Clarifying and Simplifying the Corporate Financing Rule: FINRA Seeks Comment on Proposed Amendments to Rule 5110

by Locke Lord LLP
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On April 12, 2017, the Financial Regulatory Industry Authority (“FINRA”) released a regulatory notice requesting comments on proposed amendments to FINRA Rule 5110 (commonly referred to as the Corporate Financing Rule, the “Rule”) in order to simplify, clarify and modernize the Rule. In the notice, FINRA stated that the proposed amendments “would retain the primary principle of the [R]ule that no member firm or person associated with a member firm may participate in a public offering for which the terms and conditions, including the aggregate amount of underwriting compensation, are unfair, unreasonable or inconsistent with any FINRA rule.” The proposed Rule text marked against the existing Rule text is available here.

The more significant proposed amendments to the Rule include the following:

Filing Deadline and Information Requirements1
To make the filing process more efficient and flexible, FINRA proposes to extend the filing deadline with FINRA from one business day after the filing with the Securities and Exchange Commission or state equivalent to three business days and is also clarifying and reducing the types of documents and other information that must be filed.

Filing Exemptions2
FINRA proposes to add the following types of offerings to the Rule’s list of offerings that are exempt from filing:

  • Follow-on offerings of closed-end “tender offer” funds (exempt from the Rule’s filing requirements but still subject to substantive regulation of underwriting terms and arrangements).=
  • Public offerings of insurance contracts and unit investment trusts (exempt from the Rule’s filing requirements and substantive regulation of underwriting terms and arrangements).
  • Offerings made pursuant to Regulation S and Rule 144A under the Securities Act of 1933 (exempt from the Rule’s filing requirements and substantive regulation of underwriting terms and arrangements).

FINRA also proposes to delete references to the pre-1992 shelf eligibility standards for Form S-3 and the 1991 eligibility standards for Form F-10 and a requirement that the issuer have a 36-month reporting history preceding the filing and at least $150 million aggregate market value of voting stock held by non-affiliates (or alternatively, at least $100 million aggregate market value of voting stock held by non-affiliates and an annual trading volume of at least three million shares). Issuers meeting this standard would be defined as “experienced issuers” and their public offerings would be exempt from filing, but still subject to the substantive provisions of the Rule.

Disclosure Requirements3
FINRA proposes to continue to require in the plan of distribution section of the offering document a description of each item of underwriting compensation but would not require each item to be quantified. FINRA would permit an underwriter to disclose the maximum aggregate amount of all underwriting compensation, except the discount or commission must be disclosed on the cover page of the prospectus.

Underwriting Compensation4

FINRA proposes to consolidate various provisions of the Rule addressing underwriting compensation into a single, new definition of “underwriting compensation,” which shall mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” The revised definition would also include “finder fees and underwriter’s counsel fees, including expense reimbursements and securities.”

FINRA also proposes to broaden three of the exceptions to the term “underwriting compensation”. Two exceptions regarding securities of an issuer acquired by an affiliate of a participating member firm in connection with the provision of a loan or credit facility will no longer be subject to the limitation on acquiring more than 25% of the issuer’s total equity securities. And, with respect to the exception regarding securities acquired in connection with a private placement provided that participating member firms acquire no more than 20% of the securities sold in the private placement, FINRA proposes to increase the 20% threshold to 40%.

Lock-up Restrictions5Under the proposed Rule amendments, lock-up periods on securities that are considered underwriting compensation would begin on the date of commencement of sales (rather than the date of effectiveness of the prospectus). FINRA is also proposing that lock-up restrictions would not prohibit: (1) the transfer of any security to the member’s registered persons or affiliates if all transferred securities remain subject to the restriction for the remainder of the lock-up period; or (2) the transfer or sale of the security back to the issuer in a transaction exempt from registration.

Valuation of Securities6
The proposed Rule amendments would permit valuing options, warrants and other convertible securities received as underwriting compensation based on a securities valuation method that is commercially available and appropriate for the type of securities to be valued (i.e., the Black-Scholes model for options).

Prohibited Terms and Arrangements7
The proposed Rule amendments would eliminate from the list of prohibited terms and arrangements the prohibition of a non-accountable expense reimbursement in excess of three percent of the offering proceeds.

What can we expect to see from the proposed amendments? 

The proposed changes to the Rule will make representing underwriters in an initial public offering or follow-on offering more efficient. By providing underwriters additional time to file the required documents and reducing the filing of unnecessary documents, the proposal alleviates the filing burdens placed on underwriters while still maintaining important protections for market participants. Additionally, we can expect to see a reduction in administrative and operational costs expended by underwriters through reductions in filing burden, clarifications of certain exemptions and elimination of the time and resource intensive security valuation calculations.

Comments are due by May 30, 2017.

1 FINRA Rule 5110(b) (2016).

2 FINRA Rule 5110(b)(7) (2016).

3 FINRA Rule 5110(c)(2) (2016).

4 FINRA Rule 5110(c) (2016).

5 FINRA Rule 5110(g) (2016).

6 FINRA Rule 5110(e) (2016).

7 FINRA Rule 5110(f) (2016).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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