The Financial Industry Regulatory Authority, Inc. (FINRA) has proposed the first major overhaul since 2004 of its rule regulating public offerings, titled “Regulatory Notice 17-15” (the full text of this notice is available online by clicking on the link at the end of this article). Comments must be submitted by May 30, 2017 and the Securities and Exchange Commission (SEC) must approve the proposed rule changes before they go into effect.
The proposed amendments include the following changes to Rule 5110:
1) Extend the deadline for FINRA Filings to 3 Business Days from 1 Business Day after the Filing or Submission of the Offering Document(s) with the SEC, any state securities commission or other similar U.S. regulatory authority
2) Clarify the Rule Regarding Exempt Filings
Rule 5110 currently includes a list in 5110(a)(9) of common types of offerings for which a FINRA filing is required, but it leaves FINRA with the discretion to review other types of public offerings. In order to clear up this ambiguity, the proposed amendments subject all public offerings to FINRA review, unless the offering falls under one of the specific permitted exemptions. The permitted exemptions have been expanded to include follow-on offerings of securities by a “closed-end” investment company that is operated as a tender offer fund and meets certain conditions. Additionally, insurance contracts and unit investment trusts, as well as securities that are exempt from registration Rule 144(A) or Regulation S, are explicitly no longer subject to filing and rule compliance. Note that private placements are still subject to FINRA Rules 5122 and 5123.
3) Update the “Seasoned Issuer” Exemption
The proposed amendments clarify the “seasoned issuer” exemption for issuers eligible for filing with the SEC on Forms S-3, F-3 or F-10. The proposed amendments eliminate the outdated reference to the standards for these forms prior to Oct. 21, 1992, and replace this with a new definition of an “experienced issuer.” An “experienced issuer” must have (i) a reporting history of 36 calendar months preceding the filing of the registration statement and (ii) either (a) have a public float of $150 million (aggregate market value of voting stock held by non-affiliates), or (b) have a public float of $100 million and an annual trading volume of at least 3 million shares. The current guidance provided by FINRA already employs this criteria to determine whether an issuer falls under this exemption, so the proposed amendments will likely have little practical effect.
4) Eliminate the Requirement to Disclose the Dollar Amount of Individual Items of Underwriting Compensation
The proposed amendments eliminate the term “items of value” from the current rule, replacing it with the defined term “underwriting compensation.” Further, they require the disclosure of “a description of each item of underwriting compensation received or to be received by a participating member, including the maximum aggregate amount of all underwriting compensation”. However, it is no longer required that the description include the dollar amount ascribed to each individual item of compensation (other than the underwriting discounts or commissions). Those involved in the preparation of offering documents should be aware that the following types of compensation require additional disclosure in the distribution arrangements section of the offering document: (i) securities acquired by a participating member will require disclosure of the material terms and arrangements of the acquisition; and (ii) if there is a right of first refusal, the description should reference the existence of such right and its duration.
5) Broaden the Exceptions to Underwriting Compensation
a. Securities Acquired to Prevent Dilution
Under the current rule, acquisitions and conversions to prevent dilution that met certain conditions were exempted from underwriting compensation. The proposed amendments eliminate this exception, but add securities acquired in order to prevent dilution of a long-standing interest in the issuer, as long as (i) such securities do not increase a member’s percentage ownership of the class of securities; (ii) the initial purchase was made at least two years prior to the filing date; and (iii) any subsequent purchases were made before the review period. The current formulation is broader than the original exception.
b. Purchases Based on a Prior Investment History
Under the proposed amendments, securities acquired as the result of an exercise of options or warrants that were originally acquired prior to the review period are not deemed to be underwriting compensation. Once again, this broadens the exception for purchases based on a prior investment history that exists in the current rule, which requires that the purchaser meet certain requirements, such as having engaged in previous purchases at specific times. Note that the defined term “review period” is also a new addition to the proposed amendments that defines the period from 180 days prior to the filing to 60 days following the termination of the offering. Any activities undertaken during this period in connection with the offering may be subject to FINRA review.
c. Purchases and Loans by Certain Affiliates
The existing rule placed a firm cap of 25% on the aggregate number of equity securities that entities related to any member participating in an acquisition that met the required conditions could acquire during the review period. This 25% cap no longer appears in the proposed amendments.
d. Private Placements With Institutional Investors
Similarly, the proposed amendments change the cap on the number of securities of the issuer that may be purchased by participating members or received as placement agent compensation by participating members in connection with a private placement from 20% to 40% of the “total offering” (excluding purchases subject to the affiliate exception described above).
6) Lock-up Restrictions
The proposed amendments suggest five major changes to the provision regarding lock-up restrictions:
- As opposed to the current rule, the restricted period is no longer 180 days following the date of effectiveness or commencement of sales of public offerings; rather it now begins on the date of commencement of sales in all cases.
- The lock-up restriction must be disclosed in the section on distribution arrangements in the prospectus or similar document.
- The lock-up restriction will not apply to the securities of an issuer that meet the registration requirements of SEC Registration Forms S-3, F-3 or F-10.
- The transfer of any security to any member participating in the offering and its officers or partners, its registered persons or its affiliates is not prohibited under the proposed amendments, as long as all transferred securities remain subject to the 180-day lock-up period for its duration.
- The transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC shall now be permitted under the proposed amendments.
7) Prohibited Transactions
The proposed amendments delete the prohibition on any non-accountable expense allowance in excess of 3% of the offering proceeds. The proposed amendments also delete the presumption in regard to the prohibition on the receipt by a participating member of any compensation in connection with the exercise or conversion of any warrant, option or convertible security when the exercise or conversion of such warrant, option or convertible security is not solicited by a participating member, unless the customer states in writing that the transaction was solicited and designates in writing that the broker-dealer is to receive compensation for the exercise or conversion. The rule no longer gives any guidance as to how a participating member can prove it did, in fact, solicit the exercise or conversion.
8) Securities Valuations
The proposed amendments delete 5110(e) regarding how to determine the value to be assigned to securities received as underwriting compensation. Instead, the supplementary materials provide guidance as to how to value such securities, stating that the valuation method used to determine the value of options, warrants and other convertible securities must be commercially available and appropriate for the types of securities to be valued, such as, for example, the Black-Scholes model for options. Similar to the existing rule, if a participating member wishes to reduce the proposed maximum value of any securities received as underwriting compensation, it may still reduce the proposed maximum value attributable to such securities by 10% for every 180-day period it agrees to successively lock-up such securities beyond the initial lock-up period, if applicable.
The proposed amendments to Rule 5110 can be found by clicking on the link below: http://www.finra.org/industry/notices/17-15