• The Financial Industry Regulatory Authority, Inc. proposed amendments to Rule 2210 (the “Proposed Amendments”) on November 17, 2023.
• The Proposed Amendments, which seek to align the treatment of targets and projections with Rule 206(4)-1 under the Investment Advisers Act of 1940 (“Marketing Rule”), would permit broker-dealers to distribute materials that include targeted returns and projected performance in certain circumstances.
• If adopted, the Proposed Amendments could be a welcome change for private fund managers, as FINRA’s current rule requires managers to withhold certain information from sophisticated investors that receive marketing materials through distributors and placement agents that are FINRA members.
• Although FINRA indicated that the Proposed Amendments are designed to align Rule 2210 with similar requirements applicable to the use of hypothetical performance under the Marketing Rule, the Proposed Amendments leave a number of unanswered questions and interpretive issues that should be addressed by FINRA or the Securities and Exchange Commission before the Proposed Amendments are finalized.
• Little time remains to submit comments, but feedback from fund managers and FINRA members is critical. Comments on the Proposed Amendments must be submitted on or before December 15, 2023.¹

Summary of the Proposed Amendments

The Proposed Amendments would permit FINRA members to include targeted returns or projected performance solely if the communication is either: (i) an “institutional communication” as defined in FINRA Rule 2210².; or (ii) distributed only to “qualified purchasers” (“QPs”) as defined in Section 2(a)(51) of the Investment Company Act of 1940 to promote an offering sold solely to QPs.

In addition, each of the following conditions must be met:

• Policies and Procedures. The FINRA member firm must adopt and implement 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 other applicable requirements and obligations.
• Reasonable Basis. The member must have a reasonable basis for the criteria used and assumptions made in calculating the target or projection and must retain written records supporting the basis for such criteria and assumptions.
• Prominent Disclosure Regarding Hypothetical Returns. The communication must prominently disclose that the target or projection is hypothetical in nature and that there is no guarantee the target or projection will be achieved.
• Additional Disclosure Regarding Assumptions and Risks. The member must provide sufficient information to enable the investor to understand (i) the criteria used and assumptions made in calculating the target or projection, including whether the target or projection is net of anticipated fees and expenses; and (ii) the risks and limitations of using the target or projection in making investment decisions, including reasons the target or projection might differ from actual performance.

FINRA also proposed new Supplementary Material .01 to Rule 2210 that would list some, but not all, factors members should consider in developing a reasonable basis for calculations of targeted returns and projected performance. These factors include current market and macroeconomic conditions, documented fact-based assumptions concerning the future performance of capital markets and the historical performance or volatility of the asset class.

Open Questions and Areas for Comment

The Proposed Amendments represent an important step towards aligning regulatory standards applicable to registered investment advisers and broker-dealers, particularly private fund managers and placement agents. However, the Proposed Amendments remain inconsistent with the Marketing Rule in many respects, and their application would be ambiguous in others.

Certain Forms of Targeted Returns and Projected Returns Prohibited

Perhaps the most challenging aspect of the Proposed Rules is hidden at the end of proposed Supplementary Material .01. This guidance provides factors to consider when forming a reasonable basis for assumptions and criteria used in calculating targeted returns and projected performance. Critically, the guidance would prohibit the use of (i) hypothetical, backtested performance or (ii) the prior performance of a portfolio or model created solely for the purpose of establishing a track record as a basis for the calculation of targets and projections.

These prohibitions diverge from the treatment of hypothetical performance in the Marketing Rule and would limit the practical application of the Proposed Amendments. Fund managers often establish model portfolios and seed accounts in advance of launching a new product and rely on backtests to assess how investment strategies would have performed in different market environments. Sophisticated investors routinely request this information to inform diligence efforts.

Under the Marketing Rule, backtests, models and certain seed accounts used to establish performance records are treated as hypothetical performance that may only be shared with sophisticated investors subject to conditions substantially similar to those in the Proposed Amendments. Rather than aligning the treatment of these forms of performance to the Marketing Rule, FINRA instead proposed to prohibit them entirely. FINRA did not address this inconsistency in the release accompanying the Proposed Amendments, instead citing a 28-year-old SEC staff no-action letter that imposes certain conditions on the presentation of predecessor seed account performance in the prospectus of a 1940 Act-registered fund. In other words, FINRA appears to cite SEC guidance that certain seed accounts should not be the basis for actual performance as support for the proposition that the performance of such seed accounts should never be permitted, even as the basis for hypothetical performance.

Redundant Sophistication Requirements

The Proposed Amendments impose two distinct limitations on the types of investors that may receive targeted returns and projected performance. Specifically, members would need to adopt policies and procedures reasonably designed to ensure that communications with targets and projections are relevant to the likely financial situation and investment objectives of the recipient. This standard is substantially similar to the Marketing Rule standard, which was adopted by the SEC rather than prescribing a particular class or classes of investors for which hypothetical performance would be appropriate.³ By contrast, FINRA has separately proposed to limit the use of targeted returns and projected performance only to certain sophisticated classes of investors (institutional investors and QPs). Given that express limitation, the requirement to determine that the performance is relevant to the intended audience appears unnecessary and redundant. Members may reasonably question whether the Proposed Amendments impose some additional obligation to narrow the target audience beyond institutional investors and QPs. This is not a feature of most fund managers’ existing policies, and would further limit the utility of the Proposed Amendments.

Treatment of IRRs Remains Unclear

In 2020, FINRA issued guidance to members regarding certain marketing practices in connection with private offerings, including the treatment of internal rates of return (“IRRs”).⁴ In this guidance, FINRA stated that IRRs of investment programs that have no operations or that operate as a blind pool would be inconsistent with the prohibition on projections in Rule 2210. However, the guidance provided that the IRR of investment programs with a combination of realized and unrealized holdings would comply with Rule 2210 if calculated in a manner consistent with the Global Investment Performance Standards (“GIPS”).

The Marketing Rule imposes no similar conditions on the calculation or presentation of IRR, and generally treats IRR as actual performance even when unrealized positions are included in the calculation. In the proposing release, FINRA only discusses IRR in the context of performance projections, noting that the need for cautionary disclosures “is particularly true when a projection is expressed as an internal rate of return” because “forward-looking IRR” is “calculated on the basis of future cash flows to and from investors.” It is unclear from this limited discussion whether IRR calculated in accordance with GIPS would continue to be treated as actual performance and therefore outside the scope of the Proposed Amendments, and if other measures of performance that ascribe values to unrealized positions would be treated as projections.

Treatment of Extracted Performance Also Remains Unclear

The Proposed Amendments and the proposing release also do not address FINRA’s position with respect to extracted performance. FINRA FAQs D.6.2 and D.6.3 currently prohibit the presentation of: (i) returns of any individual unrealized holding (as a prohibited projection); and (ii) the aggregate performance of all realized holdings in an investment program that also has unrealized holdings (as misleading). These FAQs are not, by their terms, limited to retail communications, and it appears that under the Proposed Amendments the extracted performance of unrealized holdings would be treated as hypothetical performance while extracted performance that aggregates realized holdings would remain prohibited. These positions are inconsistent with both the Marketing Rule—which permits extracted performance subject to certain conditions—and the Private Fund Adviser Rules, which expressly require that quarterly statements include the gross IRR and gross multiple on invested capital (“MOIC”) for the realized and unrealized portions of an illiquid fund’s portfolio.⁵

Other Practical Considerations

Application to Institutional Investors and QPs

As noted above, the Proposed Amendments would permit the use of targeted returns and projected performance in institutional communications and communications that market private offerings sold solely to QPs.

Accordingly, targeted returns and projected performance would be prohibited in retail communications used to market 1940 Act-registered funds and business development companies and any private offerings sold to investors other than QPs. It would therefore not be permissible to include targets or projections in materials used to market a mutual fund or a 3(c)(1) fund that admits non-QPs unless the materials are shared only with institutional investors as defined in FINRA Rule 2210. This approach generally aligns with prior FINRA positions regarding the distribution of related performance.⁶

Efficiencies for Fund Managers in Most Cases

Both the policies and procedures requirement and the requirements to provide information regarding the criteria, assumptions, risks and limitations of the targeted returns or projected performance mirror corresponding requirements in the Marketing Rule. The Proposed Amendments also explicitly require that the member disclose that the performance is hypothetical and not guaranteed. Although the Marketing Rule does not prescribe this disclosure, it is generally included with hypothetical performance in accordance with the Marketing Rule’s general prohibitions and the anti-fraud standards of the Advisers Act. The reasonable basis requirement in the Proposed Amendments, however, is a new requirement that does not align with the Marketing Rule. As discussed below, the practical impact of the requirement is unclear, but it may present concerns for many fund managers.

Many registered investment advisers have adopted policies that permit the distribution of target returns to accredited investors, while limiting the use of other forms of hypothetical performance with more sophisticated modeling or assumptions to QPs. In these instances, an inconsistency would remain between the private fund manager’s policies and the policy of a third-party broker using materials provided by the manager. By contrast, private fund managers generally use a QP standard in policies and procedures designed to ensure that an advertisement with hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience. Materials prepared by managers that use a QP standard would also generally satisfy the Proposed Amendments if distributed by a FINRA member broker-dealer. This would also reduce or eliminate the need for private fund managers to prepare two versions of marketing presentations and allow distributors/placement agents to share information with sophisticated investors on equal footing with the manager.

Placement Agents Must Establish and Document a Reasonable Basis

The “reasonable basis” standard—which is not an element of the Marketing Rule’s hypothetical performance requirements—will create new, onerous obligations for many third-party distributors and placement agents. Pursuant to the Proposed Amendments, the third-party placement agent would need to perform sufficient diligence on the criteria used and assumptions made by the fund manager in calculating the targets or projections contained in the material. The proposal suggests that such diligence may include inquiries into the source and accuracy of the data used, the rigor of the analysis, and the date and timeliness of any research used, among other things. This would likely require the sharing of certain backup data and assumptions by the manager. The Proposed Amendments also state that the member must itself retain written records supporting the basis for such criteria and assumptions. This obligation—which is distinct from the diligence requirement—appears to require access and retention by the broker to materials that fund managers rightly consider trade secrets, and will require careful consideration by both parties.

Notwithstanding that the “reasonable basis” standard is likely to be onerous for certain FINRA members, the guidance provided in proposed Supplementary Material .01 may be helpful to managers assessing the scope and type of assumptions that should be considered when calculating hypothetical performance under the Marketing Rule.

1. Depending on the scope and nature of comments received, the SEC staff may request that FINRA respond to comments, and FINRA may propose additional changes to the Proposed Amendments in response to comments. If the SEC does not request additional time to consider the Proposed Amendments, it must approve or reject the Proposed Amendments by January 8, 2024.
2. An institutional communication is any written communication distributed only to institutional investors, which generally includes any person with assets of at least $50 million (in addition to certain other investor types). FINRA Rule 2210(a)(4).
3. See Investment Adviser Marketing, Release No. IA-5653 (Dec. 22, 2020) at n. 671 and accompanying text.
4. See FINRA Regulatory Notice 20-21 (July 2020).
5. Private Fund Advisers; Documentation of Registered Investment Adviser Compliance Reviews, Release No. IA-6383 (Aug. 23, 2023).
6. See, e.g., FINRA Interpretive Letter to Yukako Kawata (Dec. 30, 2003), https://www.finra.org/rules-guidance/guidance/interpretive-letters/yukako-kawata-davis-polk-wardwellgeneral-letter; FINRA Interpretive Letter to Edward P. Macdonald, Hartford Funds Distributors, LLC (May 12, 2015), https://www.finra.org/rules-guidance/guidance/interpretive-letters/interpretive-letter-edward-p-macdonald-hartford-funds-distributors-llc.