On April 12, 2017, the US Financial Industry Regulatory Authority, Inc. (“FINRA”) published proposed amendments to FINRA Rule 5110, which regulates the terms and arrangements of securities underwriting conducted by FINRA member broker-dealers. If adopted, the amendment would impact a number of aspects of the Corporate Financing Rule, including to the following areas: (i) filing requirements, (ii) filing exemptions, (iii) disclosure requirements, (iv) underwriting compensation, (v) lock-up restrictions, (vi) valuation of securities, (vii) prohibited terms and arrangements and (viii) defined terms.
FINRA is currently soliciting comments to the proposal. Regulatory Notice 17-15, which outlines the proposed amendments, also sets forth specific issues and questions on which FINRA has requested comment. All comments must be received by May 30, 2017. The proposal has not at this time been filed with the US Securities and Exchange Commission (“SEC”) for review and approval. FINRA must file the proposed rule changes with the SEC, and the SEC must approve the proposed rule changes, before the proposal will become effective. The text of the proposed rule is attached hereto as Exhibit A.
Background: The Corporate Financing Rule
Rule 5110 regulates the terms and conditions of the participation of FINRA member broker-dealers in public offerings. The Rule prohibits underwriting arrangements in connection with the public offering of securities if those underwriting terms and conditions are deemed under the Rule to be “unfair” or “unreasonable.” The rule requires that a FINRA member broker-dealer participating in a public offering must, if no exemption from filing exists, file certain information with FINRA regarding the underwriting terms and arrangements.
The Corporate Financing Rule regulates underwriters’ compensation in three basic ways: (i) by aggregating all “items of value” received by underwriters and other related persons in connection with the public offering, deeming such items of value to be “compensation in connection with the public offering,” and limiting that compensation; (ii) placing a prohibition on the receipt of certain items of value in connection with participation in a public offering; and (iii) requiring disclosure of all items of value that are deemed to be compensation to the underwriters in connection with the public offering in filings to FINRA.
The Proposed Amendments
The proposed amendments would result in a range of changes to Rule 5110, including to the following areas:
- Filing requirements;
- Filing exemptions;
- Disclosure requirement;
- Underwriting compensation;
- Lock-up restrictions;
- Valuation of securities;
- Prohibited terms and arrangements; and
- Defined terms.
The below provides a brief summary of each of the proposed amendments.
Extending the Time Period for Making the Required FINRA Filings
FINRA is proposing to allow member broker-dealers more time to make the required filings with FINRA. Currently a broker-dealer is required to make a FINRA filing within one business day after filing with the SEC or state equivalent. The amended rule would extend the time period to three business days. In addition, rather than providing a non-exhaustive list of types of public offerings that are required to be filed, the proposed amendments would instead state that a public offering in which a broker-dealer participates must be filed for review unless exempted by the Rule.
Expanding and Clarifying Exemptions From the FINRA Filing Requirement
The proposed rule amendment would expand the offerings that are exempt from the filing requirement of Rule 5110 to include the following:
- Follow-on offerings of closed-end “tender offer” funds that routinely make self-tender offers and need to be in continuous distribution to offset net redemptions. Compensation for distribution of such funds will become subject to the limitations set forth in FINRA Rule 2341 (Investment Company Securities); and
- Public offerings of insurance contracts and unit investment trusts, which are also subject to FINRA Rule 2341 as well as the Investment Company Act of 1940.
Under the Corporate Financing Rule as it currently stands, shelf offerings of securities are exempt from filing under the Rule if they are made in accordance with the shelf offering standards as those standards existed at the time of the Rule’s initial adoption in 1992. This anachronism stands as a trap for the unwary, as these “pre-1992 standards” for shelf offerings are not well known today. Under the proposal, the reference to the pre-1992 standards will be replaced with the equivalent substantive criteria: generally, a three-year reporting history and $150 million in public float.
In addition, the proposal will add an explicit exemption from both the filing requirements and substantive provisions of Rule 5110 for offerings made pursuant to the SEC’s Regulation S and Rule 144A under the Securities Act of 1933.
Modification of Underwriting Compensation Disclosure Requirements
FINRA is proposing to modify the underwriting compensation disclosure requirements to eliminate the requirement for the disclosure to include the dollar amount ascribed to each individual item of compensation. Rather, under the proposed amendment, a firm would be allowed to disclose a maximum aggregate amount of all underwriting compensation, except that the discount or commission must still be separately disclosed on the cover page of the prospectus.
Consolidation of the Definition of “Underwriting Compensation”
The proposed amendment to Rule 5110 would delete the current term “items of value,” which, in the current rule, are separately identified and aggregated to determine the total amount of underwriting compensation. Instead, the amended rule would have a single new definition of “underwriting compensation,” defined to mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would also include “finder fees and underwriters’ counsel fees, including expense reimbursements and securities.” In addition, the proposal would introduce the new defined term “review period,” which varies slightly based on the type of offering, but is generally intended to continue the current Rule’s review period commencing 180 days prior to the initial filing of the applicable offering, and ending 60 days following the termination of the offering. FINRA would consider payments and benefits received during the applicable review period in evaluating underwriting compensation.
The proposal would exclude the following from the definition of “underwriting compensation”:
- Securities acquisitions and conversions to prevent dilution; and
- Purchases of securities based on a prior investment history (i.e., prior investments in the issuer occurring before the review period).
The proposal also clarifies certain exceptions from the term “underwriting compensation.” Currently, Rule 5110(d)(5) sets forth certain items of value that are excluded from underwriting compensation. Under the proposal, the following would be considered exceptions from “underwriting compensation”:
- The current Rule contains an exception for certain bona fide investments and loans that meet certain specified conditions so long as the entities do not acquire more than 25% of the issuer’s total equity securities in the 180 days prior to the initial filing of the applicable offering. The proposal removes the limitation on acquiring more than 25% of the issuer’s total equity securities.
- The current Rule also exempts from “underwriting compensation” purchases of securities of the issuer which were acquired (either purchased or received as placement agent compensation) in private placements in the 180-day period prior to the initial filing of the applicable offering so long as, among other conditions, the underwriters and related persons did not, in the aggregate, purchase (or receive as placement agent compensation) more than 20% of the total offering. The proposal increases the limit for such acquisitions by broker-dealers in private placements of the issuer from 20% to 40%.
Modification of Lock-Up Restrictions
FINRA is proposing that the 180-day lock-up restriction on securities that are considered underwriting compensation begin on the date of commencement of sales, rather than the date of effectiveness of the prospectus. In addition, FINRA is proposing to modify exceptions from the lock-up restriction to allow for (i) the transfer of any security to the broker-dealer’s registered persons or affiliates if all transferred securities remain subject to the restriction for the remainder of the lock-up period; or (ii) the transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC.
Securities Valuations Based on Commercially Available Methods
Currently, Rule 5110 prescribes specific calculations for valuing convertible and non-convertible securities received as underwriting compensation. In the proposed amendments, FINRA will allow the valuing of options, warrants and other convertible securities received as underwriting compensation based on a securities valuation method that is commercially available and appropriate for the type of securities to be valued (e.g., the Black-Scholes model for options). The proposed change for valuing convertible securities would ensure a commercially reasonable valuation of underwriting compensation for the benefit of issuers, and the public and will also ease administrative and operational burdens for firms.
Clarification of Prohibited Terms and Arrangements
FINRA is proposing to clarify the list of prohibited terms and arrangements currently in Rule 5110(f) to eliminate from the list the prohibition of a non-accountable expense reimbursement in excess of 3% of the offering proceeds. This elimination will remove the need for firms to separately monitor the receipt of this particular type of compensation.
Simplification and Clarification of Certain Defined Terms
As a general matter, the proposed amendments seek to simplify and consolidate current defined terms. As described above, the proposed amendment would delete the term “item of value” from Rule 5110 in favor of a single definition of “underwriting compensation.”
In addition, Rule 5110 currently alternates between using the defined term “underwriter and related persons” (which includes underwriter’s counsel, financial consultants and advisors, finders, any participating member and any other persons related to any participating member) and the defined term “participating member” (which includes any FINRA member that is participating in a public offering, any affiliate or associated person of the member and any immediate family). In order to provide greater consistency on the scope of persons covered by the Corporate Financing Rule, FINRA is proposing to delete the term “underwriter and related persons” and instead use the defined term “participating member.” The proposed definition of underwriting compensation would ensure that the rule continues to address fees and expenses paid to persons previously covered by the term “underwriter and related persons” (e.g., underwriter’s counsel fees and expenses, financial consulting and advisory fees and finder fees).
The proposal would also conform the definitions in Rule 5110 with those in FINRA Rule 5121 (Public Offerings of Securities With Conflicts of Interest) by deleting the definition of “public offering” in that rule and instead incorporating the definition in Rule 5110 by reference.
With this proposed rule amendment, FINRA seeks to (i) extend the time period for making the required FINRA filings; (ii) expand and clarify on exemptions from the FINRA filing requirement; (iii) modify underwriting compensation disclosure requirements; (iv) consolidate the definition of “underwriting compensation”; (v) modify lock-up restrictions; (vi) allow for securities valuations based on commercially available methods; (vii) clarify prohibited terms and arrangements; and (viii) simplify and clarify certain defined terms.
These proposed changes, which touch on a wide range of aspects of the Corporate Financing Rule, reflect a positive effort by FINRA to modernize Rule 5110 and to streamline the provisions of the rule. In this regard, the proposed amendments are generally welcome inasmuch as they recognize changes in the financial services industry as they relate to public offerings since the last substantial amendment to the Rule in 2004, and provide greater flexibility to members and reduce administrative and compliance burdens as they seek to comply with the filing and disclosure requirements of the Rule. In addition, the streamlining of the various aspects of Rule 5110 provide important clarification for broker-dealers as they seek to comply with other rules (such as FINRA Rule 5121) that are applicable to broker-dealer participation in public offerings. In other ways however, such as by maintaining the outdated position that the reimbursement of underwriters’ counsel fees and expenses are not expenses “customarily reimbursed” by the issuer, the proposal does not go far enough in aligning the FINRA Corporate Financing Rule with the reality of current practice in underwriting public offerings.
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