The proposed amendment seeks to modify the existing framework of FINRA Rule 2210 to accommodate the use of certain projections and targeted returns.

On November 13, 2023, the Financial Industry Regulatory Authority (FINRA) filed a proposed rule change with the Securities and Exchange Commission (SEC) to amend FINRA Rule 2210. If adopted, the amendment would permit FINRA-regulated firms to include certain performance projections or targeted returns with respect to a security or asset allocation or other investment strategy in their communications with certain recipients.

Overview of Current FINRA Rules

FINRA Rule 2210(d)(1)(F) generally prohibits the use of performance predictions or projections, or targeted returns in communications by firms. However, narrow exceptions are permitted for hypothetical illustrations of mathematical principles, written reports produced by investment analysis tools that meet the requirements of FINRA Rule 2214, and price targets contained in research reports on debt or equity securities. FINRA Rule 2215 permits projected performance figures in communications with the public regarding security futures or options.

Proposed Amendment Creates New Exception to General Prohibition

The proposed amendment would permit:

• institutional communications to include projections of performance or targeted returns. Institutional communications are written (including electronic) communications distributed or made available only to institutional investors, as defined under FINRA Rule 2210(a)(3) (institutional investors); and
• communications that are distributed or made available only to qualified purchasers (QPs), as defined under Section 2(a)(51)(A) of Investment Company Act of 1940, as amended, and that promote or recommend a private placement that is sold solely to QPs.

The proposed new exception would be subject to the following important conditions, explained further below:

• The firm adopting and implementing written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations
• The firm having a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return, and retaining written records supporting the basis for these criteria and assumptions
• The communication prominently disclosing that the projected performance or targeted return is hypothetical in nature and that there is no guarantee that the projected or targeted performance will be achieved
• The firm providing sufficient information to enable the investor to understand:
  • the criteria used and assumptions made in calculating the projected performance or targeted return, including whether the projected performance or targeted return is net of anticipated fees and expenses; and
  • the risks and limitations of using the projected performance or targeted return in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.

Written Policies and Procedures

Firms would be required to develop written policies and procedures “reasonably designed to ensure that the communication is relevant to the likely financial situation investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations.” To be clear, this requirement goes beyond ascertaining whether the recipient is an institutional investor or QP, as appropriate. To satisfy this requirement, FINRA recommends that firms incorporate consideration of whether the recipient of the communication containing projected performance or targeted returns has the expertise or resources to independently analyze such projections or targets. As an example provided by FINRA, a firm could implement a policy whereby the firm only includes performance projections or targeted returns in its communications with investors who have expressed interest in the past about the particular types of securities for which projections or targets are being provided.

Reasonable Basis

In order to use performance projections or targeted returns in communications, firms must have a reasonable basis for the criteria used and assumptions made in calculating such projections or targeted returns, and retain written records supporting the basis for these criteria and assumptions. In connection with this condition, FINRA has proposed to include new supplementary material to Rule 2210 that would list factors that firms should consider in developing the requisite reasonable basis. Such factors would include:

• macroeconomic conditions;
• fact-based assumptions concerning the future performance of capital markets;
• in the case of a single security, the issuing company’s operating and financial history;
• current market conditions of the industry and sector;
• reliable multi-factor financial models, if available;
• quality of assets included in a securitization;
• appropriateness of selected peer group comparisons;
• reliability of research sources;
• historical performance and performance volatility of the same or similar asset classes;
• for managed accounts or funds, past performance of other accounts or funds managed by the same investment adviser or sub-adviser;
• for fixed income investments, average weighted duration and maturity;
• impact of fees, costs, and taxes; and
• expected contribution and withdrawal rates by investors.

The proposed supplementary material would also specifically prohibit firms from basing projected performance or targeted returns upon (i) hypothetical, back-tested performance, or (ii) the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record.

Disclosure Requirements

The proposal includes various disclosures that would be required of firms using performance projections or targeted returns in their communications. Firms would be required to “prominently” disclose that the projected performance or targeted return is hypothetical in nature and that there is no guarantee that the projected performance or targeted return will be achieved. Firms would also need to provide a general description of the methodology and underlying assumptions used to arrive at the projected performance or targeted return, including whether the projected performance or targeted return is net of anticipated fees and expenses. Finally, firms would need to communicate the risks and limitations of relying on the projected performance or targeted return in making investment decisions, including reasons for why the projected performance or targeted return might differ from actual performance.

Market Impact

The private fund market has long struggled with the FINRA Rule 2210 prohibition on projections, since investors frequently insist on targeted returns and other projections. The recent adoption of a revised marketing rule under the Investment Advisers Act of 1940, as amended, further highlighted the challenges, as targeted returns and certain projections may be properly compliant with the rule. Among other things, the prohibition resulted in a disparity between funds that were marketed with a registered broker-dealer and those that were marketed otherwise (such as under Rule 3a4-1 of the Securities Exchange Act of 1934, as amended), as the latter could provide this information as long as it complied with the Investment Advisers Act marketing rule requirements. Accordingly, this proposal better aligns FINRA rules with the SEC rules and is a welcome acknowledgment of the proper scope of investor protection efforts.

Next Steps

The SEC will approve or disapprove FINRA’s proposal after review by January 8, 2024, within 45 days from publication in the Federal Register on November 24, 2023 (or a maximum of 90 days if such longer period is justified). Interested persons may submit comments to the SEC either electronically or in paper form by December 15, 2023 (within 21 days from publication in the Federal Register).