For many years, the private fund industry and the securities bar have called for a limited rule set to govern broker-dealers solely engaged in raising capital for private funds or other issuers of unregistered securities or in merger and acquisition advisory activities.1 These broker-dealers would share several common traits: they do not execute securities transactions, accept orders to purchase or sell securities, introduce or carry customer accounts, handle customer funds or securities, or participate in principal transactions or market making activity. On December 17, 2015, the Securities and Exchange Commission (SEC) issued a notice of a proposed Financial Industry Regulatory Authority, Inc. (FINRA) rule change that would establish a separate rule set (the ‘Proposed Rule Set’) for broker-dealers that meet the definition of a ‘capital acquisition broker’ (CAB) and elect to be governed under the Proposed Rule Set.2
The Proposed Rule Set is based on a notice published by FINRA in February 2014 requesting comment on a proposed rule set for firms that meet the definition of what it then called a ‘limited corporate financing broker’ (LCFB).3 This initial proposal was issued in response to industry concerns that the full FINRA rule set should not apply to broker-dealers that limit their business to certain capital raising, merger and acquisition, and corporate financing activities. While such firms do not engage in the types of activities associated with full-service broker-dealers, they are nonetheless subject to the full FINRA rule set under the current regulatory framework. The initial proposal sought to ease the regulatory burden on an LCFB firm by establishing a separate set of streamlined rules tailored to address their limited business activities.
FINRA received 51 public comments on the LCFB rule proposal during the comment period. Many of the commenters objected to the LCFB rule proposal because they believed that the LCFB definition was too narrow and the proposal did not provide enough relief from the regulatory burdens associated with FINRA membership. In response to these comments, FINRA developed the Proposed Rule Set, which revises and expands upon the initial LCFB rule proposal. While this current proposal addresses a number of the criticisms submitted in response to the LCFB proposal, private fund sponsors likely will find the Proposed Rule Set to be too restrictive to serve their needs.
‘Capital Acquisition Broker’ Definition
The Proposed Rule Set applies to broker-dealers that meet the definition of a CAB and elect to be governed under the Proposed Rule Set. Proposed CAB Rule 016 would define a CAB as a broker that solely engages in any one or more of the following activities:
- Advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
- Advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger;
- Advising a company regarding its selection of an investment banker;
- Assisting in the preparation of offering materials on behalf of an issuer;
- Providing fairness opinions, valuation services, expert testimony, litigation support, and negotiation and structuring services;
- Qualifying, identifying, soliciting, or acting as a placement agent or finder with respect to institutional investors in connection with purchases or sales of unregistered securities; and4
- Effecting securities transactions solely in connection with the transfer of ownership and control of a privately held company through the purchase, sale, exchange, issuance, repurchase, or redemption of, or a business combination involving, securities or assets of the company, to a buyer that will actively operate the company or the business conducted with the assets of the company, in accordance with the terms and conditions of an SEC rule, release, interpretation or ‘no-action’ letter that permits a person to engage in such activities without having to register as a broker or dealer pursuant to Section 15(b) of the Securities Exchange Act of 1934.
The definition of a CAB would specifically exclude any firm that carries or acts as an introducing broker with respect to customer accounts, holds or handles customer funds or securities, accepts orders from customers to purchase or sell securities (except as permitted in the last two bullets above), has investment discretion on behalf of any customer, engages in proprietary trading of securities or market-making activity, or participates in or maintains an online platform for offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act of 1933.
Definition of institutional investor
The term ‘institutional investor’ would have the same meaning as that term has under FINRA Rule 2210, on Communications With the Public, with one exception. In particular, the term would include any:
- Bank, savings and loan association, insurance company, or registered investment company;
- Governmental entity or subdivision thereof;
- Employee benefit plan, or multiple employee benefit plans offered to employees of the same employer, that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and in the aggregate have at least 100 participants;
- Qualified plan, as defined in Section 3(a)(12)(C) of the Exchange Act, or multiple qualified plans offered to employees of the same employer, that in the aggregate have at least 100 participants;
- Any other person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least US$50 million; and
- A person acting solely on behalf of any such institutional investor.
The definition also would include any person meeting the definition of “qualified purchaser” as that term is defined in Section 2(a)(51) of the Investment Company Act of 1940 (“Company Act”).5
Impact on private fund sponsors
The proposal would prohibit a CAB from soliciting persons who are accredited investors but are not also ‘institutional investors’ under the above definition. FINRA’s proposed definition of institutional investor would thus significantly restrict the universe of investors that CABs would be able to solicit for investment in private funds. It appears to us that FINRA’s proposal will have the practical effect of limiting a CAB’s private fund placement activity to funds formed under Section 3(c)(7) of the Company Act (3(c)(7) funds). As a consequence, FINRA’s proposal will lead to different considerations for sponsors of 3(c)(7) funds as compared to sponsors of funds formed under Section 3(c)(1) of the Company Act (3(c)(1) funds). Whereas the former may be able to form and register a CAB under FINRA’s proposal, that option generally will not be available to the latter. Today, sponsors of 3(c)(7) funds and 3(c)(1) funds face the risk of being deemed to have acted as an unregistered broker-dealer, in certain circumstances, when they market or solicit interest in their private funds to potential investors.6 To address this risk, private fund sponsors may hire broker-dealers to serve as placement agents or have certain employees register as representatives with a broker-dealer. The former approach requires paying substantial placement agent fees to the broker-dealer and the latter approach necessarily involves having the compensation for the employees’ placement agent activities paid to the broker-dealer with whom the employees are registered (i.e., not to the private fund sponsor). Alternatively, private fund sponsors may of course register (or have an affiliate register) as a broker-dealer and become a member of FINRA.
With FINRA’s proposal, sponsors of 3(c)(7) funds will need to weigh the process, risks and costs associated with CAB registration and the proposed CAB rule book (discussed below) in determining whether to form an in-house CAB. Such risks and costs also must be weighed against the costs of hiring a third-party CAB or traditional placement agent or having employees register with a third-party CAB or traditional placement agent. If the goals to be advanced by FINRA’s proposal are achieved, then the costs of registering and operating a CAB on an ongoing basis should be considerably less than the costs of registering and operating a traditional placement agent. If adopted, FINRA’s proposal could thus open up a number of possibilities for 3(c)(7) sponsors to increase the distribution of their shares without taking on the risk of acting as an unregistered broker-dealer.
As noted above, sponsors of 3(c)(1) funds generally would not be able to take advantage of the CAB option presented by FINRA’s proposal.7 Such sponsors would thus continue to operate in a regulatory environment in which they must hire a broker-dealer to serve as a placement agent, have employees register as representatives of a broker-dealer, or register (or have an affiliate register) as a broker-dealer if they wish to market the interests of the fund. The result of FINRA’s CAB proposal is to enlarge the differential treatment by FINRA of those who offer and sell interests in 3(c)(7) funds as opposed to 3(c)(1) funds.8
Process for CAB Registration
If a firm meets the CAB definition and elects to register as a CAB, or to create a new affiliate to so register, then the firm (or its affiliate) would need to submit a new member application pursuant to NASD Rule 1013, and would have to state in its new member application that it intends to operate solely as a CAB. If an existing FINRA member firm wishes to change its status to a CAB, then the firm would be required to file a request to amend its membership agreement to provide that the firm will limit its business activities to those permitted under the CAB definition (and the firm would need to agree to comply with the CAB rule set). An existing FINRA member firm seeking to change its status to a CAB would not need to file a new membership application pursuant to NASD Rule 1013 or a continuing membership application pursuant to NASD Rule 1017, so long as the firm does not intend to change its existing ownership, control, or business operations in connection with the decision to be regulated as a CAB.
CAB Rule Set
The Proposed Rule Set applicable to CABs would include the following general requirements:
- Duties and Conflicts (CAB Rule 200 Series) – The proposed rules contain streamlined conduct rules, including rules for know-your-customer and suitability and an abbreviated version of FINRA’s communications rules, effectively prohibiting false and misleading statements. CABs would not be subject to FINRA’s rules relating to fair prices and commissions or charges for services performed.
- Supervision (CAB Rule 300 Series) – The Proposed Rule Set would impose limited supervisory requirements incorporating some of FINRA Rule 3110, but not the provisions related to annual compliance meetings, review and investigation of transactions, documentation and supervisory procedures for supervisory personnel, or internal inspections. The rule set incorporates FINRA rules restricting influencing or rewarding employees of others and outside business activities of associated persons, and imposes anti-money laundering requirements similar to FINRA Rule 3310 but would not require chief executive officers to certify that the CAB has in place processes to establish, maintain, review, test and modify written compliance policies and written supervisory procedures reasonably designed to achieve compliance with applicable federal securities laws and regulations and FINRA rules. The rule set would also prohibit any person associated with a CAB from participating in any manner in a private securities transaction.
- Financial and Operational (CAB Rule 400 Series) – The Proposed Rule Set would subject CABs to FINRA rules regarding audits, guarantees by or flow though benefits for members, filing and contact information requirements, supplemental FOCUS information, reporting requirements, verification of assets, and certain (but not all) capital compliance requirements applicable to member firms. CABs would not be subject to FINRA rules regarding business continuity plans or testing under Regulation SCI and would have limited customer information requirements.
- Securities Offerings (CAB Rule 500 Series) – CABs would be subject to a limited subset of the rules governing securities offerings, specifically FINRA Rule 5122 (Private Placements of Securities Issued by Members) and FINRA Rule 5150 (Fairness Opinions).
- Investigations and Sanctions, Code of Procedure (CAB Rule 800 and 900 Series) – CABs would be subject to the FINRA rules governing investigations and sanctions of firms other than those covering availability of manual to customers, but not FINRA rules related to automated submission of trading data.
- Arbitration and Mediation (CAB Rule 1000 Series) – CABS would be subject to the FINRA arbitration and mediation rule set for customer and industry disputes.
As the above summary makes clear, while FINRA’s proposal would provide CABs some limited relief from the current FINRA regulatory framework, the benefits still appear to be marginal. In reviewing FINRA’s rule filing, it appears that much of the proposed ‘relief’ relates to rules that could not apply, or would not make sense to apply, to a firm engaged in the limited activities permitted by the proposed definition of CAB. While there are several examples of proposed relief that might fairly be termed to be true “policy judgment calls” by FINRA, such examples are few and far between. While the latest proposal is an improvement over the initial LCFB proposal, interested private fund sponsors should review the proposal in depth to understand the various rules and regulations to which they would become subject if they were to register as a CAB.
FINRA requests public comment on the Proposed Rule Set. The comment period expires on January 13, 2016.9
Michael B. Koffler is a partner in Sutherland’s New York office. He guides investment advisers, broker-dealers and investment funds in their compliance with federal and state securities laws and regulations, and SRO rules. Mr. Koffler advises clients on the full spectrum of business operations, including advertising, portfolio management, trading, internal controls, compliance programs, mergers and acquisitions and other management issues. He also counsels other financial institutions—banks and insurance companies—on securities issues associated with the management and distribution of investment products. Mr. Koffler began his legal career with the U.S. Securities and Exchange Commission's Division of Investment Management.
Ben Marzouk is an associate in Sutherland’s Washington DC office. He is a financial services attorney who advises broker-dealers and investment advisers on their regulatory compliance matters with the U.S. Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA), as well as state rules and regulations.
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