On January 16, 2009, the Securities and Exchange Commission (“SEC”) published a proposal by the Financial Industry Regulatory Authority, Inc. (“FINRA”) to establish a rule which would, for the first time, regulate “member private offerings,” private offerings of unregistered securities of FINRA members (broker-dealers) or their “control entities.”1 The proposed rule is intended to address detected abuses in such private offerings where member firms have been found to have used substantial portions of the proceeds of such offerings for selling compensation and related party benefits rather than for the business purposes of the firm.  

Proposed FINRA Rule 5122 would require that, subject to enumerated exemptions discussed below, a member that engages in a private offering of its own securities or the securities of a control entity would be required to provide offerees with an offering document, term sheet or similar writing containing, at a minimum, the intended use of proceeds and the offering expenses, even if the delivery of such an offering document is not otherwise required under the federal securities laws. In addition, the member would be required to use at least 85% of the offering proceeds for business purposes, which may not include offering costs, discounts, commissions or any other cash or non-cash sales incentives. Finally, the member would be required to file, no later than the time it is delivered to a potential investor, the required offering material for review by FINRA.2  

The proposed rule, which principally addresses private placements by broker-dealers of their own securities, will also affect private equity firms affiliated with broker-dealers. Significantly, the rule will apply to portfolio companies of private equity firms affiliated with a broker-dealer, where the broker-dealer beneficially owns more than 50 percent of the portfolio company and the broker-dealer underwrites the portfolio company’s private debt or equity securities offering.  

The main effect of the rule will be on private offerings of common stock to individuals and accredited investors in the United States. By its terms the proposed rule will not apply to the following offerings, among others, where the abuses noted above have not been seen:  

  • offers to employees and affiliates of the issuer or its control entities;
  • offerings pursuant to Rule 144A and Regulation S;  
  • offers to “qualified institutional buyers” (“QIBs”), “qualified purchasers” (“QPs”) and/or institutional accounts (but not “accredited investors”);  
  • offerings of investment grade debt and preferred securities;  
  • offerings in which a member acts primarily in a wholesaling capacity (i.e., it intends, as evidenced by a selling agreement, to sell through its affiliate broker-dealers less than 20% of the securities in the offering);  
  • offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor;  
  • offerings of equity and credit derivatives, including OTC options; provided that the derivative is not based principally on the member or any if its control entities; and  
  • offerings already required to be filed with FINRA under Rule 5110 or NASD Rules 2720 or 2810. The

SEC’s proposing release was published in the Federal Register on January 26, 2009, and the comment period will close on February 17, 2009.3