United States

More disclosures on the horizon as FINRA proposes Rule 5123


The Rule
In a move by the Financial Industry Regulatory Authority ("FINRA"), Rule 5123 (the "Rule") surfaced on Oct. 4, 2011, as a new proposal that would require its members and any associated persons to file a Private Placement Memorandum ("PPM"), term sheet or other disclosure document that provides details of any sales offering to each investor prior to such a sale. FINRA is seeking to protect investors by mandating more transparency about offering proceeds, offering expenses and offering compensation related to private placements of securities. Subsequent to FINRA's proposal, the Securities and Exchange Commission ("SEC") has issued a notice of a rule filing to adopt the Rule, and public commentary was allowed through Nov. 14, 2011.

The Rule would require that "Notice" Filings be filed by members of FINRA and any associated persons detailing any private placement activity. Those filings should be submitted in the form of a PPM, Term sheet or other disclosure document and need to be filed with FINRA no later than 15 calendar days after the date of the first sale. Any amendments to the PPM, term sheet or other document detailing the disclosures must also be filed with FINRA no later than 15 calendar days after the document is provided to an investor or prospective investor. Each and every member of FINRA that is participating in a specific offering will need to make a separate filing. As these notices are informational in nature, any offerings will not be subject to commentary, approval or disapproval as part of this process and all information will remain confidential. Also, there will be no fee assessed according to the proposal.

With more disclosures comes more scrutiny. Having this kind of real-time information disclosed and filed routinely will help FINRA to spot irregularities and identify areas of interest, which could ultimately help to detect and prevent fraud.

Who will be affected and when
Broker Dealers will be primarily affected. But hedge funds, private equity funds and venture capital funds that have an affiliation with a broker dealer or any entity that is a member of FINRA (such as placement agents), will also be affected by these new disclosures. FINRA will announce the implementation date of the proposed rule no later than 90 days following SEC approval date. The implementation date will not be longer than 180 days after SEC approval.

Prior to Rule 5123, FINRA released Notice 11-04 in January 2011. This Notice requested commentary and proposed amendments on Rule 5123's predecessor, Rule 5122 (Member Private Offerings). It also expanded the scope of Rule 5122 so that most disclosure requirements, filing requirements and limitations on the use of offering proceeds would apply not only to private placements of securities issued by a FINRA member or an associated person of such member, but also to any private placements in which a FINRA member or associated person participates. In response to comments received, FINRA has abandoned Notice 11-04 and proposed Rule 5123 as a separate Rule.

There are a few differences between the two Rules but one that has caused the most concern is a requirement in Rule 5122 that the offering proceeds have a limitation whereby at least 85 percent of the offering proceeds are to be used for the business purposes described in the disclosure document. Rule 5123, as written, will not have that limitation.

The disclosures that need to be provided related to sales of securities in a private placement include the following:

  • Anticipated use of the offering proceeds
  • Amount and type of offering expenses
  • Amount and type of compensation provided to sponsors, finders, consultants, members and others associated persons with the offering

These disclosures must be included in the PPM or term sheet. However, if no PPM or term sheet exists, a document must be created that includes these disclosures, provided to investors before a sale transpires and later filed with FINRA according to the timeline outlined above.

There are exemptions from the Rule for certain categories of investors or purchasers as well as for specific types of offerings.

Exemptions for certain categories of investors or purchasers include:

  • Institutional accounts, as defined in NASD Rule 3110(c)(4)
  • Qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940
  • Qualified institutional buyers, as defined in Securities Act Rule 144A
  • Investment companies, as defined in Section 3 of the Investment Company Act
  • An entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A
  • Banks, as defined in Section 3(a)(2) of the Securities Act
  • Employees and affiliates of the issuer

Exemptions for specific types of offerings include:

  • Offerings of exempted securities, as defined in Section 3(A)(12) of the Securities Exchange Act of 1934, as amended ("Exchange Act")
  • Offerings made pursuant to Securities Act Rule 144A
  • Offerings made pursuant to Securities Act Regulation S
  • Offerings of exempt securities with short-term maturities under Section 3(a)(3) of the Securities Act
  • Offerings of subordinated loans under Exchange Act Rule 15c3-1, Appendix D
  • Offerings of "variable contracts" as defined in FINRA Rule 2320(b)(2)
  • Offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in FINRA Rule 5110(b)(8)(E)
  • Offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for incorporation by reference in Forms S-3 and F-3 of the Securities Act
  • 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 securities of a commodity pool operated by a commodity pool operator, as defined under Section 1a(11) of the Commodity Exchange Act of 1936, as amended
  • Offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122

In addition, a FINRA member or associated person may apply for an exemption to the Rule for good cause pursuant to the Rule 9600 Series.

The proposed exemptions to Rule 5123 are the same as the exemptions for Rule 5122 except for two items. Rule 5123 does not permit the exemption offerings in which a member acts in a wholesaling capacity, and it does not exempt offerings of certain credit derivatives, which Rule 5122 does permit.

Exemptions for qualified purchasers hold special importance, since funds that are exempt from the Investment Company Act of 1940 under Section 3(c)(7) are comprised of qualified purchasers and would therefore be exempt from this Rule and ensuing disclosure requirements.

Additionally, there is an exemption above for Regulation S offerings. It is typical for foreign investors (non-U.S. Investors) to purchase interests in offshore hedge funds in Regulation S transactions. If there are any U.S. investors in the offshore fund, they would typically be qualified purchasers. Both investor classes would enjoy the exemptions provided by Rule 5123 and would not have any disclosures to file. Therefore, the offshore fund would appear to be exempt from this disclosure requirement.

We will continue to monitor this regulatory development and produce further updates on the details of the changes as they are proposed or approved.

For more information, please contact Todd Rosen, Director, 212.372.1715, John Hague, Partner, 312.634.3354 , or your local RSM financial services representative.