Washington regulators are weighing new rules that might make it easier for broker-dealers to offer private placements to ultra-wealthy investors and institutions, a rare ray of light in what has been a gloomy couple of regulatory seasons.
Under a rule proposal issued just before Thanksgiving, the Financial Industry Regulatory Authority, a member group that sets and enforces standards for broker-dealers, would change its rule 2210 to allow FINRA-registered brokers to offer private placement “projections” either to qualified purchasers, defined as investors with at least $5 million in assets, or institutional investors with at least $50 million in assets under management, so long as the brokers have a “reasonable” basis for sharing them. Currently, rule 2210 prohibits broker-dealers from sharing projections with anyone.
FINRA has been under pressure for years to change the rule because it can create friction between fund managers and brokers or placement agents. Since 2020, when the SEC adopted its marketing rule for registered investment advisers – a rule which allows for “hypothetical” ads and requires substantiation for any marketing claims – the pressure has intensified. The comment period on FINRA’s proposed rule-change expired Friday. It is now up to the SEC to finalize the proposal. Some hope the commission will extend the comment deadline because the rulemaking proposal hasn’t gotten wide attention.
“I do think it is a step in the positive direction,” Ropes & Gray partner Brynn Rail said of the proposal. “We hear from clients that investors want this information, ‘How are we supposed to raise a fund if we can’t tell investors what we’re looking to achieve?’” It just doesn’t make sense. It’s very hard to sell a fund when you can’t tell investors what you hope to achieve.”
Smoother, not smooth
Regulators have made clear they want to make it (a little) easier for broker-dealers to offer private placements.
“FINRA believes that the proposed rule change strikes the right balance between protecting investors and allowing more investment information to be communicated to an appropriate audience,” the self-regulatory membership group says in the rule proposal.
“As mentioned previously, projection-eligible investors often develop their own opinions regarding the future performance of an investment based on the multiple sources of information at their disposal. They test these opinions against the views and data provided by other sources, which often summarize their conclusions in terms of a projection of performance of the investment.”
As written, the rules changes may make things between brokers and private equity managers smoother, but they will not make things smooth. The qualified purchaser threshold leaves thousands – potentially, millions – of accredited investors in the dark about private equity projections sold through broker-dealers and other placement agents. Still, most experts think the rule changes are a step in the right direction.
“It creates friction in the marketing process, because the fund manager is allowed to use these projections in their marketing materials and broker-dealers are not,” says David Blass, a partner with Simpson Thacher & Bartlett. “I think FINRA appreciates that, and I’m guessing they wanted to provide clarity and relief. But I do think private equity firms will benefit from the clarity this rule provides, as well as the end of the prohibition on projections.”
The “reasonable basis” standard in the rule proposal might be a little sticky, too, Ropes & Gray associate Erin Conklin says.
“The question is, would a broker-dealer that wants to use materials prepared by a private equity manager have to form his or her own reasonable basis, or is that something the broker-dealer could delegate or offload to the manager?” she says. “The marketing rule, under the Investment Advisers Act, doesn’t include an explicit reasonable basis standard.”
Simpson Thacher’s Blass says he’s less concerned about the reasonability standard because “in all honesty, I think that issue gets sorted out in the marketplace.”
“You can form a reasonable basis in a number of ways, including assurances from related parties,” he said.
In the near month that the FINRA proposal was open for comment, only one person filed a letter. It came from Molly Diggins, general counsel to the Monument Group, a Boston-based broker-dealer that specializes in private placements.
Diggins said she was “pleased” with the direction of the rule proposal but is “concerned that many of the proposed rule’s onerous compliance prerequisites for the use of projections by FINRA members will hold negative competitive and economic implications for independent placement agents.”
She has asked the SEC to extend the comment period until the middle of January.
Speaking with Private Funds CFO, Diggins said inconsistencies in the current put placement agents – “and any manager who could benefit from the use of a placement agent” – at a competitive disadvantage. While the new rules are an improvement, they will still prohibit the use by members of hypothetical, back-tested or of model performance – “a fairly stark divergence from the marketing rule that will limit the practical application of the proposed amendments and further perpetuate the inefficiencies created by the current difference in standards,” she said.
The proposed rule’s requirement that a FINRA member both establish and document a “reasonable basis” for the criteria and assumptions used in calculating a target or projection is also poses a challenge, Diggins said.
“In particular, the proposed rule is unclear as to whether the broker-dealer must form and document its own reasonable basis for the projections and targets – a duplicative and burdensome process for any independent placement agent – or may rely on the fund sponsor who creates and supplies the projections and targets to the placement agent,” she said.
“It is great that FINRA came out with this proposal, but honestly, it’s questionable whether it’s really worth using projections as a placement agent, if you have to jump through all of the burdensome and expensive compliance hoops. We’re not going to be able to hire more people to do all this stuff. And fund managers – who consistently desire fast and uncomplicated fund-raises – may shy away from the use of a placement agent for which new compliance requirements may slow down or complicate the fundraising process.”