Introduction and Summary of Findings

In July 2020, FINRA issued Regulatory Notice 20-21, which is designed to provide guidance to broker-dealers in connection with their creation and use of retail communications relating to private placements. The complete regulatory notice may be found here.

The notice largely reflects FINRA’s recent experience in reviewing the documents filed under its rules. FINRA Rules 5122 and 5123, enacted several years ago, require member firms to file with FINRA the offering documents regarding certain types of private placements in which the member firm participates. These types of private placements typically include offerings that are sold to “retail investors”; accordingly, the offering documents for these private placements are typically “retail communications” for purposes of the FINRA communications rules[1] (FINRA Rule 2210).

The notice indicates that in connection with its review of private placement documents, it identified a variety of deficiencies. These deficiencies include:

• insufficient disclosure of important risks, including the illiquidity of the investment and the speculative nature of the investment;
• false, misleading, or “promissory” statements, such as assertions about a potential future IPO or future business success;
• inaccurate or misleading statements about the regulation or relative risks of the offering; and
• the inclusion of information that FINRA has prohibited in retail offerings, such as predictions or protections of investment performance.

Third-Party Materials (Issuer Offering Documents)

The notice reminds members that a retail communication subject to the FINRA rules can include offering materials prepared by a third party – for purposes of the notice, these materials generally consist of offering documents prepared by the issuer or its counsel for use in the private placement. For example, a private placement memorandum that a FINRA member helps prepare can be considered a communication with the public for purposes of Rule 2210. Sales literature for a private placement that a FINRA member distributes will generally be deemed to constitute a communication subject to Rule 2210, whether or not the FINRA member assisted in its preparation. Accordingly, a FINRA member is at risk for violating Rule 2210 if the offering documents do not conform to the Rule’s standards.

Balancing the Disclosure of Investment Risks and Investment Benefits

According to the Notice, Rule 2210 requires communications that discuss the benefits of an investment to also include a discussion of the relevant risks. FINRA emphasized that providing risk factor disclosure in a separate document, such as a private placement memorandum, does not serve as a substitute for disclosure contained in retail communications governed by Rule 2210.[2] Accordingly, whether or not the disclosures are properly balanced needs to be carefully considered in light of the overall presentation of information. Draftspersons of private placement offering materials are often guided by the principles articulated by the federal courts and the SEC in their analysis of the Securities Act of 1933 and related rules; however, FINRA members and their counsel must also consider the adequacy of the disclosures in light of FINRA’s rules and guidance.

Forecasts of Issuer Operating Metrics

Rule 2210(d)(1)(F) of the communication rules generally prohibits predictions and performance projections.[3] Accordingly, the notice reminds FINRA members that retail communications for private placements may not project or predict the returns that investors will realize from their investments, such as yields, income, dividends, or capital appreciation percentages.

That being said, the notice clarifies that FINRA does not consider reasonable forecasts of “issuer operating metrics,” which may convey important information about the issuer’s plans and financial position, to be barred by Rule 2210. This type of permitted information would include, for example, forecasted sales, revenues, or customer acquisition numbers. However, FINRA’s permission of this information is not unlimited – FINRA reminds members that disclosures of these operating metrics need to provide a sound basis for evaluating the facts. For example, these presentations should include “clear explanations of the key assumptions underlying the forecasted issuer operating metrics and the key risks that may impede the issuer’s achievement of the forecasted metrics.” FINRA also includes in the notice a number of considerations that members should consider when providing this information in retail communications, including the reasonableness of any forecasts and assumptions.

Additional Areas

The notice also provides guidance to members relating disclosures for registered and unregistered real estate investment programs. In particular, the notice focuses on disclosures of distribution rates, as addressed by FINRA Notice 13-18. The notice also provides guidance as to disclosures of “internal rate of return” (an “IRR”). The notice indicates that using IRR in retail communications concerning new investment programs that, for example, have no operations or that operate as a blind pool, would be inconsistent with the prohibition on unwarranted forecasts or projections.

Conclusion

The notice reflects FINRA’s concerns about the private placement documents that they have reviewed as a result of the filing process. It serves as a useful reminder that, even though private placement offering documents may be exempt from the specific form and content requirements that are applicable to public offerings, there remain standards that must be followed. Broker-dealers (and their counsel) that create and use these materials for distribution to retail investors will need to continue to be vigilant that these documents comply with Rule 2210 and FINRA’s related guidance.

[1] Generally speaking, a “retail communication” is “any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period.” See FINRA Rule 2210(a)(5).

[2] Accordingly, some broker-dealers will include a summary of relevant risk factors in sales material for an offering, even if the offering itself will involve a robust private placement memorandum.

[3] The rule also prohibits any exaggerated or unwarranted claim, opinion, or forecast.

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