Written by Jay Gould
On October 18, 2011, the SEC released a notice of FINRA’s filing of Proposed Rule 5123 (the “Proposed Rule”) which would require FINRA members and associated persons to: 1) provide to investors disclosure documents in connection with private placements prior to sale and 2) file with FINRA such disclosure documents within 15 days after the date of first sale and any subsequent amendments. These proposed changes would significantly affect fund managers who offer or sell their funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act through third party marketers, nearly all of which are required to be registered as broker-dealers.
Pre-sale requirement to provide disclosure documents to investors
The Proposed Rule would require FINRA members and associated persons that offer or sell private placements or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, to provide such disclosure documents to investors prior to sale. The disclosure documents must describe the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of offering compensation. Much of this information is currently captured in the Form D filing that most fund managers file with the SEC, but under the Proposed Rule, would go directly to investors in connection with the sale of fund interests.
As a practical matter, this likely means increased scrutiny of hedge fund and other private fund offerings by FINRA, as well as the likelihood that third party marketers that sell on behalf of hedge funds may request greater or more enhanced indemnification from fund managers in the placement agency agreement between the third party marketer and the fund manager. Accordingly, fund managers who use third party marketers to market their funds must keep their fund documents updated, taking into account all changes to fund strategies, material performance issues (to the extent applicable), regulatory changes and management personnel changes, to name a few.
Post-sale requirement to notice file with FINRA
The Proposed Rule would also require each FINRA member and associated person to notice file with FINRA by filing the PPM, term sheet or other disclosure documents no later than 15 days after the date of first sale. In addition, any amendments to such disclosure documents or disclosures required by the Proposed Rule would have to be filed no later than 15 days after such documents are provided to any investor or prospective investor. To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act to which all fund managers are already subject. Accordingly, fund managers must be careful to keep all of their documents current under the materiality standards of state and Federal securities laws.
Offerings Exempted from the Proposed Rule
The Proposed Rule would exempt several types of private placements including offerings sold only to any one or more of the following purchasers:
- 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; (Accordingly, 3(c)(7) funds would be exempt from the Proposed Rule.)
- 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; and
- employees and affiliates of the issuer.
In addition, the Rule would exempt the following types of offerings:
- offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
- offerings made pursuant to Securities Act Rule 144A or SEC 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 Rule 2320(b)(2);
- offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in 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;
- 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; and
- offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122.
Documents and information filed with FINRA pursuant to the Proposed Rule would be given confidential treatment. FINRA would use such documents and information solely for the purpose of determining compliance with FINRA rules or other applicable regulatory purposes. In addition, FINRA would afford confidential treatment to any comment or similar letters by FINRA and thus could not be discoverable by a litigant through a legal action.
A full text of the SEC Notice and Proposed Rule is available here.