The Financial Industry Regulatory Authority (“FINRA”) has announced a proposed new set of rules that address the needs of FINRA member firms that are solely corporate financing firms that advise companies on mergers and acquisitions, advise issuers on raising debt and equity capital in private placements with institutional investors, or provide advisory services on a consulting basis to companies that need assistance analyzing their strategic and financial alternatives.
While these firms often are registered as broker-dealers because they may receive transaction-based compensation as part of their services, they do not engage in many of the types of activities typically associated with traditional broker-dealers. For example, these firms typically do not carry or act as an introducing broker with respect to customer accounts, handle customer funds or securities, accept orders to purchase or sell securities either as principal or agent for the customer, exercise investment discretion on behalf of any customer, or engage in proprietary trading of securities or market-making activities.
Essentially, this proposed rule set incorporates both (i) the noteworthy departure from the Securities and Exchange Commission’s (“SEC”) long-held view that persons receiving transaction-based compensation in connection with facilitating the acquisition and or sale of a company must register with the SEC as a broker-dealer which was reflected in the SEC issued No-Action Letter on January 31, 2014, that was revised February 4, 2014 (“No Action Letter”), that stated that “the SEC would not recommend enforcement action … if an M&A Broker were to effect securities transactions in connection with the transfer of ownership of a privately-held company … without registering as a broker-dealer pursuant to Section 15(b) of the Exchange Act.”; and (ii) the February 2014 release of Regulatory Release 14-09, which requested public comment on the proposed rules for a new category of broker-dealer called the Limited Corporate Financing Brokers (“LCFB”). Due to the inconsistencies between the No Action Letter and the rule proposed rule for the LCFBs, it appears that FINRA is proposing a rule to reconcile those inconsistencies.
While the final rules have not been proposed by the SEC, and or the final proposed rules been reviewed and commented on by the broker-dealer industry, it is an important first step, as FINRA preliminary estimates that the number of member firms that meet this definition would range from 650 to 750 firms. Thus, it is possible that between 16 and 19 percent of all FINRA member firms may be eligible to operate under this proposed rule set. These firms currently are required to comply with all applicable FINRA rules and as a result, these firms incur costs that are not applicable for their business.
In any event, the proposed separate rule set that would apply exclusively to firms that meet the definition of “capital acquisition broker” (CAB) and that elect to be governed under this rule set. CABs would be subject to the FINRA By-Laws, as well as core FINRA rules that FINRA believes should apply to all firms. The new rule set would include other FINRA rules that are tailored to address CABs’ business activities.
The proposed definitions of “capital acquisition broker” and “institutional investor” are particularly important to the application of the rule set. The term “capital acquisition broker” would mean any 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; and
- 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 Exchange Act.
A firm would be permitted to register as, or change its status to, a CAB only if the firm solely engages in one or more of the activities set out above. A CAB would not include any broker or dealer that:
- Carries or acts as an introducing broker with respect to customer accounts;
- Holds or handles customers’ funds or securities;
- Accepts orders from customers to purchase or sell securities either as principal or as agent for the customer (except as permitted by paragraphs (c)(1)(F) and (G) of CAB Rule 016);
- Has investment discretion on behalf of any customer;
- Engages in proprietary trading of securities or market-making activities; or
- Participates in or maintains an online platform in connection with offerings of unregistered securities pursuant to Regulation Crowdfunding or Regulation A under the Securities Act of 1933.
The term “institutional investor” would have the same meaning as that term has under FINRA Rule 2210 (Communications with the Public), with one exception. 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, but does not include any participant of such plans;
- 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, but does not include any participant of such plans;
- Other person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million; and
- 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 (“1940 Act”).
While there are a number of changes not set out below, under the new proposed rules, the firms electing to operate as under the CAB registration category would not be subject to a number of FINRA obligations, including the requirements:
- To obtain a Fidelity Bond
- To designate a chief compliance officer.
- To have and test a business continuity plan.
- To have an annual compliance meeting.
- To review all transactions relating to the member’s investment banking or securities business that include trading and investment banking functions that are beyond the permissible scope of a CAB’s activities.
- Prohibiting supervisory personnel from supervising their own activities; and reporting to, or having their compensation or continued employment determined by a person the supervisor is supervising.
- That its chief executive officer annually certify that the member 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,
While this is a major relief for those firms electing to transition to the CAB registration category, new rule set still subjects firms to the FINRA rules related to (i) influencing and rewarding employees of others; (ii) observing high standards of commercial honor and just and equitable principles of trade in the conduct of its business; (iii) compliance with the Regulatory and Firm Element continuing education requirement; and (iv) the issuance of Fairness Opinions. The new CAB rule set also requires firms to have an Anti-Money Laundering Program (although the testing cycle would be every two years); supervise the outside business activities of registered persons; and prohibits any person associated with a CAB from participating in any manner in a private securities transaction.
Most significantly, CABs would still be subject to the majority of the current financial and operational obligations, including the requirements to: (i) have an annual financial audit; (ii) comply with the capital requirements set forth in SEC Rule 15c3-1; (iii) to have a FINOP; and (iv) maintain net capital computations and make quarterly regulatory filings with FINRA. Finally, CABs would be subject to capital compliance requirements that would require CABs to suspend business operations during any period a firm is not in compliance with the applicable net capital requirements. Additionally, CABs would be subject to SIPC Assessments.
FINRA noted that it will announce the implementation date of the proposed rule change in a Regulatory Notice to be published no later than 60 days following SEC approval. The effective date will be no later than 180 days following publication of the Regulatory Notice announcing SEC approval. Based upon the fact that the proposal will have to be placed out for public comment, and the proposed rules are approved by the SEC, it will be late 2016 at the earliest for the proposed rules to become effective.
Click here to read Federal Register Notice and or the rule filing SR-FINRA-2015-54 for the complete discussion of the proposed rule.