Perhaps in response to large scale fraud of the kind surrounding the private placements of companies like Provident Royalties LLC, on Oct. 5, the Financial Industry Regulatory Authority, or FINRA, filed a new rule proposal with the Securities and Exchange Commission, or SEC.

Proposed FINRA Rule 5123 would impose new notice and disclosure requirements on private placements, including requirements for transparency regarding the use of the proceeds, as well as full disclosure of expenses and compensation.

Private Placements

Private placements are securities sold without an initial public offering and are exempt from registration under an exception to the Securities Act of 1933, the rationale being that the typical private placement is sold to a few select and sophisticated investors.

Yet the case of Provident Royalties LLC shows that private placements may have crept beyond their traditional borders. Provident is in bankruptcy and the website of its liquidating trust shows that a total of 52 broker-dealers are enmeshed in litigation stemming from sales of the allegedly fraudulent oil and gas private placements. Twenty of these broker-dealers have shut their doors

Between 2006 and 2009, Provident raised $485 million from 7,700 investors through these placements. Although investors were told their money would be invested in oil and gas exploration and development ventures, it was co-mingled with other investment monies and some was paid out in “dividends” or “returns on capital” to earlier investors, according to the SEC complaint.

Proposed FINRA Rule 5123(a) would prohibit a member firm, or any person associated with a member firm, from offering or selling any private placement security unless the member or associated person provides a private placement memorandum, term sheet or other such documentation to each investor before the sale, according to the proposal filed with the SEC.

This documentation must describe the anticipated use of the offering proceeds, the amount and type of expenses, and the amount and type of compensation to be provided to sponsors, finders, consultants and member firms and their associated persons in connection with the offering,

Proposed Rule 5123(b) would require member firms to file the disclosure documents, including exhibits, with FINRA no later than 15 calendar days after the date of the first sale. Any material amendments to the disclosure documents would need to be filed with FINRA no later than 15 calendar days after the date the amended document is provided to an investor or prospective investor.

Any person who participates in the preparation of private placement memoranda, term sheets or other disclosure documents related to private placements would also be subject to these disclosure requirements, the rule proposal says. See the full text of the proposed rule here.

At its April 14 meeting, the FINRA Board of Governors authorized the filing of proposed Rule 5123 with the SEC. No further action by FINRA is necessary. If the rule is approved by the SEC, FINRA will announce its implementation date in a regulatory notice to be published within three months of the approval, the rule proposal said. The rule will be implemented within 180 days of approval.

In its proposal, FINRA stated that is seeks to adopt new Rule 5123, titled Private Placements of Securities, “to ensure that investors in private placements are provided detailed information about the intended use of offering proceeds, the offering expenses and offering compensation.”

In addition, the new notice requirement would provide FINRA with more timely and detailed information about the private placement activities of its member firms.

The Rule Does Not Apply to All Investors

Proposed Rule 5123(c) would exempt private placements sold only to any of the following types of purchasers:

  • Institutional accounts, as defined in NASD Rule 3110(c)(4)
  • Qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act
  • Qualified institutional buyers, as defined in Securities Act Rule 144A
  • Investment companies, as defined in Section 3 of the Investment Company Act
  • An entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A
  • Banks, as defined in Section 3(a)(2) of the Securities Act
  • Employees and affiliates of the issuer

The proposed rule would also exempt certain types of offerings, many of them already carved out of the Securities Act. These exempt offerings would include the securities of bank holding companies, and those made under Securities Act Rule 144A or SEC Regulation S.

In addition, the exempt offerings include: securities with short term maturities; subordinated loans; variable contracts; modified guaranteed annuity contracts; modified guaranteed life insurance policies; and non-convertible debt or preferred securities by issuers that meet certain eligibility criteria.

Also exempt are offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor, as well as offerings of securities of a commodity pool, and offerings filed with FINRA.

Rule Proposal FINRA Filed With the SEC

According to the rule proposal FINRA filed with the SEC, these proposed exemptions are similar to the exemptions in Rule 5122 on Member Private Offerings. In fact, proposed Rule 5123 is based on Rule 5122. The only differences are that the proposed Rule 5123 would not exempt offerings in which a member acts in a wholesaling capacity; nor would it exempt offerings of certain credit derivatives. The proposed rule would apply to all offerings in which a member participates.

The provisions in the two rules are identical regarding confidential treatment, however. Pursuant to proposed Rule 5123(d), FINRA would treat all documents and information filed pursuant to the rule confidentially, and would use the documents and information solely for the purpose of determining compliance with FINRA rules or other regulatory purposes.

Proposed Rule 5123(e) would explain how to apply for an exemption from the rule provisions for good cause.

FINRA stated in its proposal that it believes that the rule change is consistent with the provisions of Section 15A(b)(6) of the Securities Act, which requires, among other things, that FINRA rules be “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest.”

The proposed rule change should provide private placement investors with complete information about the intended use of offering proceeds, and the expenses and compensation to be paid out. The proposed rule would also provide FINRA with timely and detailed information about its member firms private placement activities

These changes should create important investor protections in connection with private placements without unduly restricting the capital formation function of the process, FINRA said in its proposal. FINRA also said it believes that the proposed rule would facilitate its efforts to identify problematic terms and conditions, and thus help it detect and prevent fraud in connection with private placements.

According to FINRA, the proposed rule would not result in any burden on competition beyond what is necessary to further the purposes of the Securities Act and its goal of transparent, well-functioning markets. The proposed rule is “both necessary and appropriate,” FINRA said in its proposal, to help prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest.

Before FINRA submitted Rule 5123 to the SEC for approval, it collected comments that were taken into consideration. Most comments fell into two main categories: those dealing with a proposed numerical limitation on the use of proceeds, and those dealing with the timing of filing requirements.

The issue that generated the most comments was a proposed requirement that 85 percent of the proceeds raised be used for the business purposes described in the disclosure documents. As a result, this limitation was removed from the final proposal.

Many of those who commented on the limitation questioned the ability of FINRA members to monitor an issuer’s use of proceeds and the potential for the rule to create additional liability.

Concerns Raised

Others raised concerns that the proposed limitation would be tantamount to regulation of non-FINRA members. Some commentators asserted that the proposed 85 percent limitation was arbitrary, and could turn out to be a barrier to capital formation and would be unworkable, especially in smaller offerings. Some feared that constraints on expenses could force issuers to eschew FINRA member firms altogether, “in favor of finders and unregistered persons.”

Questions of interpretation also came up in the comments. For example, they asked whether certain expenses — including those relating to due diligence, legal services, travel, rights of first refusal, conference expenses, management fees and appraisals and valuation — would be required to be treated as offering expenses or would be considered as expenses for business purposes.

Some of those who commented recommended that FINRA just require greater disclosures about the uses of proceeds, offering expenses, and compensation as an alternative. Based on the comments, FINRA amended the proposal, which no longer includes the substantive requirement that at least 85 percent of offering proceeds must be used for the disclosed business purposes. The proposed rule was reoriented towards disclosure.

FINRA stated in it proposal that it continues to believe the use of offering proceeds is critically important, and that those offerings in which a large portion of the proceeds are used for things other than business purposes raise grave regulatory concerns. However, FINRA also said that these concerns can be handled through the duties of broker-dealers, under the suitability and anti-fraud provisions of the securities laws.

If existing regulation and the enhanced disclosures required by the proposed rule turn out to fall short of the desired result, FINRA said in its proposal that it will reconsider the imposition of numerical limitations.

The issue that generated the next highest number of comments on the original proposal was the requirement that members file information with FINRA by the time an offering document is provided to any investor. Due to these concerns, the proposal as submitted to the SEC now contains a 15-day window.

The comments raised concerns about potential slowdowns of offerings due to the filing requirement. Several said the requirement could delay the process because firms would not want to proceed without assurances or clearances from FINRA, even though the original proposal stated such clearances would not be necessary.

Technical concerns about the filing process also came out in the comments, including concerns regarding who must file, how the members of group of sellers would know if any document had been filed already, and who would bear responsibility for amendments.

A few commentators, including the New York City Bar, said offerings might begin to be structured to avoid the filing requirement, either by limiting the offering to exempted investors or moving the transaction offshore.

As note, FINRA addressed these concerns by changing its rule proposal to require that a member file no later than 15 calendar days after the date of first sale, the same window required by SEC Form D.

FINRA’s rule proposal said “synchronizing these timing requirements may allow some filers to utilize operational efficiencies,” and take care of any implication that a seller should wait for FINRA comments as a precondition on sales. The 15-day window should be sufficient to provide FINRA staff with timely access to information about the private placement business of member firms.

Entities from which FINRA received comments on the limitation included the American Bar Association, the Securities Industry and Financial Markets Association, the New York State Bar, National Introducing Brokers Association, Sullivan & Cromwell, Patrick, Rothwell Consulting, Network 1, the Real Estate Investment Securities Association and Intellivest.

On Oct. 18, the SEC published a notice of the proposed rule to solicit comments from interested persons. The SEC comment period will run from within 45 days to 90 days of the date of publication of the notice in the Federal Register.

The SEC specifically requests comments on whether the proposed rule would affect issuers’ access to capital via the private placement market, and whether it would affect investors purchasing private placement securities through a broker-dealer subject to the new rule. For example, the SEC asks if people think the information contained in the proposed mandatory disclosures would improve an investor’s ability to decide whether to invest in a private placement. Finally, the SEC seeks comment on whether the proposed rule would affect registered broker-dealers participation in private placements.

Guiliano Law Firm

The practice of Nicholas J. Guiliano, Esq., and The Guiliano Law Firm, P.C., is limited to the representation of investors in claims for fraud in connection with the sale of securities, the sale or recommendation of excessively risky or unsuitable securities, breach of fiduciary duty, and the failure to supervise. We accept representation on a contingent fee basis, meaning there is no cost to unless we make a recovery for you, and there is never any charge for a consultation or an evaluation of your claim. For more information contact us at (877) SEC-ATTY.

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