FINRA Proposes Expansion of Rule Governing Private Placements

January 19, 2011

On January 11, 2011, FINRA announced that it is seeking comment on a proposal to expand dramatically the scope of FINRA Rule 5122, which concerns a member firm’s participation in private placements. Rule 5122, adopted in 2009, currently applies only to a private placement in which a participating broker-dealer (or its control entity) is the issuer. The proposed amendments would expand the reach of Rule 5122 to apply to all private placements in which a member firm “participates,” and not just those in which the member firm (or its control entity) is the issuer.

Rule 5122 requires, subject to certain exemptions described below, disclosure in the offering materials of the intended use of offering proceeds, expenses and compensation to be paid to the broker-dealer and its associated persons. The rule also requires that at least 85 percent of the offering proceeds must be used for the business purposes identified in the offering document. Rule 5122 mandates that offering documents in private placements subject to the rule be submitted to FINRA to allow its staff to conduct ex post reviews to assess compliance with the rule, including to ensure that 85 percent of the proceeds were, in fact, being used for the earlier-disclosed purpose. The proposed amendment would retain all of the current substantive provisions of the rule, except that it would repeal an exemption for offerings in which a member acts primarily as a wholesaler. 


FINRA Rule 5122 was developed to address conflict of interest issues and regulatory concerns that arose with regard to private placements offered by member firms. The rule generally requires that a member firm or associated person engaging in a private placement of unregistered securities issued by the firm (or a control1 entity of the firm):

  • disclose to investors in an offering document the intended use of offering proceeds, the offering expenses, and the amount of compensation that will be paid to the broker-dealer and its associated persons;
  • submit to FINRA Corporate Financing Department, via e-mail, the offering document at or prior to the time it is provided to any prospective investor; and
  • comply with the requirement that at least 85 percent of the offering proceeds raised may not be used to pay for offering costs, discounts, commission, or any other cash or non-cash sales incentives, and must be used for the business purposes disclosed in the offering document.

FINRA staff then conducts ex post reviews of offering documents to assess compliance with the rule. This review will sometimes result in additional information requests.

The current rule also provides various exemptions, including offerings of private placements:

  • to institutional accounts, qualified purchasers, qualified institutional buyers, investment companies and banks;
  • to employees of the issuer (or its control entity) and securities issued in certain conversions, stock splits and restructuring transactions;
  • of exempted securities, including such investments as certain notes with short-term maturities, variable contracts, modified guaranteed annuity contracts and life insurance policies, etc.; or
  • in which the member acts primarily in a wholesale capacity, as evidenced by an agreement to sell less than 20 percent of the offered securities in retail transactions. 


FINRA noted that although Rule 5122 plays an important part in protecting investors, it does not address private placements in which the issuer is neither a broker-dealer nor its control entity. As a consequence, the vast majority of private placements remain outside of the scope of the rule. FINRA thus proposes to expand the rule to reach any private placement in which a member participates, subject to all but one of the existing exemptions to the rule.

“Participation” in a Private Placement

The proposed amendment incorporates the definition of “participation” from Rule 51102 which corresponds to the types of services typically provided by a broker-dealer in a private placement. This amendment would expand the reach of the rule to all private placements in which a member firm “participates” and is no longer limited to those private placements when a member firm (or its control entity) is the issuer. The designation of a “control entity” has been deleted as it would no longer be relevant given the new scope of the rule.

Disclosure Requirements
According to the Regulatory Notice, in some recent SEC and FINRA enforcement actions, the participating broker-dealer’s affiliation with the issuer has facilitated the broker-dealer’s misuse of offering proceeds. In response, the proposed amendment requires that the offering document disclose if a participating member is an affiliate of the issuer and the nature of the affiliation. An “affiliate” would be defined as a company that controls, is controlled by or is under common control with a broker-dealer.

In addition, as currently written, the rule requires that the amount of the “selling compensation” to be paid to the broker-dealer and its associated persons be disclosed. To better capture the amount of any compensation that would be paid directly or indirectly to a participating member firm, the amendment would replace the term “selling compensation” with the more general term “compensation.”

Elimination of Wholesaling Exemption

The existing rule provides for an exemption under Rule 5122(c) for offerings in which a member acts primarily in a wholesaling capacity. The traditional rationale for this exemption was that the distribution of a the private placement by independent retail broker-dealers would eliminate the need for the rule. The Regulatory Notice, however, noted that several recent enforcement actions have involved private placements in which a broker-dealer affiliated with an issuer acted primarily as the wholesaler. Moreover, because the proposed amendment would expand the reach of the rule to include all private placements, the reliance upon the efforts of independent broker-dealers is no longer relevant. As a result, the proposed amendment would eliminate this exemption. 

FINRA’s Concerns About the Private Placement Market

The proposed expansion of Rule 5122 is part of a pattern in which FINRA is seeking greater control over the private placement practices. FINRA proposed the predecessor to Rule 5122 in NASD Notice to Members 07-27, which (as discussed above) only applied to offerings issued by the broker-dealer or an affiliate. That rule became effective in 2009 (FINRA Notice 09-27). Last year, FINRA Notice 10-22 explained FINRA’s views on the due diligence requirements for member firms participating in private placements. Although that notice purported only to describe existing law, many observers believed it had the effect of imposing substantial new obligations. Now FINRA is proposing to amend Rule 5122 to apply its requirements to the large majority of private placements in which member firms participate. FINRA encourages all interested parties to comment on the proposal; comments must be submitted to FINRA by March 14, 2011. For more information, see FINRA Regulatory Notice 11-04.

For additional information concerning this alert, please contact the following lawyers:

Amy Kroll, Partner, Broker-Dealer Group, 202.373.6118

David Boch, Partner, Broker-Dealer Group, 617.951.8485

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1Rule 5122 defines “control” as beneficial interest of more than 50 percent of the outstanding voting securities of a corporation or the right to more than 50 percent of the distributable profits or losses of a non-corporate entity. 
2Rule 5110(a)(5) defines “participation” as the following:
Participation in the preparation of the offering or other documents, participation in the distribution of the offering on an underwritten, non-underwritten, or any other basis, furnishing of customer and/or broker lists for solicitation, or participation in any advisory or consulting capacity to the issuer related to the offering, but not the preparation of an appraisal in a savings and loan conversion or a bank offering or the preparation of a fairness opinion pursuant to SEC Rule 13e-3.

This article was originally published by Bingham McCutchen LLP.