. Of course, FINRA does not have jurisdiction (direct or indirect)7 over the vast majority of private placement issuers, but FINRA can make referrals to the SEC.

Endnotes

1 Approval order available at http://www.sec.gov/rules/sro/finra/2012/34-67157.pdf; https://www.federalregister.gov/articles/2012/06/13/2012-14340/self-regulatory-organizations-financial-industry-regulatory-authority-inc-notice-of-filing-of. The rule was originally proposed in 2011 and has been subject to several comment periods and updates.

2 A security in a non-public offering in reliance on an available exemption from registration under the Securities Act of 1933, as amended (the Securities Act).

3 Based on the sales made by the requested FINRA member (i.e., the brokerage firm itself, not its representatives) and not those made by other FINRA members also making sales. A sale by one member would not impact the timing of a filing or the ability of other FINRA members to make use of exemptions available under FINRA Rule 5123. At least one commentator to the SEC has suggested that FINRA should allow a single filing to be made on behalf of multiple FINRA members involved or expected to be involved in a private offering and the rule does not preclude a filing made on “behalf of” several FINRA members.

4 See http://taft.law.uc.edu/CCL/33ActRls/rule501.html.

5 See http://www.law.cornell.edu/uscode/text/7/1a.

6 See http://www.finra.org/Industry/Regulation/FINRARules/RulemakingProcess/.

7 FINRA will often, as part of broker-dealer examination, make inquiry into the activities of companies controlling, under common control with, or closely affiliated with a FINRA member broker-dealer, at least as far as the broker-dealer interacts with, relies on, or sells the securities of such non-broker-dealer companies.

Gregory J. Nowak, Julia D. Corelli and Matthew R. Silver

Written by

Gregory J. Nowak
Phone: 215.981.4893
Fax: 215.981.4750
nowakg@pepperlaw.com

Julia D. Corelli
Phone: 215.981.4325
Fax: 215.981.4750
corellij@pepperlaw.com

Matthew R. Silver
Phone: 215.981.4117
Fax: 215.981.4750
silverm@pepperlaw.com


Gregory J. Nowak, Julia D. Corelli and Matthew R. Silver are members of Pepper Hamilton’s Fund Services Group, a multidisciplinary group of over 25 lawyers focused on the investment fund industry.

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.

View the PDF version


Copyright © 2014 Pepper Hamilton LLP | Use of This Site Subject to These Terms & Conditions | PRIVACY POLICY | Contact Us: phinfo@pepperlaw.com or 866.737.7372 | Find Pepper Hamilton LLP on Facebook | Pepper Hamilton LLP on LinkedIn | Follow Pepper Hamilton LLP on Twitter | Pepper Hamilton LLP YouTube Channel | View Pepper Hamilton LLP's documents on JD Supra