FINRA -- The Financial Industry Regulatory Authority -- has announced a rulemaking initiative aimed at the creation of a new class of FINRA registered securities broker-dealers that engage exclusively in a limited range of activities identified by FINRA as, essentially, advising companies and private funds on capital raising and restructuring transactions. Investment banking or mergers and acquisition (M&A) firms meeting the definition of “limited corporate financing broker” (LCFB) would be eligible to register with FINRA under a proposed streamlined rule set that would apply exclusively to those firms. LCFB membership status would be open to new applicants as well as existing FINRA member firms that elect to convert their status to an LCFB based on the limited scope of their activities.
Few issues cause as much consternation among smaller investment banking and M&A firms as the prospect of required registration and licensing as a securities broker-dealer under federal and state securities laws by reason of activities and transactions actually or potentially involving the purchase or sale of securities. Whether involving capital raising or facilitating corporate transactions by means of equity transfers, firms that are not broker-dealers or affiliated with a broker-dealer tread carefully in rendering their services, and are necessarily constrained in the range of services they may provide and the manner in which they may be compensated.
Legislative initiatives aimed at exempting M&A intermediaries from federal broker-dealer registration for small transactions involving the sale of privately owned businesses are underway, and most recently the Staff of the U.S. Securities and Exchange Commission (SEC) has recognized that activities of an “M&A Broker,” as that term is defined in the same privately held company setting, will not trigger the federal broker-dealer registration requirement where services of the intermediary satisfy certain limitations.
In the main, however, investment banking and M&A firms continue to grapple with the potential for being found to be an unregistered broker-dealer in the larger context of their engagements that involve securities transactions and any form of transaction-based compensation. The solution for some firms is to become a broker-dealer, in which the major undertaking is becoming and operating as a FINRA member firm, subject to the full range of FINRA rules without regard to the limited nature of the firm’s securities-related activities.
Defining LCFB and the Scope of Permissible Activities
Recognizing that firms not engaged in the types of activities typically associated with traditional brokerdealers should be subjected only to rules that match the limited scope of their business, FINRA proposes an LCFB membership status open to any firm engaged solely in limited activities. Under the proposed rules (for which comments by all interested parties may be submitted to FINRA up to April 28, 2014), the term “limited corporate financing broker” would be defined as any firm that solely engages in one or more of the following activities:
Advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
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;
Advising a company regarding its selection of an investment banker;
Assisting in the preparation of offering materials on behalf of the issuer;
Providing fairness opinions; and
Qualifying, identifying or soliciting potential institutional investors.
FINRA membership as an LCFB would not operate as an exemption from federal and state laws applicable to broker-dealers generally. Compliance with state licensing requirements, for example, would still be required in the absence of an available exemption. However, because most of the business and operations of broker-dealers, and the conduct of associated persons, are directly regulated by FINRA, the prospect of a form of membership that subjects LCFBs to a specifically tailored, streamlined rule set may for a significant number of firms meaningfully alter the mix of factors weighed in favor or against becoming a FINRA registered broker-dealer.
A New Rule Set
The rules applicable to LCBFs would be streamlined in recognition of the fact that these firms do not engage in traditional broker-dealer activity. They do not, for example, carry or maintain customer accounts. They do not take orders from customers for the purchase or sale of securities. They do not hold or handle customer funds or securities. They do not exercise any investment discretion on behalf of any customer, and they do not engage in proprietary trading of securities or market-making activities. Importantly, unless the particular context requires otherwise, an LCFB would be subject to the FINRA bylaws and to certain core FINRA rules that are applied to all member firms. Otherwise, however, LCFBs would look only to the specific LCFB rule set in the conduct of their business and operations.
As with FINRA membership generally, LCFB membership status would involve registration of the firm as well as its associated persons. The proposed rules establish specific membership application and associated person registration procedures for LCFBs. Although LCFB firm principals and representatives would in general be subject to the same registration and qualification examination requirements, they would be eligible for fewer registration categories than the array in place for traditional broker-dealers. Associated persons, for example, would be eligible to register as a general securities representative (Series 7), limited representative -- corporate securities (Series 62), limited representative -- private securities offerings (Series 82), limited representative -- investment banking (Series 82), and operations professional (Series 99). Applications for FINRA membership as an LCFB would be based on the declaration by the proposed member firm that it intends to operate as an LCFB, and in reviewing an application, FINRA would consider not only basic standards for membership, but also a determination that the applicant firm’s proposed activities are consistent with the limitations that would be imposed by the LCFB rules.
The proposed LCFB rule set includes conduct rules; supervisory requirements; financial and operational rules; and provisions for investigations and sanctions. The proposed rules, however, are aimed specifically at an LCFB’s limited business activities. LCFBs would be held to existing baseline responsibilities such as observing standard commercial honor and principles of trade, and prohibiting the use of manipulative, deceptive or other fraudulent devices. Other conduct rules, however, would be modified. For example, the FINRA “know-yourcustomer” obligation would be modified in the LCFB rules to eliminate any reference to opening and maintaining customer accounts. And the fairly complex FINRA rule governing “communications with the public” would be substantially abbreviated in the LCFB rules so as to simply prohibit false or misleading statements. The “suitability” rule for LCFBs, on the other hand, would be substantially the same as that already in place applicable to all FINRA member firms and associated persons, and would remain focused on recommended transactions and investment strategies, which invites the question FINRA has itself posed, namely, whether an LCFB normally makes recommendations to customers to purchase or sell securities. FINRA has requested comments on the question of whether an LCFB should be subject to rules requiring firms to know their customers and imposing suitability obligations at all.
Supervisory rules proposed for LCFBs would be modified. Firms would be subject to some, but not all, existing FINRA supervisory rules. They would not, for example, be subject to annual compliance meeting, review and investigation of transactions, and internal inspection requirements. They would, however, be subject to rules dealing with outside business activities, borrowing from or lending to customers, and to those rules regarding influencing or rewarding employees of others. LCFB rules also mandate the implementation of an anti-money laundering program, but with a relaxed requirement for conducting the required independent testing for compliance.
Capital compliance requirements for LCFBs would be modified as well. The proposed rules include some, but not all, of the requirements in rules otherwise applicable to FINRA member firms. The proposed rules contain specific requirements concerning withdrawal of capital, subordinated loans, notes collateralized by securities and capital borrowings. Financial and operational requirements in general would be modified in recognition of the fact that LCFBs would not carry or maintain customer accounts.
A Response to Regulatory Uncertainty
Proposing to create a newly available LCFB membership status, FINRA expressed sensitivity to the fact that many existing member firms that engage entirely in corporate financing or investment banking activity are members for the principal, if not sole, purpose of facilitating payment of transaction-based compensation for their services. In its February Regulatory Notice (14-09) proposing the rules, FINRA observed:
Some FINRA-regulated firms are solely corporate financing firms that advise companies on mergers and acquisitions, advise issuers on raising debt and equity capital in private placements with institutional investors, or provide advisory services on a consulting basis to companies that need assistance analyzing their strategic and financial alternatives. These firms often are registered as broker-dealers because they may receive transaction-based compensation as part of their services.
Grappling with an ever-present conundrum, these firms have already made the decision to deal with regulatory uncertainty in the conduct of their business activities, by becoming FINRA member firms and obtaining appropriate state licensing, which in nearly all cases today is predicated on FINRA membership. Although fully subject to state registration or licensing requirements and state enforcement authority, the significant ongoing regulatory burdens for these firms are those imposed by FINRA, and conversion to LCFB status would translate into sensible compliance cost savings. The extent of savings is not certain, however, and a specific request for comment made by FINRA is whether the proposed LCFB rules appropriately accommodate the scope of LCFB business models.
The offsetting consideration in all of this is that any LCFB rule set must provide sufficient protections to customers of the LCFB. What customer “protections” are actually necessary and appropriate regarding services provided by LCFBs is an open question and, as noted earlier, FINRA has requested comments specifically on that point. Perhaps the most important question is the extent to which the creation of LCFB member status by FINRA, and adoption of specifically tailored rules, would lead investment banking and M&A firms facing the broker-dealer conundrum actually to register as LCFBs.
To Be or Not to Be
Will creating a distinct LCFB status of FINRA membership offer any encouragement for firms that are not currently FINRA members to become such, or any compelling reason to do so? As noted above, to become an LCFB member firm does not lessen the impact of other regulation by the SEC or state securities regulators, with which firms must still be licensed. As SEC registered broker-dealers, LCFBs would be subject to the requirements for all broker-dealers imposed by the Securities Exchange Act of 1934 and SEC rules. FINRA financial and operational rules for LCFBs would be streamlined, based on the fact that LCFBs will not carry or maintain customer accounts, but baseline books and records, net capital reporting and other federal requirements remain applicable. LCBFs would also be subject to specific FINRA rules relating to investigations, sanctions, the FINRA Code of Procedure, and to arbitration and mediation rules. As additional guidance and the prospect of federal legislation aimed at identifying an activity construct for which no broker-dealer registration would be required, FINRA itself has asked the question whether it is likely that some limited corporate financing firms will eschew any broker-dealer status, being satisfied that their activities are sufficiently limited to those consistent with available guidance. Along the same line, FINRA has also specifically asked whether there are current member firms that would qualify for the proposed LCFB rule set but would choose not to do so and why.
What is certain in all of this is the steadily growing recognition of the need for rationalizing the brokerdealer regulatory structure to accommodate activities for which the need for customer protection that underlies the existing broker-dealer regulatory and self-regulatory structure is quite different. The proposal for LCFB membership status by FINRA is predicated on that recognition, and the momentum on legislative, administrative, and now self-regulatory, fronts is clearly established.