As summarized below, FINRA is currently seeking comment on proposed amendments to FINRA Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements) to make substantive, organizational and terminology changes to the rule. carngearThe proposal is intended to modernize Rule 5110 and to simplify and clarify its provisions.

The rule proposal would retain the primary principle of the rule that no member firm or person associated with a member firm may participate in a public offering for which the terms and conditions, including the aggregate amount of underwriting compensation, are unfair, unreasonable or inconsistent with any FINRA rule.

As background, Rule 5110 prohibits unfair underwriting arrangements in connection with the public offering of securities. This rule was adopted in 1992 in response to persistent problems with underwriters dealing unfairly with issuers. The rule requires a member that participates in a public offering to file information with FINRA about the underwriting terms and arrangements.

FINRA’s Corporate Financing Department reviews this information prior to the commencement of the offering to determine whether the underwriting compensation and other terms and arrangements meet the requirements of the applicable FINRA rules.

Rule 5110 was last modernized in 2004 to better reflect the various financial activities of multi-service firms. After years of experience with those amendments and subsequent, narrower amendments that addressed industry practices regarding particular underwriting terms and arrangements, FINRA recently conducted the equivalent of a retrospective review of the rule to further modernize it by, among other things, significantly improving the administration of the rule and simplifying its provisions without lessening important protections for market participants, including investors and issuers participating in offerings. FINRA is proposing a range of changes to Rule 5110, including to the following areas, among others:

  • filing requirements;
  • filing exemptions;
  • disclosure requirements;
  • underwriting compensation;
  • lock-up restrictions; and
  • valuation of securities.

Filing Requirements

FINRA is proposing changes to the filing requirements to create a process that is both more flexible and more efficient.  For example, FINRA is proposing to allow members more time to make the required filings with FINRA (from one business day after filing with the SEC or state equivalent to three business days), and 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.

In addition, rather than providing a non-exhaustive list of types of public offerings that are required to be filed, the proposed amendments would instead state that a public offering in which a member participates must be filed for review unless exempted by the rule.

Filing Exemptions

Rule 5110 contains a list of offerings that are exempt from filing, but remain subject to the rule’s prohibition on unreasonable underwriting terms and arrangements. FINRA proposes to add to the list of offerings that are exempt from filing follow-on offerings of closed-end “tender offer” funds that routinely make self-tender offers and need to be in continuous distribution to offset net redemptions. Compensation for distribution of tender offer funds will become subject to the limitations in FINRA Rule 2341 (Investment Company Securities).

The proposal would also 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 public offerings of insurance contracts and unit investment trusts. The proposed changes may reduce costs to firms by reducing filing burdens and clarifying the scope of the exemptions.

Disclosure Requirements

The SEC’s Regulation S-K requires fees and expenses identified by FINRA as underwriting compensation to be disclosed in the prospectus. FINRA is proposing to modify the underwriting compensation disclosure requirements. Although the proposal would continue to require that a description of each item of underwriting compensation be disclosed, it would no longer require the disclosure to include the dollar amount ascribed to each individual item of compensation. FINRA is proposing to permit a firm to disclose the maximum aggregate amount of all underwriting compensation, except the discount or commission that must be disclosed on the cover page of the prospectus.

Underwriting Compensation

FINRA is proposing to clarify what is considered underwriting compensation for purposes of Rule 5110.  FINRA is proposing to consolidate the various provisions of the current rule that address what constitutes underwriting compensation into a single, new definition of “underwriting compensation.” The proposal would define “underwriting compensation” to mean “any payment, right, interest, or benefit received or to be received by a participating member from any source for underwriting, allocation, distribution, advisory and other investment banking services in connection with a public offering.” Underwriting compensation would also include “finder fees and underwriter’s counsel fees, including expense reimbursements and securities.”

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, FINRA proposes that the lock-up period begin on the date of commencement of sales (rather than the date of effectiveness of the prospectus).

FINRA is also proposing to modify the exceptions from the lock-up restriction. In addition, FINRA is proposing that the lock-up restriction not prohibit: (1) 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 (2) the transfer or sale of the security back to the issuer in a transaction exempt from registration with the SEC, because these transfers or sales do not involve the types of underwriting services covered by Rule 5110.

Valuation of Securities

Rule 5110 currently prescribes specific calculations for valuing convertible and nonconvertible securities received as underwriting compensation. However, applying these calculations can be time and resource intensive for both firms and FINRA. Rather than the specific calculations currently in the rule, FINRA is proposing in the Supplementary Material to instead allow valuing options, warrants and other convertible securities received as underwriting compensation based on a securities valuation method that is commercially available and appropriate for the type of securities to be valued (e.g., the Black-Scholes model for options).

For further information, please refer to FINRA Regulatory Notice 2017-15.