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«SECURITIES AND EXCHANGE COMMISSION (Release No. 34-59599; File No. SR-FINRA-2008-020) March 19, 2009 Self-Regulatory Organizations; Financial ...»

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(Release No. 34-59599; File No. SR-FINRA-2008-020)

March 19, 2009

Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving

Proposed Rule Change, as Modified by Amendment No. 2 Thereto, Relating to Private

Placements of Securities Issued by Members

I. Introduction

The Financial Industry Regulatory Authority, Inc. (“FINRA”) (f/k/a National Association

of Securities Dealers, Inc. (“NASD”)) filed with the Securities and Exchange Commission (“Commission” or “SEC”) on September 11, 2008, and amended on January 7, 2009, 1 pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act” or “Act”) 2 and Rule 19b-4 thereunder, 3 a proposal to adopt new FINRA Rule 5122 (“Rule”) which would prohibit FINRA members or associated persons from offering or selling any security in a “Member Private Offerings” unless certain conditions have been met. This proposal was published for comment in the Federal Register on January 26, 2009. 4 The Commission received two comments on the proposal. 5 This order approves this proposed rule change.

1 Amendment No. 2 to SR-FINRA-2008-020. This amendment replaced and superseded the original filing submitted to the SEC on September 11, 2008. Amendment No. 1, which was filed on December 22, 2008, was withdrawn on January 7, 2009.

2 15 U.S.C. 78s(b)(1).

3 17 CFR 240.19b-4.

4 Exchange Act Release No. 59262 (January 16, 2009), 74 FR 4487 (January 26, 2009) (SR-FINRA-2008-020).

5 See letter from Neville Golvala for ChoiceTrade dated February 17, 2009 (“2009 ChoiceTrade letter”) and letter from Jack L. Hollander for the Investment Program Association (“IPA”) dated February 17, 2009 (“IPA letter”).

2 II. Description of the Proposed Rule Change FINRA proposed to adopt new FINRA Rule 5122, which would require a member that engages in a private placement of unregistered securities issued by the member or a control entity to (1) disclose to investors in a private placement memorandum, term sheet or other offering document the intended use of offering proceeds and the offering expenses, (2) file such offering document with FINRA, and (3) commit that at least 85 percent of the offering proceeds will be used for business purposes, which shall not include offering costs, discounts, commissions and any other cash or non-cash sales incentives.

A. Background FINRA proposed the Rule in response to problems identified in connection with private placements by members of their own securities or those of a control entity (referred to as “Member Private Offerings” or “MPOs”). In recent years, FINRA has investigated and brought numerous enforcement cases concerning abuses in connection with MPOs. 6 Among the allegations in these cases were that members failed to provide written offering documents to 6 Franklin Ross, Inc., NASD No. E072004001501 (settled April 2006), summarized in NASD Notice Disciplinary Actions, p. 1 (May 2006); Capital Growth Financial, LLC, NASD No. E072003099001 (settled February 2006), summarized in NASD Notice Disciplinary Actions, p. 1 (April 2006); Craig & Associates, NASD No. E3B2003026801 (settled August 2005), summarized in NASD Notice Disciplinary Actions, p. D6 (October 2005); Online Brokerage Services, Inc., NASD No. C8A050021 (settled March 2005), summarized in NASD Notice Disciplinary Actions, p. D5 (May 2005); IAR Securities/Legend Merchant Group, NASD No. C10030058 (settled July 2004), summarized in NASD Notice Disciplinary Actions, p. D1 (July 2004); Shelman Securities Corp., NASD No. C06030013 (settled December 2003), summarized in NASD Notice Disciplinary Actions, p. D1 (February 2004); Neil Brooks, NASD No. C06030009 (settled June 2003), summarized in NASD Press Release, NASD Files Three Enforcement Actions for Fraudulent Hedge Fund Offerings (August 18, 2003); Dep’t of Enforcement v. L.H. Ross & Co., Inc., Complaint No. CAF040056 (Hearing Panel decision January 15, 2005); Dep’t of Enforcement v. Win Capital Corp., Complaint No.

CLI030013 (Hearing Panel decision August 6, 2004). In addition to these cases, FINRA has numerous ongoing investigations involving MPOs.

3 investors or provided offering documents that contained misleading, incorrect, or selective disclosure, such as omissions and misrepresentations regarding selling compensation and the use of offering proceeds. In addition, as part of its examination program, FINRA conducted a nonpublic sweep of firms that had engaged in MPOs and found widespread problems. The MPO sweep revealed that in some cases, offering proceeds were used for individual bonuses, sales contest awards, commissions in excess of 20 percent, or other undisclosed compensation.

Because MPOs are private placements, they are not subject to existing FINRA rules governing underwriting terms and arrangements and conflicts of interest by members in public offerings. 7 This proposed rule change is intended to provide investor protections for MPOs that are similar to the protections provided by NASD Rule 2720 for public offerings by members. 8 In response to concerns about MPOs, FINRA issued Notice to Members 07-27 (“NTM 07-27”) in June 2007 to solicit comment on a proposed new rule regarding MPOs (then numbered proposed NASD Rule 2721). FINRA received sixteen comment letters in response to NTM 07-27. 9 These comments were varied. Some of these commenters expressed support for 7 FINRA Rule 5110 and NASD Rules 2720 and 2810 govern member participation in public offerings of securities.

8 Members would remain subject to other FINRA rules that govern a member’s participation in the offer and sale of a security, including FINRA Rules 2010 and 2020 and NASD Rule 2310. Members also are subject to the anti-fraud provisions of the federal securities laws, including Sections 10(b), 11, 12 and 17 of the Exchange Act.

9 The following is a list of persons and entities submitting comment letters in response to NTM 07-27: Letter from Timothy P. Selby for Alston & Bird LLP dated July 20, 2007 (“Alston & Bird letter”), letter from Keith F. Higgins for American Bar Association (“ABA”) Committee on Federal Regulation of Securities dated July 20, 2007 (“ABA letter”), letter from Todd Anders dated July 13, 2007 (“Anders letter”), letter from Neville Golvala for ChoiceTrade dated July 19, 2007 (“2007 ChoiceTrade letter”), letter from Stephen E. Roth, et al of Sutherland, Asbill & Brennan, LLP for the Committee of Annuity Insurers (“CAI”) dated July 20, 2007 (“CAI letter”), letter from Peter J Chepucavage for the International Association of Small Broker-Dealers and Advisors (“IASBDA”) dated July 20, 2007 (“IASBDA letter”), letter from Alan Z. Engel for LEC 4 the intent of the proposed rule but voiced concerns about its breadth and scope, 10 while others questioned the benefit or necessity of the proposed rule.11 Most of these comment letters also suggested edits to the proposed rule. 12 These comments received in response to NTM 07-27, and changes to the Rule as proposed as compared to the rule as it appeared in NTM 07-27, are described in more detail below in Sections II.B through II.F.

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The proposed rule change states that no member or associated person may offer or sell any security in a MPO unless certain conditions are met. The proposed rule change defines a MPO as “a private placement of unregistered securities issued by a member or control entity.” The proposed rule further defines two of the terms in the definition of MPO, “private placement” Investment Corp. dated June 14, 2007 (“LEC letter”), letter from Daniel T. McHugh for Lombard Securities Inc. dated July 20, 2007 (“Lombard letter”), letter from Dexter M.

Johnson for Mallon & Johnson, P.C. dated July 19, 2007 (“Mallon & Johnson letter”), letter from John G. Gaine for Managed Funds Association (“MFA”) dated July 20, 2007 (“MFA letter”), letter from Curtis N. Sorrells for MGL Consulting Corp. dated July 20, 2007 (“MGL letter”), letter from Thomas W. Sexton for the National Futures Association (“NFA”) dated July 20, 2007 (“NFA letter”), letter from Michael S. Sackheim and David A. Form for the New York City Bar Committee of Futures and Derivatives Regulation dated July 10, 2007 (“NYC Bar letter”), letter from Joseph A. Fillip, Jr. for PFG Distribution Co. dated July 19, 2007 (“PFG letter”), letter from Mary Kuan for Securities Industry and Financial Markets Association (“SIFMA”) dated July 27, 2007 (“SIFMA letter”), and letter from Bill Keisler for Stephens Inc. dated July 20, 2007 (“Stephens letter”).

10 See MFA letter, CAI letter, and Alston & Bird letter.

11 See Anders letter, Mallon & Johnson letter, 2007 ChoiceTrade letter, ABA letter, and SIFMA letter. FINRA did not agree with SIFMA that the potential for abuses in connection with private offerings by non-members is a reason to abandon the proposed rule change. The FINRA staff believed that offerings by members raise unique conflicts that require the protections of the proposed rule change. FINRA also disagreed with SIFMA’s contention that they do not have legal authority to adopt the proposed rule change.

12 See Alston & Bird letter, ABA letter, LEC letter, Mallon & Johnson letter, MFA letter, MGL letter, PFG letter, and SIFMA letter.

5 and “control entity.” In response to one comment received in response to NTM 07-27, 13 FINRA defined the term “private placement” to be “a non-public offering of securities conducted in reliance on an available exemption from registration under the Securities Act [of 1933].” The proposed rule change defines the term “control entity” as “any entity that controls or is under common control with a member, or that is controlled by a member or its associated persons.” The term “control” is defined as “a beneficial interest, as defined in Rule 5130(i)(1), of more than 50 percent of the outstanding voting securities of a corporation, or the right to more than 50 percent of the distributable profits or losses of a partnership or other non-corporate legal entity.” 14 The power to direct the management or policies of a corporation or partnership alone (e.g., a general partner), absent meeting the majority ownership or right to the majority of profits, would not constitute “control” as defined in proposed FINRA Rule 5122. For purposes of this definition, FINRA clarified that entities may calculate the percentage of control using a “flow through” concept, by looking through ownership levels to calculate the total percentage of control. For example, if broker-dealer ABC owns 50 percent of corporation DEF that in turn holds a 60 percent interest in corporation GHI, and ABC is engaged in a private offering of GHI, ABC would have a 30 percent interest in GHI (50 percent of 60 percent), and thus GHI would not be considered a control entity under this definition.

FINRA also reaffirmed, as stated in NTM 07-27, that performance and management fees earned by a general partner would not be included in the determination of partnership profit or loss percentages. However, if such performance and management fees are subsequently re

–  –  –

invested in the partnership, thereby increasing the general partner’s ownership interest, then such interests would be considered in determining whether the partnership is a control entity.

In response to several comments received in response to NTM 07-27 advocating that the timing for determining control take place at the conclusion rather than the commencement of an offering, 15 FINRA revised the definition of control to be determined immediately after the closing of an offering. The definition also clarifies that, in the case of multiple closings, control will be determined immediately after each closing. If an offering is intended to raise sufficient funds such that the member would not control the entity under the control standard, but fails to raise sufficient funds, the member must promptly come into compliance with the Rule, including providing the required disclosures to investors and filings with FINRA’s Corporate Financing Department (“Department”).

C. Disclosure Requirements The proposed rule change would require that a member provide a written offering document to each prospective investor in an MPO, whether accredited or not, and that the offering document disclose the intended use of offering proceeds as well as offering expenses and selling compensation. 16 If the offering has a private placement memorandum or term sheet, then such memorandum or term sheet must be provided to each prospective investor and must contain these disclosures. If the offering does not have a private placement memorandum or term sheet, then the member must prepare an offering document that discloses the intended use 15 See Alston & Bird letter, ABA letter, LEC letter, MFA letter, MGL letter, NYC Bar letter, and SIFMA letter.

16 Given that FINRA is not imposing limits on selling compensation as it does in other rules, they did not believe it was necessary to provide a detailed definition of “selling compensation” as urged by SIFMA. FINRA believed that the term “selling compensation” for purposes of a disclosure requirement is sufficiently clear.

7 of offering proceeds as well as offering expenses and selling compensation. FINRA clarified that the Rule is not meant to require a particular form of disclosure, however. To emphasize this point, FINRA proposed to issue Supplemental Material 5122.01, which would note that nothing in the Rule shall require a member to prepare a private placement memorandum that meets the additional requirements of Rule 502 under the Securities Act of 1933 (“Securities Act”).

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