In April 2017, FINRA released a set of significant proposed amendments to its Rule 5110, known as the "Corporate Financing Rule." FINRA's regulatory notice relating to the proposed amendments, together with the text of the proposed revisions, may be found here.
The proposed revisions would make substantive, organizational and terminology changes to the rule. According to FINRA, the proposal is intended to modernize the rule, and to simplify and clarify its provisions.
In this article, we discuss the potential impact of the proposed revisions to the rule on offerings of structured notes. For additional discussion of the proposal, please see our client alert, which may be found here.
Underwriting Compensation and Hedging Activities
The proposal includes an effort to consolidate the existing provisions of the rule into a single definition of "underwriting compensation" 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."
In many structured note offerings, the underwriter or its affiliate will enter into a hedging transaction with the issuer. Accordingly, these arrangements raise the question of whether that hedge transaction could be deemed "underwriting compensation," requiring disclosure of the transaction's value.
The proposed rules take a similar approach to the existing rules. New "Supplementary Material" would provide, in part: "derivative instruments acquired in a transaction related to the public offering and at a fair price, will be considered underwriting compensation but will have no compensation value." (Emphasis added.) In contrast, "derivative instruments acquired in a transaction related to the public offering but not at a fair price, will be considered underwriting compensation and subject to the normal valuation requirements of this Rule and members must provide a description of the methodology used to value the [derivative instrument]." (Emphasis added.)
The proposal indicates that a derivative will be considered to have been entered into at "fair value" when "participating members have priced a derivative instrument or non-convertible or non-exchangeable debt security in good faith, on an arm's-length, commercially reasonable basis, and in accordance with pricing methods and models and procedures used in the ordinary course of their business for pricing similar transactions."
Similar to the existing rule, the proposal appears to contemplate hedging arrangements between issuers and their affiliated underwriters, provided that the terms of the transaction satisfy the specified criteria.
The proposed new rules would purport to bar an underwriter from receiving underwriting compensation "for which a value cannot be determined." Of course, a party to a hedge transaction will likely not know the amount of profit or loss that may result from the transaction. However, that fact would not appear to bar entry into the hedge, as long as the transaction itself, like most financial transactions, can be valued.
The SEC regulation governing prospectus disclosures, Regulation S-K (Item 508), incorporates by reference FINRA's rules, and requires disclosure in the "Plan of Distribution" section of all items considered to be underwriting compensation. The proposed amendments attempt to provide guidance to issuers as to how to satisfy this disclosure obligation.
Under the proposed amendments, the specific value of each item of compensation need not be separately disclosed in the "Plan of Distribution" section. Instead, the proposed rules would provide that this section of the prospectus must simply describe the maximum aggregate amount of all underwriting compensation. As a result, the rule would clarify that, for example, if an underwriter receives an "underwriting discount" and a "structuring fee" (and/or other compensation, such as a license fee) for its services, these items would not need to be separately quantified in the Plan of Distribution section. However, to the extent that the underwriters receive compensation that is additional to the underwriting discount, the underwriting table on the prospectus cover page would need to include a footnote that cross-references the "Plan of Distribution" section in which the additional compensation is described.
Most structured notes are offered by financial institutions that have outstanding investment grade debt securities that rank equally with the structured notes. Accordingly, few offerings relating to structured notes are filed with FINRA given the availability of the exemption from FINRA filing that applies to these investment grade debt issuers. As a result, we will not address here the proposed changes to FINRA's filing requirements, such as its lengthening of the period in which offering documents must be filed. However, where offerings are required to be filed, if the underwriter or an affiliate enters into a derivative transaction relating to the public offering, the instrument will be subject to the filing requirement, and must be accompanied by a representation that a registered principal or senior manager of the participating member has determined if the transaction was or will be entered into at a fair price.
The proposed amendment makes explicit that Rule 144A and Regulation S offerings of securities are exempt from the Corporate Financing Rule. This has become understood in the market, but was not explicitly stated in the text of the existing rule. Regulation D Rule 506 offerings were specifically exempt from the rule, and that would continue to be the case under the proposal.
FINRA has established a comment period ending May 30, 2017 for interested persons to submit comments.