The Financial Industry Regulatory Authority, Inc. (FINRA) recently proposed amendments to its Corporate Financing Rule that would provide issuers and investment banks greater flexibility to negotiate termination fees and rights of first refusal in connection with proposed public offerings.
FINRA's Corporate Financing Rule – Rule 5110 – governs compensation arrangements FINRA members may receive in connection with participation in public offerings. FINRA currently interprets the Corporate Financing Rule to prohibit members from entering into arrangements that provide the member the right to receive a payment in connection with most transactions that occur in lieu of—or after termination of a member's participation in—a proposed public offering (e.g. "tail fees"). Exceptions to this general rule are limited to fees in exchange offers or similar transactions in which the member provides substantial structuring or advisory services beyond typical underwriting and distribution services. FINRA also interprets the Corporate Financing Rule to prohibit members from receiving a right of first refusal in connection with a public offering when a member's participation in the originally contemplated transaction is terminated. If a member includes any of these provisions in an engagement letter or other agreement with an issuer in connection with a public offering, FINRA will require the member and issuer to amend the agreement to eliminate the problematic provision before confirming that it has no objections to the proposed compensation arrangements, which is required to close the offering.
FINRA members often seek post-termination fees or rights of first refusal to protect themselves from performing significant work structuring an offering, performing due diligence on an issuer, preparing offering-related documents or otherwise, only to have the issuer decide shortly before launching the offering to complete the transaction with another investment bank. Issuers, especially small- or mid-cap issuers, often are willing to agree to these arrangements to have the opportunity to work with an advisor that can help raise needed capital for a market segment that many investors and investment banks are increasingly overlooking. FINRA acknowledged in its notice proposing the amendments that its current interpretation of the Corporate Financing Rule might unnecessarily interfere with the ability of issuers and investment banks to negotiate compensation arrangements that suit issuers' business interests.
FINRA's proposed amendments would eliminate this unnecessary interference by permitting members to enter into agreements that include termination fees or rights of first refusal currently prohibited by the Corporate Financing Rule if the agreements are written and the following requirements are met:
- The amount of a termination fee must be reasonable in relation to the services contemplated in the agreement, and fees arising from services provided under a right of first refusal must be customary for the type of services contemplated in the agreement;
- The issuer must have a right of "termination for cause," which includes the member's material failure to provide the services contemplated in the agreement;
- An issuer's termination for cause must eliminate any obligations with respect to any termination fee or right of first refusal; and
- The termination fee must require an offering or other transaction (as set forth in the agreement) to be consummated within two years of the date the engagement is terminated by the issuer for the issuer to be responsible for paying the fee.
The amended Corporate Financing Rule would not change the current restrictions prohibiting FINRA members from agreeing to a right of first refusal that has a duration of more than three years from the commencement of sales in a public offering. The amended rule would also require the right of first refusal to terminate no later than three years after the termination of the engagement between the issuer and member.
Potential Issues Arising from Proposed Amendments
The flexibility afforded by the proposed amendments should be welcome news for issuers and investment banks. Assuming the amendments are adopted, FINRA members would need to carefully analyze their engagement letters for contemplated public offerings to ensure compliance with the requirements summarized above.
Members should note that the proposed amendments raise several questions, which FINRA might address after completion of the comment process, such as:
- Whether FINRA would independently examine if a termination fee is "reasonable" in relation to the services contemplated in the agreement as required by the proposed amendments, or whether an agreement only would need to recite this requirement, in which case FINRA would respect the acknowledgement of sophisticated, arm's-length contracting parties;
- The level of scrutiny and manner in which FINRA would examine whether fees arising from services provided under a right of first refusal are "customary" for the type of services contemplated in an agreement, as required by the proposed amendments, which—for future public offerings—we anticipate would be the existing standard of review for reasonable compensation under the Corporate Financing Rule; and
- What additional triggers for "termination-for-cause" issuers would demand to avoid obligations for termination fees or rights of first refusal, and whether FINRA would interpret the amended rule to require "for-cause" triggers in addition to a member's failure to provide services contemplated in an agreement, or if that single trigger set forth in the amended rule would suffice to comply with the new requirement.
The comment period for the proposed amendments expires on July 23, 2012.