In November of 2023, FINRA made an initial rule filing with the Securities and Exchange Commission (SEC) pursuant to Exchange Act Rule 19b-4, seeking to amend FINRA Rule 2210 – Communications with the Public (the ”Communications with the Public Rule”). The amendment proposed to permit FINRA-member, SEC-registered broker-dealers (“member firms”) to project performance of, or provide targeted returns for, a security, asset allocation, or other investment strategy in communications related to certain types of non-public offerings[1] when sent to (I) institutional investors[2] or (II) certain “qualified purchasers,” subject to certain terms and conditions.

On February 22, 2024, FINRA filed Partial Amendment No. 1 with the SEC to expand the definition of “qualified purchaser” in the proposed amendments to the Communications with the Public Rule to include “Knowledgeable Employees,” as defined in Rule 3c-5 under the Investment Company Act of 1940 (the ICA). The proposal, if approved, would expand the category of persons who may receive the abovementioned communications, providing conditional relief from specific Communications with the Public Rule prohibitions. The purpose of the partial amendment is to reduce friction between existing SEC and FINRA rules and the proposed amendments.

Practically, the amendment, if accepted, would allow for speculative information to be provided to a sub-set of investors who are more likely to be able to conduct thorough diligence and protect their own interests, and who are eligible to invest in certain non-public offerings that are relying on exemptions from registration under the Securities Act of 1933 (Securities Act) and the ICA.

As proposed, the amendments would place suitability, reasonability of projections and targets, and disclosure obligations on member firms using communications conditionally exempt from the Communications with the Public Rule’s broadest prohibitions (as outlined below); the partial amendment does not change those proposed requirements.

Comments are due on the combined amendment twenty-one (21) days after publication in the Federal Register.

FINRA Rule 2210 – the Communications with the Public Rule:

The Communications with the Public Rule governs the standards by which member firms communicate with the public, establishing content standards, compliance, and operational requirements as well as carveouts from the rules. The rule generally prohibits member firms from predicting or projecting performance, implying that past performance will recur, or making any exaggerated or unwarranted claim, opinion, or forecast,[3] subject to specific exemptions for communications to institutional investors. FINRA takes the view that the general prohibitions against performance projections will protect investors who may lack the capacity to understand the risks and limitations of using projected performance in making investment decisions.[4]

Qualified Purchasers:

Institutional investors are generally those persons with total assets of at least $50 million or various government registered or governmental entities, as further defined by FINRA.[5]

In contrast, the term “qualified purchaser” is defined in ICA Section 2(a)(51)(A) and is used to determine the suitability of a participant in a private fund that is exempt from registration under ICA Section 3(c)(7). To be a “qualified purchaser,” one must generally have more than $5,000,000 in investments.[6] ICA Section 3(c)(7) requires that all beneficial owners of a private fund relying on the exclusions must be qualified purchasers at the time that they acquire the fund’s securities. However, Rule 3c-5 under the ICA provides that certain “knowledgeable employees” of a Section 3(c)(7) fund or its affiliates may beneficially own an interest in the Section 3(c)(7) fund and not breach the rules due to their insider position within the Section 3(c)(7) fund.

“Knowledgeable Employees” generally include executive officers, directors, trustees, general partners, advisory board members, or persons serving in similar capacities of the fund or certain of its affiliates, and other employees who participate in the investment activities of the fund or certain of the fund’s affiliates. ICA Rule 3c-5 requires a person to have acted in the above capacity for at least 12 months prior (either in their current role or a prior qualifying role) to qualify as a “Knowledgeable Employee.”

Initial Misaligned Definition of Qualified Purchaser:

This proposal, if approved, will provide a larger number of investors with potentially insightful and useful information that may further aid in their investment-making decisions. As originally proposed, the amendment did not mirror the term “qualified purchaser” as defined by ICA Rule 3c-5; that is, it excluded knowledgeable employees from the definition. This misalignment could lead to odd situations where a member firm desires to communicate with the participants in a private fund relying on Section 3(c)(7) but cannot send the same communication to all of them. As “knowledgeable employees” are generally those persons who manage a Section 3(c)(7) investment company, this could inadvertently preclude a member firm from sending the management of a fund the same materials as it delivers to the underlying investor participants.

FINRA’s proposed partial amendment rectifies this by adding “Knowledgeable Employees” to the category of persons who may receive communications conditionally exempt from the Communications with the Public Rule’s broadest prohibitions. FINRA had previously stated that “ . . . a member’s views regarding the projected performance of an investment strategy or single security may be useful to institutional investors and qualified purchasers . . . as defined in the [ICA] . . .”[7] FINRA clarified that “it is appropriate to amend the proposed rule change to include—along with [Qualified Purchasers]—knowledgeable employees in connection with specified non-public offerings as among the categories of investors who may receive communications that include projections or targeted returns, when the proposed rule change’s other conditions are met.”

Next Steps:

If the partial amendment, together with the initial proposed amendment to the Communications with the Public Rule, is approved by the SEC, the communications standards governing FINRA-member broker-dealers and the investor suitability rules governing private funds and investment advisers will be more closely aligned. As FINRA noted, “the proposed rule change is narrowly tailored to address the need for projections or targeted returns by restricting their use only in specified scenarios involving institutional investors or [qualified purchasers], well-established categories of persons that have been previously determined to be financially sophisticated or able to engage expertise for purposes of the securities laws.”[8]

The partial amendment did not alter FINRA’s proposed effectiveness time; therefore, within 45 days of the date of publication of the amendment in the Federal Register or within such longer period as the SEC may designate, the revised Communications with the Public Rule will become effective. It is likely that the SEC staff will make a public interest finding and approve FINRA’s proposed rule filings.

[1] The exempt offerings fall under FINRA Rules 5122 (Member Private Offerings) and 5123 (Private Placement Offerings).

[2] Defined by FINRA Rule 2210(b)(3).

[3] See FINRA Rule 2210(d)(1)(f).

[4] See 82482 Federal Register / Vol. 88, No. 225 / Friday, November 24, 2023.

[5] See FINRA Rules 2210(a) and 4512(c).

[6] See 15 U.S.C. 80a–2(a)(51)(A).

[7] See 82482 Federal Register / Vol. 88, No. 225 / Friday, November 24, 2023.

[8] See 82482 Federal Register / Vol. 88, No. 225 / Friday, November 24, 2023, e.g., Privately Offered Investment Companies, Investment Company Act Release No. 22597 (April 3, 1997), 62 FR 17512 (April 9, 1997) (adopting rules to implement a legislative exclusion from regulation under section 3(c)(7) of the Investment Company Act for privately offered investment companies “whose investors are all highly sophisticated investors, termed ‘qualified purchasers’”).

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