The North American Securities Administrators Association (NASAA) recently suggested several ways in which the Financial Industry Regulatory Authority (FINRA) could enhance investor protection by improving the disclosure by FINRA member firms in private placements of securities. NASAA’s comments came in the context of a comment letter to the U.S. Securities and Exchange Commission regarding FINRA’s proposed new Rule 5123, which would require FINRA members and associated persons that offer or sell certain private placements to provide relevant disclosure to each investor prior to sale. Although the state regulators regard the proposal as a good start, NASAA believes that the new rule falls short of addressing the issues inherent in securities that are not subject to substantive regulatory review.
NASAA expressed disappointment that FINRA has retreated from its efforts to expand the “85 Percent Rule" currently found in FINRA Rule 5122. The 85 Percent Rule requires that at least 85 percent of a “Member Private Offering" may not be used to pay for offering costs and compensation, and must be used for business purposes disclosed in the offering document. NASAA believes that this provision, which currently covers only private placements of unregistered securities issued by FINRA member firms or their control entities, should be expanded to encompass all private placements of securities.
NASAA applauded FINRA’s proposal to require compensation disclosure for funds provided to finders and solicitors. NASAA stressed, however, that such disclosure does not replace or supplant the need for FINRA to develop a registration requirement for finders and solicitors, noting that individuals or firms providing such services may be required to register as either broker-dealers or agents under state law.
Although acknowledging that the proposal would require FINRA member firms to disclose the anticipated use of offering proceeds, expenses, and compensation, NASAA noted that proposal does not require member firms to disclose the risks associated with the private placement. NASAA wrote that the knowledge of potential risks, such as liquidity issues or lack of operating history, is fundamental to a potential investor’s evaluation of a private placement and the decision of whether to invest.
Among its other comments, NASAA wrote that the exemptions provided under the new rule are too extensive and almost subsume the proposal. For example, NASAA noted that the proposal excludes modified insurance contracts, short term promissory notes, limited partnership shares, direct participation programs, commodity pools, and credit and derivative products, all of which have extensive negative regulatory histories. Additionally, NASAA expressed concern that FINRA member firms could potentially read the rule as excluding structured products as “credit and derivative" securities. NASAA firmly believes that structured products should not be exempted under the rule.