FINRA issues guidance on private placement retail communications

On July 1, the Financial Industry Regulatory Authority (FINRA) issued Regulatory Notice 20-21 (RN 20-21), providing guidance to help FINRA members comply with FINRA’s rules with respect to retail communications concerning private placement offerings.  As discussed in more detail below, RN 20-21 addresses third-party prepared materials, balanced presentations of risks and benefits, reasonable forecasts of issuer operating metrics, distribution rates and internal rates of return.

In its January 2020 Risk Monitoring and Examination Priorities Letter, which we discussed in an earlier client alert, FINRA noted that it would pay special attention to private placement retail communications, in particular their review, approval, distribution and supervision, including whether:

• Broker-dealers omit material information necessary to make communications fair and not misleading
• Broker-dealers balance promotional content with key risks specific to the issuer
• Communications contain false, misleading or promissory statements or claims
• Forecasts of issuer metrics are reasonable and accompanied by clear explanations and
• Communications contain prohibited predictions or projections of investment performance.

According to FINRA, recent reviews uncovered deficiencies in these areas.  Some retail communications have failed to balance the discussion of the benefits of a private placement investment with disclosure of risks, such as the investment being illiquid or speculative, while other retail communications contained false, misleading or promissory statements or claims.  RN 20-21 is intended to assist firms in the preparation, review, approval, distribution and use of private placement retail communications so that they comply with FINRA Rule 2210.

Background

Private placements, non-public securities offerings that rely on an exemption from registration with the Securities and Exchange Commission (SEC), are sold primarily pursuant to SEC Regulation D (Reg D) under the Securities Act of 1933, as amended, which imposes a number of conditions on such sales.  Private placements sold by FINRA member broker-dealers – as opposed to those sold directly by issuers – are also generally subject to FINRA Rules 5122 and 5123.  Under these rules, broker-dealers must file offering documents regarding certain private placements in which they participate, unless an exception applies (eg, the securities are only offered to qualified purchasers).

According to SEC and FINRA data, issuers make about 20,000 new offering Reg D filings each year, and about 4,000 of those are offered through an intermediary such as a broker-dealer.  Of the 4,000, FINRA receives about 2,000 filings per year from its member firms under FINRA Rules 5122 or 5123, indicating that for at least some of the remaining 2,000 filings, broker-dealers may be availing themselves of a FINRA filing exemption.

In addition to the filing requirements above, many private placement offerings directed at retail investors include various forms of marketing communications that meet FINRA’s definition of “retail communication” and are subject to FINRA Rule 2210.  FINRA defines a “retail communication” as “any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.” If a broker-dealer distributes or uses retail communications, whether prepared by it or a third party, the broker-dealer must comply with Rule 2210.  According to RN 20-21, over 40 percent of private placements filed with FINRA include retail communications, and broker-dealers increasingly distribute private placements through online platforms and other widely disseminated forms of communication such as digital advertisements.

FINRA Rule 2210(d)(1) requires that all broker-dealer communications must be fair, balanced and not misleading.  Communications promoting the potential rewards of an investment also must disclose associated risks in a balanced manner.  Communications must be accurate and provide a sound basis for evaluating the facts with respect to the products or services discussed.  There must be no false, misleading or promissory statements or claims; communications that a broker-dealer knows or has reason to know contain any untrue statement of material fact or are otherwise false or misleading are prohibited.

Guidance on private placement retail communications

RN20-21 provides guidance in the following five areas: 

Third-party prepared materials

FINRA’s long-held position is that a broker-dealer assisting in preparing private placement memoranda (PPMs) or other offering documents should expect them to be considered communications with the public for purposes of Rule 2210.  If a PPM or other offering document presents information that is not fair and balanced, or is misleading, the broker-dealer may be deemed to have violated the rule. Moreover, sales literature concerning a private placement that a broker-dealer distributes will generally be deemed to constitute a communication with the public, whether or not the broker-dealer was involved in its preparation.

In addition, FINRA has observed issuer-prepared PPMs that are bound or presented as one electronic file with retail communications.  The marketing and promotional content of these retail communications can be distinguished from the factual descriptions and financial information about the issuer generally disclosed in PPMs.  According to FINRA, a retail communication is subject to Rule 2210 whether it is attached to a PPM or is a standalone document.

Balanced presentation of risks and benefits

As noted above, Rule 2210 requires communications discussing the benefits of an investment to include a discussion of the risks.  Thus, retail communications that discuss the potential benefits of investing in private placements should also disclose risks, such as the potential for the investment to lose value, potential lack of liquidity and speculative nature of the investment.  According to FINRA, disclosure in a separate document such as a PPM, or in a different section of a website, is not an adequate substitute for disclosure contained in or integrated with a retail communication.  FINRA notes that retail communications often highlight an issuer’s business and discuss the value proposition of an investment.  A discussion of associated key risks is therefore needed to balance the presentation.  By way of example, FINRA noted that for a startup company, these could include a limited track record; more experienced or larger competitors; overreliance on financing; reliance on a single supplier, customer or employee; or lack of management experience.

Reasonable forecasts of issuer operating metrics

FINRA Rule 2210(d)(1)(F) generally prohibits any performance prediction or projection, or any exaggerated or unwarranted claim, opinion or forecast.  Private placement retail communications therefore may not project or predict returns such as yields, income, dividends, capital appreciation percentages or any other future investment performance.  FINRA states that reasonable forecasts of operating metrics, such as sales or revenue forecasts or customer acquisition numbers, may convey important information regarding the issuer’s plans and financial position and would not be inconsistent with the rule.  However, such presentations should provide a sound basis for evaluating the facts, including clear explanations of key assumptions and risks that may impede achieving the forecasted metrics.  FINRA advises firms to consider:

• The forecast’s time period (generally, over five years is deemed unreasonable)
• Whether growth rate assumptions are commensurate with the business
• Whether forecasted gross margins are commensurate with industry averages and
• Whether sales and customer acquisition forecasts are reasonable in relation to the overall market for the issuer’s products or services.

Revenue sources such as royalty or master lease agreements may provide a basis for reasonable operating metric forecasts, but it is inconsistent with FINRA rules to depict specific revenue or cash flows as guaranteed or certain.  Moreover, firms may not use data from operating metric forecasts to project specific returns.

Distribution rates

According to FINRA, some issuers fund a portion of their distributions through return of principal or loan proceeds, and broker-dealers must not misrepresent the amount or composition of such distributions. Broker-dealers are also prohibited from stating or implying that a distribution rate is a “yield” or “current yield” or that investment in the program is comparable to a fixed income investment such as a bond or note.

In Regulatory Notice 13-18 (RN 13-18), FINRA provided guidance on communications for registered and unregistered real estate investment programs.  According to RN 20-21, some non-real estate private placement investments employ similar structures; accordingly, the principles relating to distribution rates in RN 13-18 are applicable to communications regarding private placement investments designed to provide distributions to investors.  Consistent with RN 13-18, presentations of distribution rates should disclose:

• Payments are not guaranteed and may be modified at the program’s discretion
• If the distribution rate consists of return of principal (including offering proceeds) or borrowings, a breakdown of the components showing what portion of the quoted percentage represents cash flows from investments or operations, what portion represents return of principal, and what portion represents borrowings
• The period during which distributions have been funded from return of principal (including offering proceeds), borrowings or sources other than cash flows from investment or operations
• If distributions include a return of principal, that by returning principal to investors, the program will have less money to invest, which may lower its overall return and
• If distributions include borrowed funds, that since borrowed funds were used to pay distributions, the distribution rate may not be sustainable.

Finally, according to FINRA, retail communications should not include an annualized distribution rate until the program has paid distributions that, on an annualized basis, are at a minimum equal to that rate for at least two consecutive full quarterly periods.

Internal Rate of Return

Internal Rate of Return (IRR) is a performance measure commonly used in marketing private placements of real estate, private equity and venture capital.  It shows a return earned by investors over a particular period calculated on the basis of cash flows to and from investors.  According to FINRA, a drawback of IRR calculations is their inherent assumption that investors will be able to reinvest distributions at the IRR rate, which is unlikely to occur in practice.  Another is that in order to calculate IRR for a portfolio that includes holdings not yet sold or otherwise liquidated or matured, a valuation of those assets must be estimated.  Depending on the nature of the asset, such estimated values may be based on subjective factors and assumptions.

According to FINRA, using IRR in retail communications concerning privately placed new investment programs with no operations or that operate as blind pools would be inconsistent with the prohibition on unwarranted forecasts or projections in Rule 2210(d)(1)(F).  However, FINRA interprets Rule 2210 to permit retail communications to include IRR for completed investment programs.  FINRA does not view as inconsistent with the rule retail communications that provide an IRR for a specific investment in a portfolio provided the IRR represents the actual performance of that holding.

Investment programs such as private equity funds and REITs may have a combination of realized investments and unrealized holdings in their portfolios. Where the program has ongoing operations, FINRA interprets Rule 2210 to permit inclusion of IRR if it is calculated in a manner consistent with the Global Investment Performance Standards (GIPS) adopted by the CFA Institute and includes additional GIPS-required metrics such as paid-in capital, committed capital and distributions paid to investors.

Having identified private placement retail communications as a 2020 examination priority and published RN 20-21, broker-dealers should be prepared for FINRA and other examiners to carefully scrutinize these communications for compliance with the guidance. 

If you have any questions concerning RN 20-21 or private placement retail communications generally, or if you need assistance in reviewing your procedures for retail communications concerning private placement offerings, please contact one of the authors or a member of the DLA Piper Financial Services team.

This information does not, and is not intended to, constitute legal advice.  All information, content, and materials are for general informational purposes only.  No reader should act, or refrain from acting, with respect to any particular legal matter on the basis of this information without first seeking legal advice from counsel in the relevant jurisdiction.