The Financial Industry Regulatory Authority (“FINRA”) filed with the SEC a proposed rule change to permit broker-dealers to include projections of investment performance and target investment returns in (i) communications with “institutional investors,” as defined in FINRA Rule 2210, and (ii) communications promoting private placements of securities sold to “qualified purchasers” (“QPs”) as defined in the Investment Company Act of 1940 (the “Investment Company Act”).
This is a significant proposal that, if adopted, would permit broker-dealers acting as placement agents in offerings of private funds to QPs under Section 3(c)(7) of the Investment Company Act to include projections and targets in fund marketing materials. This represents a significant liberalization of the current regime, which severely limits the use of investment projections or targets in private fund sales material distributed by broker-dealers, even though investment advisers are permitted to include projections and targets in private fund marketing material in accordance with Rule 206(4)-1 under the Investment Advisers Act of 1940 (the “IA Marketing Rule”). The FINRA proposal would, however, impose substantial conditions on the ability of broker-dealers to make use of projections and targets, and would require firms to establish detailed compliance procedures in order to satisfy the relevant conditions.
Section I of this memorandum addresses the current FINRA requirements applicable to use of projections and targets as well as the key investor definitions relevant to the FINRA proposal.
Section II of this memorandum provides a summary of FINRA’s proposed rule governing use of projections and targets in broker-dealer marketing materials.
Section III discusses issues and questions raised by the FINRA proposal.
Projections and Targets: Current FINRA Requirements
Projections: FINRA Rule 2210 prohibits predictions or projections of investment performance except for (i) a hypothetical illustration of mathematical principles, provided that it does not predict or project the performance of an investment or investment strategy; (ii) an investment analysis tool, or a written report produced by an investment analysis tool, that meets the requirements of FINRA Rule 2214; or (iii) a price target in a research report. This means, for example, that a broker-dealer that distributes marketing material for a private fund is prohibited from including projections of fund performance in the marketing deck.
Target Returns: FINRA guidance prohibits target returns in communications with “retail investors.” In a recent Advertising FAQ, FINRA noted that “As discussed in Regulatory Notice 20-21, ‘retail communications may not project or predict returns to investors such as yields, income, dividends, capital appreciation, percentages or any other future investment performance.’ This prohibition extends to retail communications that include target returns to investors.” The FAQ did not, however, include a similar prohibition on sending target returns to “institutional investors.” Accordingly, it is broadly accepted that target returns may be sent to “institutional investors.” While the FINRA proposal does not address this issue at any length, the proposal notes that “[b]ecause Rule 2210 generally precludes a member from providing projected performance or targeted returns in marketing communications distributed to institutional investors and QPs, these investors cannot obtain a member’s potentially different and valuable perspective.”
Disparity with Advisers Act Marketing Rule: The IA Marketing Rule permits SEC-registered investment advisers to distribute marketing material containing projections or targets subject to compliance with requirements applicable to “hypothetical performance.” The FINRA restrictions on use of projections and targets thus create a significant disparity between the information that an investment adviser may include in a private fund marketing deck, and material that a broker-dealer acting as placement agent may distribute to investors. The FINRA proposal partially addresses this disparity, at least with respect to 3(c)(7) funds.
Retail vs. Institutional Investors
Under the FINRA proposal, the permissibility of sending a projection or target depends on whether the investor is an “institutional investor” or QP.
FINRA Rule 2210 defines an “institutional investor” as any natural person or legal entity with assets of at least $50 million, as well as certain regulated entities (e.g., banks, registered investment companies, and registered investment advisers). FINRA Rule 2210 defines a “retail investor” as any person other than an “institutional investor.” Significantly, under these definitions, a QP with less than $50 million in assets is a “retail investor” under FINRA Rule 2210.
FINRA Proposed Requirements for Use of Projections and Target Returns
Under the FINRA proposal, a broker-dealer may include projections and targets in communications to customers subject to compliance with the following requirements.
In reviewing the proposal, firms should consider what compliance procedures would be necessary in order to satisfy these requirements and whether the required procedures are reasonable to implement.
1. Permitted Recipients and Offerings:
A broker-dealer may include a projection or target with respect to a security, asset allocation or other investment strategy in a communication sent exclusively to:
i. “institutional investors,” as defined in FINRA Rule 2210(a)(4), including specified regulated entities and any entity or natural person with total assets of at least $50 million; or
ii. “qualified purchasers,” as defined in Section 2(a)(51)(A) of the Investment Company Act, in a communication promoting a private placement of securities sold exclusively to “qualified purchasers.”
2. Compliance Policies:
The broker-dealer must adopt compliance policies reasonably designed to ensure that the projection or target is “relevant to the likely financial situation and investment objectives of the investor receiving the communication,” and complies with all applicable requirements.
3. Reasonable Basis for Projection or Target:
The broker-dealer must (i) have a “reasonable basis for the criteria used and assumptions made” in calculating the projection or target and (ii) retain records supporting the basis for those criteria and assumptions.
Permitted Factors: In forming a reasonable basis for the criteria used and assumptions made in calculating a projection or target, a broker-dealer should “consider multiple factors, with no one factor being determinative,” which may include:
- macroeconomic conditions;
- assumptions concerning the future performance of capital markets;
- the operating and financial history of an operating company issuing a security;
- market conditions of the issuer’s industry or sector, and the state of the business cycle;
- financial models, taking into account the assumptions and potential limitations of such models;
- the quality of the assets included in a securitization;
- the appropriateness of selected peer-group comparisons;
- the reliability of research sources;
- the historical performance and performance volatility of the same or similar asset classes;
- for managed accounts or funds, the past performance of other accounts or funds managed by the same investment adviser or sub-adviser, that have “substantially similar investment objectives, policies, and strategies” as the account or fund for which the projection or target is shown;
- the average weighted duration and maturity of debt securities;
- the impact of fees, costs, and taxes; and
- the expected contribution and withdrawal rates by investors.
Prohibited Factors: Broker-dealers may not base projections or targets on:
i. hypothetical, back-tested performance; or
ii. the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record.
An investment manager’s proprietary seed capital accounts that were created for purposes unrelated to the establishment of a performance record would not fall within this prohibition.
The communication must prominently disclose that the projection or target is hypothetical in nature and there is no guarantee that the projection or target will be achieved.
5. Underlying Information:
The communication must provide sufficient information to enable the investor to understand:
i. the criteria used and assumptions made in calculating the projection or target, including whether the projection or target is net of anticipated fees and expenses; and
ii. the risks and limitations of using the projection or target in making investment decisions, including reasons why the projection or target might differ from actual performance.
Issues and Questions raised by the FINRA proposal.
Comparison to IA Marketing Rule
FINRA notes that the proposed requirements are “in many respects” consistent with the treatment of projections and targets in the marketing rule under the IA Marketing Rule. In particular, FINRA’s proposed Compliance Policy and Underlying Information requirements (addressed in Section II.2 and II.5 above) reflect parallel requirements applicable to targets and projections in the IA Marketing Rule. According to the FINRA proposal, broker-dealers should be permitted to comply with these requirements in line with SEC guidance under the IA Marketing Rule. However, unlike the IA Marketing Rule, the FINRA proposed rule limits distribution of communications containing projections and targets to (i) “institutional investors” and (ii) private placements of securities sold exclusively to QPs, and requires broker-dealers to document the basis for a firm’s determination that use of the projection or target is reasonable based on the multi-factor test described above.
Compliance Policies: Relevance of Projection or Target to Recipients
Under the FINRA proposal, a broker-dealer may only send projections or targets to institutional investors, or to QPs in 3(c)(7) funds, in accordance with compliance policies reasonably designed to ensure that the communication is “relevant to the likely financial situation and investment objectives of the investor receiving the communication.” In other words, qualification as an “institutional investor,” or QP in a 3(c)(7) fund, is insufficient in itself. In addition, the broker-dealer must make a determination as to whether the projection or target is “relevant” to the investor (the “Relevance Requirement”). The IA Marketing Rule similarly requires investment advisers to make a relevance determination in connection with projections or targets sent to an adviser’s clients.
Determining Relevance to Investors
The proposal provides that a firm may meet the Relevance Requirement “by relying on its past experiences with particular types of institutional investors and QP private placement investors who seek this information.” The proposal further notes that a broker-dealer “. . . may wish to further tailor its intended audience for such a communication to persons or entities that have expressed interest in particular types of securities, or who have invested in similar securities in the past.”
Investor Financial Resources or Expertise
The proposal requires that a broker-dealer “should only include a projection or target where the firm reasonably believes the investors have access to resources to independently analyze this information or have the financial expertise to understand the risks and limitations of such presentations.” If an investor does not have this financial expertise, “the compliance policies be reasonably designed to ensure that the investor has the resources necessary to access financial professionals that possess this expertise.”
It is not clear from the wording of the proposed rule whether a broker-dealer is required to determine whether the projection or target is relevant to each specific investor receiving the communication, or to the category of investors to whom the broker-dealer intends to send the communication. The IA Marketing Rule provides that an investment adviser is required to determine whether the communication is relevant to the “intended audience,” meaning the category of investors to whom the communication is sent. If, as FINRA indicates in the proposal, the Relevance Requirement is to be interpreted in line with the IA Marketing Rule, broker-dealers should similarly be permitted to make the relevance determination based on the “intended audience,” and not on the characteristics of each specific investor.
Criteria and assumptions made in calculating the projection or target: The FINRA proposal explains a broker-dealer should provide a “general description of the methodology used sufficient to enable the investors to understand the basis of the methodology, as well as the assumptions underlying the projection or targeted return.” A firm would not, however, be required to disclose proprietary or confidential information regarding the firm’s methodology and criteria. This is similar to the approach taken in the IA Marketing Rule.
Risks and Limitations of Projections and Targets: In addressing the limitations of projections, a communication may need to disclose that a projection may differ from actual performance as the projection does not reflect actual cash flows into and out of an investment portfolio. FINRA notes that this is particularly true when a projection is expressed as an internal rate of return (“IRR”), since “forward-looking IRR shows a return earned by investors over a particular period, calculated on the basis of future cash flows to and from investors. If the actual future cash flows differ from the assumptions, the actual IRR may differ from the projected IRR.”
Fair and Balanced: Long-Term Projections
FINRA notes that all projections and targets are subject to the overarching requirement that they be fair and balanced. FINRA believes this requirement would prohibit a firm from “presenting a projection that purports to show longer term returns for an equity security offered shortly before or after the date of the communication, as it would be viewed as unwarranted and lacking a sound basis due to the difficulty in predicting future securities markets and economic conditions.” The scope of this guidance is unclear. For example, in the case of a marketing deck for a new private equity fund, over what time period could performance be projected?
Oversight of Third-Party Systems
Where a broker-dealer relies on third-party models or software to create a projection or target, the firm’s supervisory procedures must be sufficient to confirm that any projections or targets created by third party comply with the requirements of the rule. For this purpose, the proposal provides that a broker-dealer should make reasonable efforts to determine whether the model is sound and should make reasonable inquiries into the source and accuracy of the data used to create the projection or target. In evaluating a third-party model, a broker-dealer should consider “the assumptions used to create the projection or target, the rigor of its analysis, the date and timeliness of any research used to create the model or software, and the objectivity and independence of the entity that created the model or software.”
Projections and Targets Outside Scope of Proposal
Knowledgeable Employees: The proposal does not address the permissibility of sending projections or targets to “knowledgeable employees,” as defined in Rule 3c-5 under the Investment Company Act, investing in 3(c)(7) funds.
3(c)(1) Funds: The proposal does not extend to private funds offered under Section 3(c)(1) of the Investment Company Act. A broker-dealer would still be prohibited from including projections or targets in marketing material for 3(c)(1) funds.