The Financial Industry Regulatory Authority, Inc. filed proposed amendments to FINRA Rule 5110 (Proposed Rule Change) with the Securities and Exchange Commission on April 11, 2019. Rule 5110 (Rule) imposes certain substantive and filing requirements on FINRA members (Members) that participate in public offerings of securities. Comments are due to the SEC by May 23, 2019.

The Proposed Rule Change is part of FINRA’s review of its rulebook and is intended to lessen the regulatory costs and burdens of complying with the Rule. Specifically, the Proposed Rule Change relates to: certain filing requirements, including with respect to shelf offerings; underwriting compensation; the treatment of non-convertible or non-exchangeable debt securities and derivatives; lock-up arrangements; prohibited terms and arrangements; exemptions from the Rule’s requirements; exceptions for venture capital offerings; and updates to certain definitions.

This OnPoint provides an overview of the Proposed Rule Change, and highlights potential key differences between the Rule as currently in force and as proposed to be amended, as well as between the current version of the Rule and the version proposed for comment in FINRA Regulatory Notice 17-15 (issued in advance of the FINRA Board of Governors’ authorization of filing the Proposed Rule Change with the SEC).

Summary of Proposed Rule Change

General Filing Requirements

In an effort to create a more flexible and efficient process while maintaining the Rule’s protections, FINRA proposes to update the Rule’s general filing requirements and codify common practices.

A helpful change would provide more time for Members to make filings with FINRA under the Rule, and would prevent inadvertent filing delays by extending the filing deadline to three business days from one business day after filing with the SEC or a state securities commission.

The Proposed Rule Change would reduce the types of documents and information that must be filed with FINRA under the Rule. Specifically, the Proposed Rule Change would require Members to provide any corresponding SEC document identification number (if available), and to file: the industry-standard master forms of agreement (if requested by FINRA); amendments to previously filed documents (if there have been changes relating to the disclosures that impact the underwriting terms and arrangements); a representation as to whether any associated person or affiliate of a participating Member is a beneficial owner of at least five percent of “equity and equity-linked securities;” and an estimate of the maximum value for each item of underwriting compensation. “Participating Member” is a new term that combines “underwriter” and “related persons.” The Proposed Rule Change would clarify that only one Member participating in an offering is required to make these filings.

The Proposed Rule Change also would require any Member acting as a managing underwriter (or in a similar role) to notify the other Members participating in a public offering if such Member has been informed of an unfair or unreasonable finding in an opinion by FINRA regarding the underwriting terms and arrangements, and the proposed terms and arrangements have not been subsequently modified.

In addition, for clarity, the Proposed Rule Change would incorporate into the Rule the requirement that, before a Member engages in a distribution or sale of securities, all public offerings in which the Member participates must be filed for review, unless exempted by the Rule, and the Member must receive an opinion from FINRA that is has no objection to the information in the filings.

The Proposed Rule Change also would require Members to provide written notification to FINRA regarding all underwriting compensation received, or to be received, under certain conditions; and if an offering is not completed according to the terms of an agreement between the Member and the issuer.

Filing Requirements for Shelf Offerings

The Proposed Rule Change would include in the Rule FINRA’s interpretation that shelf offerings of certain experienced issuers are exempt from the Rule’s filing requirements, and streamline the filing requirements applicable to non-exempt shelf offerings. FINRA proposes to define “experienced issuer” as an issuer with: (i) a 36-month reporting history and voting stock held by non-affiliates having at least $150 million in aggregate market value; or (ii) voting stock held by non-affiliates having an aggregate market value of at least $100 million, and an annual trading volume of three million shares or more. For issuers that do not meet this definition or any other exemption from filing, the Rule would continue to apply, but the information required to be filed would be limited to the registration statement number and, if requested by FINRA, any of the documents generally required to be filed in connection with other public offerings.

Exemptions from Filing and Substantive Requirements

Other public offerings can be exempt solely from the Rule’s filing requirements (but still be subject to the Rule’s substantive requirements), or from both the filing and substantive requirements. In an effort to reduce Members’ filing and compliance costs, the Proposed Rule Change would expand the circumstances under which a public offering may be exempted from the Rule’s requirements.

Under the Proposed Rule Change, public offerings of the securities of banks that have qualifying outstanding debt securities would be exempt from the Rule’s filing requirements, but not its substantive requirements. The Proposed Rule change would define “bank” as a bank as defined in Exchange Act Section 3(a)(6) or a foreign bank that would be exempt under the Rule, and would refer only to the regulated entity and not its subsidiaries or other affiliates. According to FINRA, the definition is intended to harmonize the definition for purposes of the proposed venture capital exceptions and other exemptions under the Rule.

Public offerings of closed-end tender offer funds, insurance contracts and unit investment trusts would be exempted from both the filing and substantive requirements of the Rule.

Further, the Proposed Rule Change would exclude from the definition of “public offering”: offerings exempt from SEC registration pursuant to Section 4(a)(1), (a)(2) and (a)(6) of the Securities Act; certain offerings exempt from registration pursuant to Rule 504 of Regulation D; and securities that are “exempted securities” as defined in Section 3(a)(12) of the Securities Exchange Act of 1934. Offerings that are excluded from the definition of public offering would be exempt from all requirements under the Rule.

Underwriting Compensation

The elements of “underwriting compensation” would continue to be a focus of the Rule as it is proposed to be amended. The Proposed Rule Change would define “underwriting compensation” as “any payment, right, interest, or benefit received or to be received by a [P]articipating [M]ember from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would specifically include: fees paid to finders and financial consultants and advisors, whether paid in cash or securities; registration fees; costs of printing or engraving or any other item of value; and underwriter’s counsel fees and expenses.

The Proposed Rule Change also would delete “items of value” as a defined term, but expand upon two current, non-exhaustive lists of examples of payments or benefits that would (or would not) be considered underwriting compensation, in order to cover the concept of what previously had been considered as items of value. For example:

 

Payments for services beyond the traditional scope of underwriting activities (e.g., records management and legal costs resulting from a contractual breach, securities acquired pursuant to a governmental or court-approved proceeding) would not be considered underwriting compensation.

 

 

Consistent with current practice under the Rule, non-cash compensation would continue to be considered underwriting compensation.

 

Unlike Notice 17-15, the Proposed Rule Change would not eliminate itemized disclosure. The Notice 17‑15 proposal would have replaced the requirement to disclose itemized underwriting compensation with a requirement to disclose an estimate of the maximum aggregate amount of all underwriting compensation; any discount or commission would have been required to be disclosed in the prospectus.

The Proposed Rule Change also would add the term “review period,” which would be the time period specified for a particular type of offering for determining whether a payment qualifies as underwriting compensation. Payments and benefits received during the review period would be considered underwriting compensation. The definition of review period would require securities anticipated to be purchased from a public offering by a Participating Member to be included as underwriting compensation, although these securities may be excluded based on the principles-based approach (described below) that might delay the progress of FINRA’s review of the offering.

FINRA also would apply a principles-based approach to determining whether an issuer’s securities acquired from third parties or in issuer-directed sales programs would be excluded from the definition of underwriting compensation. This approach would begin with a presumption that the issuer’s securities received during the review period are underwriting compensation.

With respect to an issuer’s securities received from third parties, FINRA proposes to consider the following factors (among others) in its determination: the nature of the relationship (if any) between the issuer and the third party; the nature of the transactions in which the securities were acquired (e.g., whether engaged in as part of the Member’s ordinary course of business); and any disparity between the price paid and the offering price or market price.

With respect to an issuer’s securities acquired in issuer-directed sales programs, FINRA proposes to consider the following factors (among others) in its determination: the existence and nature of any pre-existing relationship between the issuer and the person acquiring the securities; and whether the securities were acquired on the same terms and at the same price as by other similarly situated persons participating in the directed sales program.

Venture Capital Exceptions to Underwriting Compensation Definition

In recognition of the contribution to capital formation provided by venture capital (VC) transactions, the Proposed Rule Change would exclude from the definition of underwriting compensation certain acquisitions of VC-related securities by Members, and expand already existing VC exceptions under the Rule. The Proposed Rule Change also would add definitional exceptions for securities acquisitions and conversions for the purpose of preventing dilution.

The Proposed Rule Change would exclude from underwriting compensation securities received by a Member for services rendered in connection with a private placement, as well as securities acquired in a private placement before the required filing date of the public offering. With respect to institutional investors not affiliated with a Member, the Proposed Rule Change would require that such investors purchase at least 51% of the total number of securities sold in the private placement, at the same time and on the same terms, and would raise the aggregate percentage that Participating Members may acquire from 20% to 40% of the securities sold in the private placement. Increasing the threshold would allow more Members to participate in the private placement as well as any subsequent public offering.

The Proposed Rule Change also would expand the current VC exceptions by allowing Members affiliated with an issuer to acquire more than 25% of the issuer’s total equity securities,if such affiliated Members are in the business of making investments or loans, directly or indirectly, including through a newly formed entity.

Further, when an offering is “significantly” delayed and an issuer requires funding, the Proposed Rule Change would implement a principles-based approach to provide additional flexibility in determining the availability of VC exceptions for acquired securities.

Treatment of Non-Convertible or Non-Exchangeable Debt Securities and Derivatives as Underwriting Compensation

The Proposed Rule Change would clarify when non-convertible or non-exchangeable debt securities and derivative instruments acquired in a transaction should be considered underwriting compensation, and, if so, how these should be valued. This determination would depend on whether the securities are related to a public offering and whether the securities were acquired at a “fair price.”

Non-convertible or non-exchangeable debt securities and derivative instruments acquired in a transaction unrelated to a public offering would not be viewed as underwriting compensation, and therefore would have no compensation value.

Conversely, non-convertible or non-exchangeable debt securities and derivative instruments acquired in a transaction related to a public offering would be considered underwriting compensation. In this instance, a description of the securities and/or instruments acquired must be filed with FINRA, together with a representation that a registered principal or senior manager of the Participating Member has determined that the transaction was or will be entered into at a fair price. If the transaction involves a fair price, the securities and/or instruments would be deemed to have no compensation value. However, if the transaction does not involve a fair price, the securities and/or instruments would be subject to the Rule’s standard valuation requirements.

 

 

Lock-Up Restrictions

In certain circumstances, the Rule imposes lock-up restrictions with respect to securities deemed to be underwriting compensation. The Proposed Rule Change would introduce a number of clarifications and changes – for example, by requiring lock-up restrictions to be disclosed in a prospectus’ (or similar document’s) discussion of distribution arrangements. 

The Proposed Rule Change also would add exceptions to the Rule’s current lock-up restrictions for: (i) securities acquired from an issuer in a transaction that meets the registration requirements of SEC Form S-3, F-3 or F‑10; (ii) securities acquired in a transaction meeting one of the Rule’s VC exceptions (discussed above); (iii) securities received as underwriting compensation, but which are registered and sold as part of a firm commitment offering; (iv) derivative instruments acquired at a fair price in connection with a hedging transaction related to the public offering; and securities transferred or sold back to an issuer, if the transaction is exempt from SEC registration.

The Proposed Rule Change would clarify the treatment of non-convertible or non-exchangeable debt securities acquired in a transaction related to the public offering and derivative instruments acquired at a fair price in connection with a hedging transaction related to the public offering. The former would not be subject to the Rule’s lock-up requirement, but the latter would be.

Other Prohibited Terms and Arrangements

The Rule currently provides a list of terms and arrangements that are prohibited in connection with a public offering. The Proposed Rule Change would amend this list by: clarifying the scope of activities that are deemed to be related to public offerings. Moreover, the Proposed Rule Change would prohibit the receipt of any underwriting compensation prior to the commencement of sales in the public offering, unless the payment: is an advance against expenses expected to be incurred (which would be reimbursed if not actually incurred); or represents advisory or consulting fees for services provided in connection with an offering that is subsequently completed on its terms.

Right of First Refusal

The Proposed Rule Change would prohibit certain payments by an issuer to waive or terminate a right of first refusal to participate in a future capital-raising transaction. Specifically, an issuer would be prohibited from making any payments or fees to waive or terminate a right of first refusal to participate in a future public offering, private placement or other financing if the payment has a value in excess of the greater of: (i) 1% of the proceeds of the transaction for which the right of first refusal was granted (or an amount in excess of 1% if additional compensation is available to be paid in connection with the original offering); or (ii) 5% of the underwriting discount or commission paid in connection with the future financing (including any overallotment option that may be exercised). The prohibition in the current Rule against any non-cash payment or fee to waive or terminate a right of first refusal would be retained.

Conclusion

Although the Proposed Rule Change primarily seeks to modernize the Rule by improving its administration and simplifying its terms for Members, it is important to note that the proposal presents a number of significant and meaningful changes to the definition of underwriting compensation, and the scope and application of the Rule that are similar to, but distinguishable from, the changes suggested in Notice 17-15. In advance of any final determination by the SEC to approve the Proposed Rule Change, Members should consider the potential impact of the Proposed Rule Change on their operations to determine whether any corresponding modifications or enhancements may be appropriate, and should be prepared to comply with the changes once the final rules have been implemented.