For many years, the private fund industry and the securities bar have called for a limited rule set to govern broker-dealers solely engaged in raising capital for private funds or other issuers of unregistered securities or in merger and acquisition advisory activities.¹ These broker-dealers share several common traits: they do not execute securities transactions, accept orders to purchase or sell securities, introduce or carry customer accounts, handle customer funds or securities, or participate in principal transactions or market making activity. On August 18, 2016, the Securities and Exchange Commission (SEC) approved a Financial Industry Regulatory Authority, Inc. (FINRA) rule change that establishes a separate rule set (the CAB Rule Set) for broker-dealers that meet the definition of a “capital acquisition broker” (CAB) and elect to be governed under the CAB Rule Set.² 

Background

The CAB Rule Set is based on a notice published by FINRA in February 2014 requesting comment on a proposed rule set for firms that meet the definition of what it then called a “limited corporate financing broker” (LCFB).³ The LCFB rule proposal was revised and expanded based on public comments, and later re-proposed as the CAB Rule Set on December 17, 2015 (the CAB Proposal).⁴ The CAB Proposal, as well as the earlier LCFB proposal, was issued in response to industry concerns that the full FINRA rule set should not apply to broker-dealers that limit their business to certain capital raising, merger and acquisition and corporate financing activities. While such firms do not engage in the types of activities associated with full service broker-dealers, they are nonetheless subject to the full FINRA rule set under the current regulatory framework. The CAB Proposal sought to ease the regulatory burden on these limited-purpose broker-dealers by establishing a separate set of streamlined rules tailored to address their limited business activities.

FINRA received 17 public comment letters on the CAB Proposal, including letters from the North American Securities Administrators Association, Inc., (NASAA), the New York Bar Association, and a variety of industry participants, such as registered broker-dealers, investment advisers, placement agents and financial consulting firms. In response to these comments, FINRA amended the CAB Proposal on April 11, 2016, to clarify the CAB definition (Amendment No. 1),⁵ and then amended it again on July 1, 2016, to narrow the scope of permissible CAB business activities (Amendment No. 2).⁶ While the final CAB Rule Set, as amended, offers an intriguing alternative to the traditional private fund placement agent model, many private fund sponsors likely will find the CAB Rule Set too restrictive to serve their needs.

“Capital Acquisition Broker” Definition

The CAB Rule Set applies to broker-dealers that meet the definition of a CAB and elect to be governed under the CAB Rule Set. CAB Rule 016 defines a CAB as a broker that solely engages in any one or more of the following activities:

• Advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
• Advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger;
• Advising a company regarding its selection of an investment banker;
• Assisting in the preparation of offering materials on behalf of an issuer;
• Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;
• Qualifying, identifying, soliciting or acting as a placement agent or finder (i) on behalf of an issuer in connection with a sale of newly issued, unregistered securities to institutional investors,⁷ or (ii) on behalf of an issuer or control person in connection with a change in control of a privately held company; and
• Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company, in accordance with the terms and conditions of an SEC rule, release, interpretation or “no-action” letter that permits a person to engage in such activities without having to register as a broker or dealer pursuant to Section 15(b) of the Securities Exchange Act of 1934.

The definition of a CAB specifically excludes any firm that carries or acts as an introducing broker with respect to customer accounts, holds or handles customer funds or securities, accepts orders from customers to purchase or sell securities (except as permitted in the last two bullets above), has investment discretion on behalf of any customer, engages in proprietary trading of securities or market-making activity, participates in or maintains an online platform for offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act of 1933 (the 1933 Act), or effects securities transactions that trigger certain reporting requirements under the FINRA rulebook.

Amendment Nos. 1 and 2 revised the definition of a CAB to address public comments concerning how CABs might participate in secondary market transactions. In response to these comments, Amendment No. 1 revised the definition of a CAB to specifically exclude any broker-dealer that effected securities transactions that trigger reporting requirements under FINRA rules that govern securities reporting requirements on national exchanges and over-the-counter markets.⁸ 

In addition, Amendment No. 2 narrowed the range of a CAB’s permissible secondary market activities under CAB Rule 016(c)(1)(F). Prior to Amendment No. 2, CAB Rule 016 would have permitted a CAB to qualify, identify, solicit or act as a placement agent or finder with respect to institutional investors in connection with any purchase or sale of unregistered securities.  However, Amendment No. 2 limited the scope of these activities to cover only the sale of newly issued unregistered securities. The practical impact of Amendment No. 2 is to limit a CAB’s participation in the secondary market for unregistered securities. For instance, Amendment No. 2 effectively prevents CABs from helping a customer dispose of his or her securities purchased in a private placement, since CABs may only participate in sales of newly issued unregistered securities. These limitations on the secondary market activities of CABs may ultimately discourage private fund placement agents from registering as CABs.

Definition of Institutional Investor

The term “institutional investor” has the same meaning as that term has under FINRA Rule 2210 (Communications with the Public), with one exception. In particular, the term includes any: 

• Bank, savings and loan association, insurance company or registered investment company;
• Governmental entity or subdivision thereof;
• Employee benefit plan, or multiple employee benefit plans offered to employees of the same employer, that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and in the aggregate have at least 100 participants;
• Qualified plan, as defined in Section 3(a)(12)(C) of the Exchange Act, or multiple qualified plans offered to employees of the same employer, that in the aggregate have at least 100 participants;
• Any other person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million; and
• A person acting solely on behalf of any such institutional investor. 

The definition also includes any person meeting the definition of ‘‘qualified purchaser’’ as that term is defined in Section 2(a)(51) of the Investment Company Act of 1940 (the Company Act).⁹ 

FINRA received many comment letters requesting an expansion of the “institutional investor” definition to include all “accredited investors,” as defined in Regulation D under the 1933 Act.  Whereas a “qualified purchaser” under the Company Act must own at least $5 million in investments (or $25 million for an entity), an “accredited investor” under the 1933 Act generally only needs either an annual income of at least $200,000 in the last two years or a net worth in excess of $1 million. Commenters noted that including “accredited investors” would expand the potential pool of investors that CABs may qualify, identify, solicit, or for which a CAB may act as a placement agent or finder.

In response to these comments, FINRA noted that CABs may provide a wide array of negotiation, consulting and advisory services to customers without regard to whether they fall within the definition of an “institutional investor,” particularly since the “institutional investor” definition only applies to activities that fall under CAB Rule 016(c)(1)(F). More substantively, however, FINRA concluded that it was not appropriate to include all accredited investors in the “institutional investor” definition because those investors may not have the required financial sophistication to understand the risks associated with investments sold by CABs. In support of this claim, FINRA cited several examples of widespread fraud and abuse in the private placement market.¹⁰

Impact on Private Fund Sponsors

As noted above, the CAB Rule Set, as amended, prohibits a CAB from soliciting persons who are accredited investors but are not also “institutional investors” under the above definition. Accordingly, FINRA’s definition of institutional investor will significantly restrict the universe of investors that CABs will be able to solicit for investment in private funds. It appears that the CAB Rule Set will have the practical effect of limiting a CAB’s private fund placement activity to funds formed under Section 3(c)(7) of the Company Act (3(c)(7) funds). This is because a “qualified purchaser” under the Company Act meets the definition of an “institutional investor” under the CAB Rule Set, and 3(c)(7) funds may only be purchased by “qualified purchasers.” As a consequence, the CAB Rule Set will lead to different considerations for sponsors of 3(c)(7) funds as compared to sponsors of funds formed under Section 3(c)(1) of the Company Act (3(c)(1) funds), which are generally sold to accredited investors who are not qualified purchasers. Whereas the former may be able to form and register a CAB under the CAB Rule Set, that option generally will not be available to the latter because accredited investors are not included in the definition of an “institutional investor.”

Today, sponsors of 3(c)(7) funds and 3(c)(1) funds face the risk of being deemed to have acted as unregistered broker-dealers, in certain circumstances, when they market or solicit interest in their private funds to potential investors.¹¹ To address this risk, private fund sponsors may hire broker-dealers to serve as placement agents or have certain employees register as representatives with a broker-dealer. The former approach requires paying substantial placement agent fees to the broker-dealer, and the latter approach necessarily involves having the compensation for the employees’ placement agent activities paid to the broker-dealer with whom the employees are registered (i.e., not to the private fund sponsor). Alternatively, private fund sponsors may, of course, register (or have an affiliate register) as a broker-dealer and become a member of FINRA.

With the CAB Rule Set, sponsors of 3(c)(7) funds will need to weigh the process, risks and costs associated with CAB registration and the CAB rule book (discussed below) in determining whether to form an in-house CAB. Such risks and costs also must be weighed against the costs of hiring a third-party CAB or traditional placement agent or having employees register with a third-party CAB or traditional placement agent. If the goals of the CAB Rule Set are achieved, then the costs of registering and operating a CAB on an ongoing basis should be considerably less than the costs of registering and operating a traditional placement agent. The CAB Rule Set could thus open up a number of possibilities for 3(c)(7) sponsors to increase the distribution of their shares without taking on the risk of acting as unregistered broker-dealers.

As noted above, sponsors of 3(c)(1) funds generally will not be able to take advantage of the CAB option presented by the CAB Rule Set.¹² Such sponsors will thus continue to operate in a regulatory environment in which they must hire a broker-dealer to serve as a placement agent, have employees register as representatives of a broker-dealer, or register (or have an affiliate register) as a broker-dealer if they wish to actively market, offer and sell interests of the fund. The result of FINRA’s CAB Rule Set is to enlarge the differential treatment by FINRA of those who offer and sell interests in 3(c)(7) funds as opposed to 3(c)(1) funds.¹³

Process for CAB Registration

If a firm meets the CAB definition and elects to register as a CAB, or to create a new affiliate to so register, then the firm (or its affiliate) will need to submit a new member application pursuant to NASD Rule 1013, and state in its application that it intends to operate solely as a CAB. If an existing FINRA member firm wishes to change its status to a CAB, then the firm will be required to file a request to amend its membership agreement to provide that the firm will limit its business activities to those permitted under the CAB definition (and the firm will need to agree to comply with the CAB Rule Set). An existing FINRA member firm seeking to change its status to a CAB will not need to file a new membership application pursuant to NASD Rule 1013 or a continuing membership application pursuant to NASD Rule 1017, so long as the firm does not intend to change its existing ownership, control or business operations in connection with the decision to be regulated as a CAB.

The New York Bar Association commented on the registration process by requesting a streamlined 60-day approval process for new CAB member applications, rather than the 180-days initially proposed by FINRA. In response, FINRA rejected this comment, stating that its staff will generally need more than 60 days to conduct a proper investigation of the CAB and complete the required membership interview process. The lengthy new membership approval process may reduce the number of private fund placement agents that seek to register as a CAB.

CAB Rule Set

The CAB Rule Set will include the following general requirements:

• Duties and Conflicts (CAB Rule 200 Series) – The CAB Rule Set contains streamlined conduct rules, including rules for know-your-customer and suitability and an abbreviated version of FINRA’s communications rules, effectively prohibiting false and misleading statements. CABs will not be subject to FINRA’s rules relating to fair prices and commissions or charges for services performed. In response to public comments on the CAB Proposal, FINRA declined to offer minimum compliance standards for CABs performing suitability analyses on behalf of institutional investors represented by an agent. Instead, it stated that determining the essential facts needed to effectively service a customer’s account and the information necessary to form a reasonable basis to believe that a recommendation is suitable for a non-institutional customer, or that an institutional customer (or its agent) is capable of evaluating investment risks independently, will vary depending on the facts and circumstances. FINRA also confirmed that the CAB suitability rule applies at the time of a recommendation and that a recommendation normally would not create an ongoing duty to monitor and make subsequent recommendations.
• Supervision (CAB Rule 300 Series) – The CAB Rule Set imposes limited supervisory requirements incorporating some requirements in FINRA Rule 3110, but not the provisions related to annual compliance meetings, review and investigation of transactions, documentation and supervisory procedures for supervisory personnel, or internal inspections. The CAB Rule Set incorporates FINRA rules restricting influencing or rewarding employees of others and outside business activities of associated persons, and imposes anti-money laundering requirements similar to FINRA Rule 3310 but does not require chief executive officers to certify that the CAB has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable federal securities laws and regulations and FINRA rules. The CAB Rule Set also prohibits any person associated with a CAB from participating in any manner in a private securities transaction (PST). Although several comment letters objected to the prohibition on PSTs, FINRA emphasized that CABs are not well positioned to supervise and keep records of PSTs, especially if CAB employees engaged in PSTs with retail investors through registered investment advisers or banks.
• Financial and Operational (CAB Rule 400 Series) – The CAB Rule Set subjects CABs to FINRA rules regarding audits, guarantees by or flow-through benefits for members, filing and contact information requirements, supplemental FOCUS information, reporting requirements, verification of assets, and certain (but not all) capital compliance requirements applicable to member firms. CABs are not subject to FINRA rules regarding business continuity plans or testing under Regulation SCI and have limited customer information requirements.
• Securities Offerings (CAB Rule 500 Series) – CABs are subject to a limited subset of the rules governing securities offerings, specifically FINRA Rule 5122 (Private Placements of Securities Issued by Members) and FINRA Rule 5150 (Fairness Opinions).
• Investigations and Sanctions, Code of Procedure (CAB Rule 800 and 900 Series) – CABs are subject to the FINRA rules governing investigations and sanctions of firms other than those covering availability of manual to customers, but not FINRA rules related to automated submission of trading data.
• Arbitration and Mediation (CAB Rule 1000 Series) – CABs are subject to the FINRA arbitration and mediation rule set for customer and industry disputes.

NASAA submitted a comment letter on the CAB Proposal requesting that the SEC delay approving the full CAB Rule Set until NASAA, FINRA and the SEC have had the opportunity to fully collaborate on their competing proposals. In this respect, NASAA adopted a model rule on September 29, 2015, exempting certain merger and acquisition brokers from state registration requirements, and wanted to streamline its proposal in line with FINRA’s CAB Rule Set.¹⁴ In responding to NASAA’s comment, FINRA said it did not believe there were any significant differences between the NASAA model rule and the CAB Rule Set that should preclude the SEC’s approval of the CAB Rule Set.

As the above summary makes clear, while FINRA’s CAB Rule Set will provide limited relief from the current FINRA regulatory framework, the benefits appear to be marginal. In reviewing the Adopting Release, it appears clear that much of the relief relates to rules that would not apply, or would not make sense to apply, to a firm engaged in the limited activities permitted by the definition of CAB. While there are several examples of relief that might fairly be termed to be true “policy judgment calls” by FINRA, such examples are few and far between. While the CAB Rule Set is an improvement over the earlier LCFB proposal, interested private fund sponsors should review the Adopting Release in depth to understand the various rules and regulations to which they would become subject if they were to register as CABs.

Effective Date

FINRA has yet to announce an effective date for the CAB Rule Set, but is expected to issue a regulatory notice announcing the effective date in the near future.
                                          
  
¹See, e.g., Report and Recommendations of the Task Force on Private Placement Broker-Dealers By the Task Force on Private Placement Broker-Dealers, ABA Section of Business Law, available at http://www.lplegal.com/sites/default/files/ABA%20Task%20Force%20Report%20on%20Unregistered%20Broker-Dealers.pdf. 
  
² SEC Release No. 34-78617; File No. SR-FINRA-2015-054, available at https://www.gpo.gov/fdsys/pkg/FR-2016-08-24/pdf/2016-20211.pdf (the Adopting Release).
  
³ FINRA Regulatory Notice 14-09, available at http://www.finra.org/sites/default/files/NoticeDocument/p449586.pdf. 
  
⁴ SEC Release No. 34-76675; File No. SR-FINRA-2015-054, available at http://www.sec.gov/rules/sro/finra/2015/34-76675.pdf.
  
⁵ SEC Release No. 34-77581; File No. SR-FINRA-2015-054, available at http://www.finra.org/sites/default/files/SR-FINRA-2015-054-nof-amendment-1.pdf. 
  
⁶ SEC Release No. 34-78220; File No. SR-FINRA-2015-054, available at http://www.finra.org/sites/default/files/SR-FINRA-2016-054-nof-amm2.pdf. 
  
⁷ As discussed below, the CAB Rule Set generally adopts the same definition of an “institutional investor” under FINRA Rule 2210, but also includes, among other things, the following entities: banks, insurance companies, registered investment companies, governmental entities, employee benefit plans and qualified plans.
  
⁸ More specifically, Amendment No. 1 excluded any broker-dealer that effected securities transactions that would trigger reporting requirements under FINRA Rules 6300 Series, 6400 Series, 6500 Series, 6600 Series, 6700 Series, 7300 Series or 7400 Series.
  
⁹See CAB Rule 016(i). FINRA Rule 2210 does not include “qualified purchaser” within its definition of “institutional investor.” Section 2(a)(51) of the Company Act provides that the following persons (among others) are “qualified purchasers” for purposes of Section 3(c)(7): An individual who owns not less than $5 million in investments and any person, including an entity acting for its accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25 million in investments.
  
¹⁰See, e.g., FN 85 of the Adopting Release (“In 2015, FINRA conducted over 650 reviews involving private placements from sources including customer complaints, tips, referrals, and firm filings. FINRA states that approximately 100 of these matters are currently open and under review, and that it has recently settled many cases regarding private placements…In addition, FINRA states that the SEC has settled cases involving fraud or abuse in the private placement market.”).
  
¹¹See In the Matter of Ranieri Partners LLC and Donald W. Phillips, SEC Release No. 34-69091, Administrative Proceeding File No. 3-15234 (March 8, 2013); see also In the Matter of William M. Stephens, SEC Release No. 34-69090, Administrative Proceeding File No. 3-15233, and David W. Blass, Chief Counsel, Division of Trading and Markets, U.S. Sec. and Exch. Comm’n, “A Few Observations in the Private Fund Space” (April 5, 2013).
  
¹² While a CAB could solicit institutional investors for 3(c)(1) funds under FINRA’s CAB Rule Set, it is somewhat rare for a sponsor of a 3(c)(1) fund to seek out institutional investors (as defined in FINRA’s CAB Rule Set). Even in situations where this occurs, it is questionable whether it would be economically viable for a CAB to focus its business model on finding institutional investors to invest in such funds.  Accordingly, we believe that the practical result of FINRA’s CAB Rule Set is that CABs will in large measure only serve as placement agents for 3(c)(7) funds.
  
¹³See, e.g., letter from Thomas M. Selman, Senior Vice President, NASD, to Yukako Kawata (Davis Polk & Wardwell) (Dec. 30, 2003).
  
¹⁴ NASAA Model Rule, available at http://nasaa.cdn.s3.amazonaws.com/wp-content/uploads/2011/07/MA-Broker-Model-Rule-adopted-Sept-29-2015-corrected.pdf.