On December 4, 2015, the Financial Industry Regulatory Authority (“FINRA”) filed with the Securities and Exchange Commission (the “SEC”) a proposed rule that would create a separate set of rules for firms that meet the definition of a ‘‘Capital Acquisition Broker’’ (each a “CAB” and collectively, “CABs”).1 Under the proposed rules (the “CAB Rules”), all broker-dealers approved for FINRA membership as a CAB and all those associated with a CAB would be subject to the CAB Rules if a CAB elects to be governed by the new rules. A CAB will continue to be subject to the current FINRA by-laws and will be required to be a FINRA member.
The CAB Rules were issued in response to industry concerns that the full set of FINRA rules should not apply to broker-dealers that limit their business to certain capital raising, merger and acquisition, and corporate financing activities. While such firms do not engage in the types of activities associated with full-service broker-dealers (for example, they do not buy or sell securities on behalf of customers or hold or supervise customer securities or accounts), they are nonetheless subject to the full set of FINRA rules under the current regulatory framework because they may receive transaction-based compensation for their services. The CAB Rules would preserve a CAB’s ability to receive transaction-based compensation, but ease the regulatory burdens by creating the streamlined rules tailored to address CABs’ limited activities and business model. The proposed CAB Rules replace the “limited corporate financing broker” rules proposed by FINRA in early 2014.2 If the SEC approves the CAB Rules, FINRA will announce the implementation date of the proposed rule change in a future filing.
“Capital Acquisition Broker” Definition
The proposed rules define a CAB as any broker that solely engages in any one or more of the following activities:
- a. advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
- b. advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger;
- c. advising a company regarding its selection of an investment banker;
- d. assisting in the preparation of offering materials on behalf of an issuer;
- e. providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;
- f. qualifying, identifying, soliciting or acting as a placement agent or finder with respect to institutional investors in connection with a sale of a newly-issued, unregistered securities to institutional investors;
- g. effecting M&A transactions solely in connection with the transfer of ownership and control of a privately held company to a buyer that will actively operate the company, in accordance with the terms of the SEC rule, interpretation or “no-action” letter that permits a person to engage in such activities without having to register as a broker-dealer.3
A CAB will not include any broker or dealer that acts as an introducing broker with respect to customer accounts or one that handles customers’ funds or securities, accepts orders to buy or sell securities either as principal or agent for the customer (except as permitted in paragraphs (f) and (g) above), exercises investment discretion on behalf of any customer, engages in proprietary trading of securities or market-making activities, or participates in an online platform to offer securities pursuant to the Regulation Crowdfunding or Regulation A under the Securities Act of 1933, as amended, or effects securities transactions that would require the broker or dealer to report the transactions under the FINRA trade reporting rules (Rules 6300 Series, 6400 Series, 6500 Series, 6600 Series, 6700 Series, 7300 Series or 7400 Series).
A CAB would be limited to facilitating private placements to “institutional investors.” Under the CAB Rules, “institutional investor” would mirror the same term under FINRA Rule 2210 (Communications with the Public), however the CAB Rules also include a “qualified purchaser.” Thus, institutional investors would include any:
- bank, savings and loan association, insurance company or registered investment company;
- governmental entity or subdivision thereof;
- employee benefit plan or qualified plan that meets certain requirements;
- person acting solely on behalf of any such institutional investor;
- person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million); or
- person meeting the definition of “qualified purchaser” as that term is defined in Section 2(a)(51) of the Investment Company Act of 1940, as amended (the “Investment Company Act”).4
The inclusion of “qualified purchasers” in the definition of “institutional investors” is specific only to the CAB Rules. FINRA considered but rejected the idea of including solicitation of accredited investors in the allowable CAB activities. In FINRA’s view, qualified purchasers are more likely to have the resources necessary to protect themselves from potential sales practice problems.
A CAB applicant would file the same FINRA membership application procedures as any other applicant, provided that:
- To qualify, an applicant would state it intends to operate solely as a CAB.
- FINRA would assess if applicant’s proposed activities qualify for CAB status.
- An existing FINRA member that seeks to change its status to a CAB and is already approved to engage in the activities of a capital acquisition broker, but which does not intend to change its existing ownership, control or business operations, must file a request to amend its membership agreement or obtain a membership agreement to provide that: (1) the member’s activities will be limited to those permitted under the CAB Rules; and (2) the member agrees to comply with the CAB Rules.
- If during the first year a conversion back to a full-service FINRA membership is sought, a CAB could file a request to amend its membership agreement.5
Associated Person Registration
Since the CAB Rules incorporate by reference to existing NASD rules regarding registration and qualification of principals and representatives, CAB firm principals and representatives would be subject to the same registration, qualification examination and continuing education requirements as principals and representatives of other FINRA firms. CABs would also be subject to current rules regarding Operations Professional (Series 99) registration.
Reduced Regulatory Requirements
CABs would be subject to a separate set of rules as more fully set forth below under “The CAB Rules.” Some important differences between the CAB Rules and the FINRA rules applicable to full-service broker-dealers include:
- CABs would be subject to a set of streamlined customer communication rules which dispenses with the process and filing requirements of Rule 2210 (Communications with the Public), and removes the prohibition on predictions or projections of performance. However, the CAB Rules would continue to require that communications are not false, exaggerated, unwarranted or misleading (which would include, for example, providing a sound basis for evaluating the facts in regard to any particular security or security type, industry or service), and would continue to prohibit communications from implying that past performance will recur or making any exaggerated or unwarranted claim, opinion or forecast.
- CABs would not be subject to the rule governing commissions, mark-ups and charges (FINRA Rules 2121 (Fair Prices and Commissions), 2122 (Charges for Services Performed) and 2124 (Net Transactions with Customers)).
- The rules governing supervision by CABs would be somewhat less demanding than the requirements of Rule 3110 (Supervision), and would dispense with the specific requirements in that rule regarding internal inspections, review of transactions, annual compliance meetings and certain documentation requirements. CABs would also be able to create their own supervisory procedures tailored to their business model.
- CABs would not be required to maintain a business continuity plan or fidelity bond.
- CABs would be subject to streamlined requirements regarding the information they must obtain regarding their customers under Rule 4512 (Customer Account Information).
- CABs would be eligible to conduct the required independent testing for compliance with written anti-money laundering (“AML”) programs on a two-year cycle rather than a one-year cycle applicable to all other broker-dealers.6
- The chief executive officer of a CAB would not be required to certify annually to the CAB’s compliance program.
However, CABs would be required to comply with some of the FINRA rules that are considered the most onerous – meeting net capital requirements, filing supplemental Financial and Operational Combined Uniform Single (FOCUS) reports, obtaining audited financial statements,7 and employing an operations principal.
The CAB Rules
Duties and Conflicts: The proposed CAB 200 series would establish a streamlined set of conduct rules.
- CABs would follow the FINRA know-your-customer and suitability obligations (including an exception to the customer-specific suitability obligations for institutional investors).
- CABs would observe a streamlined version of FINRA Rule 2210 (Communications with the Public), which generally forbids false and misleading statements, but CAB Rules would remove the prohibition on predictions or projections of performance. However, communications implying that past performance will recur or making any exaggerated or unwarranted claim, opinion or forecast (which would include, for example, communications that do not provide sound basis for evaluating the facts in regard to any particular security or security type, industry or service), would continue to be prohibited.
- CABs would not be subject to FINRA rules covering Fair Prices and Commissions, Charges for Services Performed, and Net Transactions with Customers (FINRA Rules 2121, 2122 and 2124).8
- CABs would be permitted to qualify, identify, solicit or act as a placement or agent only on the behalf of:
- i. an issuer in connection with a sale of newly-issued unregistered securities to institutional investors; or
- ii. an issuer or control person in connection with an initial or secondary securities transaction related to a change of control of a privately-held company.
- CABs would be permitted to effect securities transactions solely in connection with a transfer of ownership and control of a privately-held company to a buyer that will actively operate the company, in accordance with the terms of the SEC rule, interpretation or “no-action” letter that permits a person to engage in such activities without having to register as a broker-dealer pursuant to Section 15(b) of the Exchange Act.9
- CABs would be subject to current rules on Standards of Commercial Honor and Principals of Trade (Rule 2010); Use of Manipulative, Deceptive or Other Fraudulent Devices (Rule 2020); Payments to Unregistered Persons (Rule 2040); Transactions Involving FINRA Employees (Rule 2070); Expungement of Customer Dispute Information from the Central Registration Depository (CRD) System (Rules 2080 and 2081); and the FINRA arbitration requirements in Rules 2263 and 2268.
Supervision and Responsibilities relating to Associated Persons: The proposed CAB 300 Series would establish a limited set of supervisory rules for CABs and their associated persons:
- CABs would observe FINRA Rules covering Influencing or Rewarding Employees of Others, Borrowing from or Lending to Customers, and Outside Business Activities of Registered Persons (FINRA Rules 3220, 3240 and 3270).
- CABs would be required to follow a portion of FINRA Rule 3110 (Supervision), including supervision of offices, personnel, customer complaints, correspondence and internal communications and both the Regulatory and Firm Element continuing education requirements.
- CABs would not be subject to rules covering the annual compliance meeting, and supervisory procedures for supervisory personnel (for example, a CAB’s supervisory personnel may supervise their own activities). However, CABs would still be required to have sufficient knowledge of and comply with applicable securities laws and regulations and the CAB Rules.
- CABs would not be subject to rules covering trading and investment banking functions not permitted in the CAB category of membership.
- CABs would not be required to conduct internal inspections of their businesses.
- CABs would be required to designate a chief compliance officer but not require that its chief executive officer certify that the CAB has policies in place to achieve compliance with applicable federal securities laws and regulations.
- Any CABs associated person would be prohibited from participating in a private securities transaction.10
- CABs would be required to implement a written anti-money laundering (“AML”) program; but be eligible to conduct the required independent testing for compliance no less frequently than every two years rather than every year (but testing should be more frequent than required if circumstances warrant).
Financial and Operational Rules: The proposed CAB 400 Series would establish a streamlined set of rules concerning firms’ financial and operational obligations.
- CABs would be subject to FINRA Rule 4140 (Audit), Rule 4150 (Guarantees by, or Flow through Benefits for, Members), Rule 4160 (Verification of Assets), Rule 4511 (Books and Records – General Requirements), Rule 4513 (Records of Written Customer Complaints), Rule 4517 (Member Filing and Contact Information Requirements), Rule 4524 (Supplemental FOCUS Information), Rule 4530 (Reporting Requirements), and Rule 4570 (Custodian of Books and Records).
- CABs would be required to observe a portion of the capital compliance requirements of FINRA Rule 4110.
- CABs would be required to suspend business operations during any period a firm is not in compliance with the applicable net capital requirements set forth in Rule 15c3-1 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and observe rules regarding withdrawal of capital, subordinated loans, notes collateralized by securities, and capital borrowings.
- CABs would not be required to maintain a business continuity plan or conduct testing pursuant to Regulation Systems Compliance and Integrity.
- CABs would have limited requirements governing customer contact info.
- CABs would continue to make and preserve all books and records required under Rules 17a-3 and 17a-4 of the Exchange Act.
Securities Offering and Trading Standards and Practices: The proposed CAB Rule 500 Series would subject CABs to certain rules concerning securities offerings.
- CABs would be subject FINRA Rule 5122 (Private Placements of Securities Issued by Members) and FINRA Rule 5150 (Fairness Opinions).
Investigations and Sanctions, Code of Procedure, Code of Arbitration Procedure and Code of Mediation Procedure:
- CABs would be subject to FINRA rules governing Investigations and Sanctions of Firms, but none related to automated trading.
- CABs would not be required to make available a current copy of the FINRA manual for examination by customers.
- CABs would be subject to FINRA rules governing disciplinary and other proceedings involving firms but not rules on grievances related to automated trading.
- CABs would be subject to FINRA rules of arbitration procedure for customer disputes, industry disputes, and for mediation procedures.
Impact on Private Fund Sponsors
Currently, sponsors of funds formed under Section 3(c)(7) of the Investment Company Act (“3(c)(7) funds”) and funds formed under Section 3(c)(1) of the Investment Company Act (“3(c)(1) funds”) face the risk of being deemed to have acted as an unregistered broker-dealer, in certain circumstances, when they market or solicit interest in their private funds to potential investors. To address this risk, private fund sponsors may hire third-party broker-dealers to serve as placement agents, have certain employees register as representatives of a third-party broker dealer or, alternatively, may register (or have an affiliate register) as a broker-dealer and become a member of FINRA.
Since the CAB Rules would prohibit a CAB from soliciting persons who are accredited investors but are not also “institutional investors,” it will limit a CAB’s private fund placement activity to 3(c)(7) funds. As a consequence, FINRA’s proposal will lead to different considerations for clients that are sponsors of 3(c)(7) funds as compared to sponsors of 3(c)(1) funds. Whereas the former may be able to form and register a CAB under FINRA’s proposal, that option generally will not be available to the latter.
Sponsors of 3(c)(7) funds will need to weigh the process, risks and costs associated with CAB registration and the proposed CAB rule book (discussed below) in determining whether to become (or have an affiliate become) a CAB. Such risks and costs also must be weighed against the costs of hiring a third-party broker-dealer or having employees register with a third-party broker-dealer (including a CAB). If the goals of proposed CAB Rules are achieved, then the costs of registering and operating a CAB on an ongoing basis should be considerably less than the costs of registering and operating a traditional broker-dealer. If adopted, FINRA’s proposal could thus encourage sponsors of 3(c)(7) funds to reduce the risk of acting as an unregistered broker-dealer by registering as a CAB. The CAB Rules are also expected to reduce the regulatory burden for sponsors of 3(c)(7) funds that are currently registered as broker-dealers but fall within the definition of a CAB.