SEC Approves FINRA Rule Changes for Brokers Participating in Private Securities Offerings

The Securities and Exchange Commission (“SEC”) has approved amendments to two Financial Industry Regulatory Authority (“FINRA”) rules (Rule 5123 and Rule 5110) governing FINRA-member broker-dealers’ participation in securities offerings. Although the amendments apply directly only to broker-dealers, they may streamline capital-raising processes by expanding the universe of accredited-investor offerings exempt from FINRA filing requirements. The amendments also allow underwriter affiliates to invest in nontraded REIT and direct participation program offerings without the time and expense of seeking, as previously required, case-by-case FINRA exemptions.

FINRA Rule 5123 requires FINRA-member firms that sell securities in certain private placements to provide a notice filing of the offering materials with FINRA—generally within 15 days after the first sale. FINRA Rule 5110 regulates underwriting terms and arrangements in public offerings; its purpose is to help ensure that underwriting compensation and related arrangements are fair and appropriately disclosed.

Updates to Rule 5123

Brokers make a Rule 5123 notice filing of a private placement memorandum or similar disclosure document when they sell offerings to investors who do not fall into certain exempted categories.  The amendment proposes to expand the exemption for offerings sold exclusively to accredited investors by adding two categories that the SEC included when it expanded the accredited investor definition in 2020:

• Family offices with more than $5 million in assets under management, provided they were not formed for the specific purpose of acquiring the offered securities and meet the other conditions of the SEC’s accredited investor definition; and
• Entities—including certain corporations, partnerships, limited liability companies, trusts, and other organizations—not formed for the purpose of acquiring the offered securities and owning more than $5 million in investments.

As a result, a private placement sold solely to investors within these two added categories as well as the other accredited investor categories previously included within the Rule 5123 filing exemption (such as banks, brokers,  registered investment advisers, private business development companies, certain tax exempt entities, and trusts with assets in excess of $5 million) may, following enactment of the rule changes, qualify for the Rule 5123 filing exemption.

Updates to Rule 5110

Rule 5110 governs underwriting terms and compensation in public offerings in which FINRA-member firms participate. The approved amendments update and clarify aspects of FINRA’s corporate-financing framework, including the circumstances in which filings are required and how certain compensation and related arrangements are treated.

Valuation for Underwriting Compensation

FINRA currently requires a participating broker-dealer that receives securities as underwriting compensation to value those securities using either (i) the public offering price per security; or (ii) if the security has a bona fide public market, the market price on the date the broker-dealer acquired the securities.  FINRA stated that its members have had difficulty determining if a security has a bona fide public market.

The proposed amendment would replace the “bona fide public market” standard with valuation based on the security’s closing market price on the acquisition date, as reported on either a US registered national securities exchange or a qualifying foreign securities market.

Exclusions from Underwriting Compensation for Certain Securities Acquisitions.

Rule 5110 amendments add an exclusion from underwriting compensation for investments made by the underwriter’s affiliates in (i) debt-for-equity exchanges, (ii) capital investments for direct participation programs and nontraded REITs, and (iii) non-convertible preferred securities. Historically, “underwriting compensation” has been broader than a stated underwriting discount or commission. It could include, for example, cash fees and commissions; expense reimbursements or nonaccountable expense allowances; warrants, options, or other securities received by the underwriter or related persons; financial advisory, consulting, or similar fees that are connected to the offering; and certain rights or benefits given in connection with the underwriter’s participation.

The Rule update’s clarification is particularly important where an underwriter, placement agent, affiliate, or associated person has another commercial relationship with the issuer. The amendments provide a more structured framework for analyzing whether a payment, equity grant, warrant, advisory fee, or similar benefit is truly independent of the offering—or is effectively additional compensation for distributing the securities.

To qualify under the exclusion provided in the newly SEC approved rule changes, the investment must be:

• disclosed in the prospectus;
• priced based on net asset value;
• made in an offering subject to FINRA’s direct participation program rule (Rule 2310); and
• subject to a 180-day restriction after sales begin.

Previously, FINRA members had to seek this relief on a case-by-case basis. 

Treatment of Tail Fees

The rule updates would also clarify that payments that provide compensation in the event of a subsequent financing from investors introduced by a FINRA member following the termination of an agreement (so-called “tail fees”) are comparable to termination fees for purpose of Rule 5110 and subject to the same requirements.  Specifically, the obligation to pay the tail fee must end completely if the issuer terminates the engagement for cause; the fee amount must stay reasonable when compared to the actual underwriting services planned in the original agreement; and the issuer cannot be forced to pay the tail fee unless the later transaction is completed within two years of the date the original engagement was terminated.

Private fund sponsors should not view the amendments as eliminating regulatory obligations. In particular, the amendments do not eliminate the need for careful review of placement-agent compensation, expense reimbursement, side letters, selling agreements, and potential conflicts of interest. Sponsors should continue to ensure that offering documents and marketing materials accurately describe the fund and its strategy, fees, risks, liquidity terms, and service-provider relationships. In addition, as FINRA aligns certain regulatory guidance between private placements and public offerings, one can expect that examiners will also align their view of what constitutes reasonable underwriting compensation with private placement compensation, including nonmonetary compensation and tail fees.

The SEC’s approval is a welcome step toward a more efficient process. For brokers it offers clarity, and for private fund sponsors the greatest benefit may be a smoother and more predictable fundraising process when working with broker-dealer placement agents—without compromising the investor protection objectives that remain central to private offerings.