In recent years, FINRA has enacted new rules regarding private placement transactions of FINRA member firms – FINRA Rule 5122 (Private Placements of Securities Issued by Members) and FINRA Rule 5123 (Private Placement of Securities).  Each of these rules has its own filing requirements, as well as specified exemptions from such filings.  In this entry, we will focus on FINRA Rule 5122 and the treatment of member private offerings.

FINRA Rule 5122

The offering of securities by a member firm or a control entity of the firm in a private placement can raise conflicts of interest and has been an area of regulatory concern in recent years. To address these concerns, FINRA enacted Rule 5122 which requires a member firm or associated person that engages in a private placement of unregistered securities issued by the firm or a control entity of such firm 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’s Corporate Financing Department at or prior to the time it is provided to any investor; 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.

Disclosure Requirements

FINRA believes that every investor or potential investor in a member private offering should receive basic information concerning the offering. Consequently, Rule 5122(b)(1) requires firms to provide a written offering document to each prospective investor in a member private offering, whether or not such individual is deemed an accredited investor under Rule 501 of Regulation D, and that the offering document disclose the intended use of offering proceeds, as well as offering expenses and selling compensation.

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 firm must prepare an offering document that discloses the intended use of offering proceeds as well as offering expenses and selling compensation. The rule does not require a particular form of disclosure.

Filing Requirements

Rule 5122(b)(2) requires that a member firm file a private placement memorandum, term sheet or other offering document with FINRA’s Corporate Financing Department at or prior to the first time such document is provided to any prospective investor. This means that before the PPM can be given to any person or entity outside of the firm for solicitation purposes, it must first be submitted to FINRA.  This is an area that is often missed by firms and one that FINRA is keying in on during onsite examinations.

The firm must also file any amendments or exhibits to the offering document with FINRA within ten days of being provided to any investor or prospective investor.

Use of Proceeds

Rule 5122(b)(3) requires that at least 85 percent of the offering proceeds raised via a member private offering be used for business purposes (excluding offering costs, discounts, commissions or any other cash or non-cash sales incentives). The use of offering proceeds also must be consistent with the required disclosures to investors, as described above. This requirement was created to address abuses where firms or control entities used substantial amounts of offering proceeds for selling compensation and related party benefits, rather than business purposes. The rule, however, does not limit the total amount of underwriting compensation, although no more than 15 percent of the money raised from investors in the private placement could be used to pay underwriting expenses.

Exemptions from Filing Requirements

Rule 5122(c) provides a number of exemptions from the filing requirements of the rule based on type of offerings and type of investors. The rule exempts member private offerings sold solely to the following:

  • institutional accounts, as defined in FINRA Rule 4512;
  • qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;
  • qualified institutional buyers, as defined in Securities Act Rule 144A;
  • investment companies, as defined in Section 3 of the Investment Company Act;
  • an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A; and
  • banks, as defined in Section 3(a)(2) of the Securities Act.
  • offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
  • offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;
  • offerings in which a firm acts primarily in a wholesaling capacity (e.,it intends, as evidenced by a selling agreement, to sell through its affiliate broker-dealers, less than 20 percent of the securities in the offering);
  • offerings of exempted securities with short term maturities under Section 3(a)(3) of the Securities Act;
  • offerings of subordinated loans under SEA Rule 15c3-1, Appendix D;
  • offerings of “variable contracts,” as defined in FINRA Rule 2320(b)(2);
  • offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referred to in Rule 5110(b)(8)(E);
  • offerings of securities of a commodity pool operated by a commodity pool operator, as defined under Section 1a(5) of the Commodity Exchange Act;
  • offerings of equity and credit derivatives, including OTC options, provided that the derivative is not based principally on the member or any of its control entities; and
  • offerings filed with FINRA under Rule 5110, Rule 5121or Rule 2310.
  • offerings of unregistered investment-grade rated debt and preferred securities;
  • offerings to employees and affiliates of the issuer or its control entities; and
  • offerings of securities issued in conversions, stock splits and restructuring transactions made to existing investors without the need for additional consideration or investments on the part of the investor.

It should be noted, a firm can be exempt from the filing requirements of Rule 5122 by meeting multiple of the categories for exemption; however, the flip side is also true.  If a firm does not meet the exemptions from filing for the full offering, a filing must be made.  For instance, if a member private offering is initially only offered to institutions and QIBs, no filing is required.  However, when the firm accepts their first accredited investor, the filing requirement is tripped.  This is an area that firms should ensure they are monitoring closely if they choose to not make the filing required under Rule 5122.