SEC Approves Proposed Amendments to FINRA Corporate Financing Rule 5110

Practical Law Legal Update w-023-4869 (Approx. 8 pages)

SEC Approves Proposed Amendments to FINRA Corporate Financing Rule 5110

by Practical Law Corporate & Securities

Filing Requirements

FINRA is amending its filing requirements under Rule 5110 to:

Allow members more time to make the required filings with FINRA by extending the deadline from one business day after filing with the SEC or state equivalent to three business days.
Clarify and further reduce the types of documents and information that must be filed by directing members to provide the SEC document identification number, if available, and require filing:
- industry-standard master forms of agreement only if specifically requested by FINRA;
- amendments to previously filed documents only if there have been changes relating to the disclosures that impact the underwriting terms and arrangements for the public offering in those documents;
- an estimate of the maximum value for each item of underwriting compensation;
- a representation as to whether any officer or director of the issuer and any beneficial owner of 10 percent or more of the issuer's "equity and equity-linked securities" is an associated person or affiliate of a participating member; and
- a description of any securities of the issuer acquired and beneficially owned by any participating member during the "review period", subject to certain exceptions.
Not require filing a description of any securities acquired in accordance with Supplementary Material .01(b), which provides a non-exhaustive list of payments generally not deemed underwriting compensation.
Make other amendments to clarify that:
- a member participating in a filing is not required to file with FINRA if the filing is made by another member participating in the offering;
- a public offering in which a member participates must be filed for review unless exempted by the rule (instead of providing the current non-exhaustive list of types of public offerings that are required to be filed);
- no member may engage in the distribution or sale of securities unless FINRA has provided an opinion that it has no objection to the proposed underwriting terms and arrangements.
- Any member acting as managing underwriter or in a similar capacity must inform other members participating in the offering if it receives an opinion from FINRA that the underwriting terms and arrangements are unfair and unreasonable, and the proposed terms and arrangements have not been appropriately modified;
If an offering is not completed according to the terms of the underwriting agreement between the issuer and the member, and the member has received underwriting compensation, require the member to notify FINRA of all compensation received or to be received, including a copy of any agreement governing the arrangement.
For shelf offerings by issuers that do not qualify as an "experienced issuer", streamline the filing requirements by requiring only the following to be filed:
- the issuer's Securities Act registration statement number; and
- other documents and information set out in Rule 5110(a)(4)(A) and (B), if specifically requested by FINRA.

Filing Exemptions

FINRA is also amending the filing exemptions under Rule 5110 to:

Codify the historical standard exempting public offerings by an "experienced issuer" from Rule 5110's filing requirement.
Clarify that banks, including foreign banks, that have outstanding unsecured investment grade debt with a term of issue of at least four years meet an exemption from the filing requirements that is available to corporate issuers.
Expand the current list of offerings that are exempt from both the rule's filing requirements and substantive regulation of underwriting terms and arrangements to include, among others, issuer self-tender offers under Rule 13e-4 of the Exchange Act and public offerings of:
- securities by closed-end "tender offer" funds;
- insurance contracts;
- unit investment trusts.
Reclassify three items from offerings exempt from filing and rule compliance to offerings excluded from the definition of "public offering":
- offerings exempt from registration under Sections 4(a)(1), (2) and (6) of the Securities Act;
- offerings exempt under Regulation D; and
- offerings exempt under Section 3(a)(12) of the Exchange Act.

Disclosure Requirements

The rule amendments will clarify in new Supplementary Material .05 that Rule 5110 requires disclosure of certain material terms relating to underwriting compensation in the prospectus, including:

when securities are acquired by a participating member, the material terms and arrangements of the acquisition (for example, exercise terms, demand rights, piggyback registration rights, and lock-up periods); and
any right of first refusal granted to a participating member and its duration.

Underwriting Compensation

The rule amendments will clarify what is considered "underwriting compensation" for purposes of Rule 5110 by:

Consolidating the various provisions of the current rule that address what constitutes underwriting compensation into a single, new defined term.
Introducing the defined term "review period" and making clear that the applicable period would vary based on the type of offering.
Making clarifying changes to the list in the Supplementary Material of payments or benefits that would be considered underwriting compensation.
Providing new examples in the list in the Supplementary Material of payments or benefits that would not be considered underwriting compensation, including:
- non-convertible or non-exchangeable debt securities or derivatives acquired in a transaction unrelated to the public offering;
- any payment for accountable expenses received by a member under Rule 5110(g)(5)(A) in a prior offering that was not completed, if the member participates in a revised public offering.
Outlining principles-based approaches in the Supplementary Materials for determining whether issuer securities received from third parties or acquired in a directed sales program are considered "underwriting compensation," including factors FINRA will consider.

Venture Capital Exceptions

In addition to the above changes and clarifications to underwriting compensation, the rule amendments to Rule 5110 also consist of changes geared towards venture capital transactions, including:

FINRA will no longer treat as underwriting compensation securities acquisitions covered by two of the current exceptions, conditioned on the prior investments in the issuer occurring before the review period:
- securities acquisitions and conversions to prevent dilution; and
- purchases based on a prior investment history.
Updating two of the exceptions regarding purchases and loans by certain affiliates, and investments in and loans to certain issuers, by:
- removing a limitation on acquiring more than 25% of the issuer's total equity securities; and
- conditioning the availability of these exceptions to require that the affiliate directly or indirectly be in the business of making investments and loans or be an entity that has been newly formed to do so.
Updating the exception governing private placements with institutional investors by:
- raising the threshold syndicate members in the aggregate may acquire from 20% to 40% of the securities sold in the private placement;
- expanding the scope to include providing services for a private placement rather than just acting as a placement agent; and
- clarifying that the exception is available where the institutional investors participating are not affiliates of a member and purchase at least 51% of the total number of securities at the same time and on the same terms
A new co-investments exception from underwriting compensation for securities acquired in a private placement before the required filing date of the public offering by a participating member if at least 15% of the total number of securities sold in the private placement were acquired, at the same time and on the same terms, by one or more entities that is an open-end investment company not traded on an exchange, and no such entity is an affiliate of a FINRA member participating in the offering.
FINRA will consider factors in new Supplementary Material .02 to Rule 5110 in determining whether securities acquired in a transaction that occurs after the required filing date but otherwise meets the requirements of a venture capital exception may be excluded from underwriting compensation.

New Supplementary Material .07 to Rule 5110 will also expressly provide that the determination of whether a securities acquisition may qualify for a venture capital exception from underwriting compensation is to be made at the time of the securities acquisition.

Lock-Up Restrictions

Subject to some exceptions, Rule 5110 requires a 180-day lock-up restriction on securities that are considered underwriting compensation. Because a prospectus may become effective long before the commencement of sales, the rule amendments will require that the lock-up period begin on the date of commencement of sales, instead of the date of effectiveness of the prospectus.

The amended rule will also:

Provide the lock-up restriction must be disclosed in the section on distribution arrangements in the prospectus or similar document.
Modify the exceptions from the lock-up restriction. For example, exceptions will be added for:
- securities acquired from an issuer that meets the registration requirements of Forms S-3, F-3, or F-10;
- securities acquired in a transaction meeting one of Rule 5110's venture capital exceptions;
- securities that are "actively-traded," as defined in Rule 101(c)(1) of Regulation M.
Not prohibit:
- the transfer of any security to the member's registered persons or affiliates if all transferred securities remain subject to the restriction for the remainder of the lock-up period; or
- the transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC.

Prohibited Terms and Arrangements

The changes to Rule 5110 will clarify the list of prohibited terms and arrangements, including:

Clarifying the scope of relevant activities that would be deemed related to the public offering.
Referring to the commencement of sales of the public offering (rather than the date of effectiveness) in relation to receiving underwriting compensation consisting of any option, warrant or convertible security within specified terms.
Clarifying it would be considered a prohibited arrangement for any underwriting compensation to be paid before the commencement of sales of a public offering, except if it is:
- an advance against accountable expenses actually anticipated to be incurred, which must be reimbursed to the issuer to the extent not incurred; or
- advisory or consulting fees for services provided in connection with the offering that subsequently is completed under terms of an agreement entered into by an issuer and participating member.
Simplifying a provision relating to payments made by an issuer to waive or terminate a right of first refusal to participate in a future capital-raising transaction.

Defined Terms

The rule amendments will make the following changes to the defined terms:

Consolidate the defined terms in one location.
Simply and clarify the defined terms.
Make the terminology more consistent throughout the rule's various provisions. For example, the amended Rule 5110 will introduce a single definition of "underwriting compensation."
Add consistency to the scope of persons covered by the rule. For example, Rule 5110 currently alternates between using the defined term "underwriter and related persons" (which includes underwriter's counsel, financial consultants and advisors, finders, any participating member, and any other persons related to any participating member) and the defined term "participating member" (which includes any FINRA member that is participating in a public offering, any affiliate or associated person of the member, and any immediate family). The rule change will eliminate the term "underwriter and related persons" and instead use the defined term "participating member." The new definition of "underwriting compensation" will ensure that the rule continues to address fees and expenses paid to persons previously covered by the term "underwriter and related persons" (for example, underwriter's counsel fees and expenses, financial consulting and advisory fees, and finder fees).
Modernize the rule language. For example, references to the definition of "national securities exchange" in the Exchange Act will replace references to specific securities exchanges.
Add new definitions to provide greater predictability, such as associated person, experienced issuer, equity-linked securities, public offering, review period, and overallotment option.
Adopt an updated definition of public offering, which includes offerings made under Regulation S and Rule 144A as well as the three types of exempt offerings reclassified from rule compliance (see Filing Exemptions).
Conform the definition in FINRA Rule 5121 (Public Offerings of Securities with Conflicts of Interest) by deleting the definition of "public offering" in that rule and instead incorporating the updated definition in Rule 5110 by reference.

To learn more about the role of FINRA in registered securities offerings, see Practice Note, FINRA and Securities Offerings: The Road to No Objections.

SEC Approves Proposed Amendments to FINRA Corporate Financing Rule 5110 | Practical Law