FINRA provides guidance on retail communications for private placement offerings

The U.S. Financial Industry Regulatory Authority (“FINRA”) recently released Regulatory Notice 20-21 (the “Notice”) to provide guidance to its securities broker members about the application of FINRA Rule 2210 to “retail communications” concerning private placements. In general, Rule 2210 applies broad content standards to all communications by members—e.g., such communications must be fair, balanced and not misleading—and applies more specific conditions that vary based on the type of communication and the intended audience. For example, any comparison in retail communications between investments must disclose all material differences between them.

Since the 2013 adoption of Regulation D Rule 506(c), which permits general solicitation of accredited investors by issuers raising capital via private placements, FINRA has observed members communicating on behalf of such issuers via online platforms, using digital advertisements, or otherwise engaged in widely distributed communications about private placements with retail investors.

In recent reviews of such retail communications, FINRA identified several common practices FINRA believes are inconsistent with Rule 2210, including members:

  1. failing to disclose the illiquid and speculative nature of certain privately placed investments;
  2. failing to balance claims of a privately placed investment’s benefits by disclosing its corresponding risks; and
  3. including false, misleading or promissory statements or claims (e.g., the likelihood of a public offering, claims about the issuer’s new or untried business model, inaccurate or misleading assertions concerning the regulation or relative risk of the offering and projections of investment performance).

The Notice serves as a useful guide to member firms in identifying red flags in their retail communications concerning private placements of issuers, including private funds. Brokers that act as placement agents are therefore encouraged to do a holistic review of their retail communications, with particular attention paid to the issues and guidance discussed below.

Is a placement agent liable for third-party prepared materials?

Yes. FINRA noted that past disciplinary actions demonstrate that members can be liable for violations of Rule 2210 when distributing or using retail communications prepared by a third party. If a member assists in the preparation of a private placement memorandum (“PPM”) or other offering document, the member should expect that such materials will be considered a communication of the member for purposes of Rule 2210. The Notice, however, clearly cautions that sales literature distributed by a member concerning a private placement will also be deemed communications by that member even where the member had no role in preparing the materials in question. In addition, FINRA noted that, where a PPM is bound or presented as one electronic file with retail communications (e.g., cover pages or exhibits distinguishable from a PPM by their marketing or promotional content), such retail communications will constitute a communication of the member for purposes of Rule 2210.

Does a placement agent’s retail communications adequately present investment risks and benefits?

Retail communications that promote the potential rewards or benefits of an investment must also disclose the investment’s associated risks in a balanced manner. For many if not all private placement offerings, these risks include, among others, the potential for the investment to lose value, its lack of liquidity and its speculative nature. Where retail communications highlight or promote key features of an issuer’s business, such communications must also disclose the key risks associated with an investment in the issuer to balance the positive portrayal of the investment. For instance, when the issuer is a start-up company, the communications might disclose the company’s limited track record, more experienced or larger competitors, overreliance on financing, reliance on a single supplier, customer, or employee, or lack of management experience. FINRA specifically noted that it is not enough to disclose these risks in a separate document, such as a PPM, or in a different section of a website. To comply with Rule 2210, members must integrate such disclosures within the retail communication itself.

Is a placement agent properly utilizing forecasts and issuer operating metrics?

Rule 2210(d)(1)(F) generally prohibits using predictions or projections of performance, as well as any exaggerated or unwarranted claim, opinion or forecast. As a result, retail communications about private placements generally may not project or predict returns to investors. FINRA does, however, allow reasonable forecasts of issuer operating metrics (e.g., forecasted sales, revenues, or customer acquisition numbers) that may convey important information about an issuer’s plans and financial position. Presentations of these forecasts should include a sound basis for evaluating the facts as required in Rule 2210(d)(1)(A).

For example, such forecasts should be presented together with key assumptions made in forecasting these metrics and the key risks that could cause the issuer to fall short of projections. Although contractual sources of revenue (e.g., royalties) can inform reasonable forecasts, it would be inconsistent with Rule 2210 to characterize revenue or cash flows from such sources as guaranteed.

Members should consider the following when preparing and using forecasts of issuer operating metrics:

  • The time period forecasted (generally more than five years would be considered unreasonable);
  • Whether growth rate assumptions are commensurate with the nature and size of the business;
  • Whether forecasted growth margins are commensurate with industry averages; and
  • Whether sales and customer acquisition forecasts are reasonable in relation to the overall market for the issuer’s products or services.

Does a placement agent’s retail communications disclose all material information concerning distribution rates?

Some issuers will fund a portion of their distributions through return of the principal or loan proceeds. Members may not misrepresent the amount or composition of these distributions. In addition, members may not state or imply that a distribution rate is a “yield” or “current yield” or that investment in the program is like investing in a fixed income investment. Retail communications may not include an annualized distribution rate until a program has paid distributions that are, on an annual basis, at a minimum equal to that rate for at least two consecutive quarterly periods.

Presentations of distribution rates should disclose:

  • That distribution payments are not guaranteed and can be modified at the program’s discretion;
  • If the distribution rate consists of return of principal or borrowings, a breakdown of the components of the distribution rate showing what portion of the quoted percentage represents cash flows from the program’s investments or operations, what portion represents return of principal and what portion represents borrowings;
  • The time period during which the distributions were funded from return of principal (including offering proceeds), borrowings or any other sources other than cash flows from investment operations;
  • If the distributions include a return of principal, that by returning principal to investors, the program will have less money to invest, which may lower its overall returns; and
  • if the distribution includes borrowed funds, the materials should disclose that, since borrowed funds were used to pay distributions, the distribution rate may not be sustainable.

May a placement agent’s retail communications use internal rates of return (IRRs) to highlight issuer performance?

Yes, for completed investment programs, although FINRA has identified drawbacks, including the inherent assumption that investors will be able to reinvest any distributions from the investment at the IRR rate, which is unlikely to occur in practice, and the inherent difficulty and subjectivity involved in valuing assets in portfolios with holdings that have not yet been sold. In addition, retail communications may provide an IRR for a specific investment in a portfolio if the IRR represents the actual performance of that holding.

Rule 2210, however, does not permit the use of IRR when promoting new investment programs with no operations or that operate as a blind pool. Such uses would be inconsistent with Rule 2210’s prohibition on unwarranted forecasts or projections.

If a program has a combination of realized and unrealized investments, FINRA will permit the inclusion of IRR if it is calculated consistent with the Global Investment Performance Standards ("GIPS") adopted by the CFA Institute. This standard would include additional GIPS metrics such as paid-in-capital, committed capital and distributions to be paid to investors.