Filings, Finders and Prohibited Compensation

Rule 5123: filing the offering

FINRA Rule 5123 applies to a member that sells a security in a private placement. The member must either submit to FINRA — or have a designated member submit on its behalf — a copy of any private placement memorandum, term sheet or other offering document, together with any retail communication that promotes or recommends the private placement, including any materially amended versions; or notify FINRA that no such offering documents or retail communications were used.

The deadline is WITHIN 15 CALENDAR DAYS OF THE DATE OF FIRST SALE. Filing is through the electronic form FINRA prescribes.

Two features distinguish this from the Rule 2210 advertising filings in the last lesson. It is a notice filing, not a review: FINRA is not approving anything, and nothing waits on a response. And it is unavoidable — a member that used no offering document at all must file a notice saying so. There is no silent option.

FINRA accords confidential treatment to everything filed under the rule and uses it only for compliance review and other regulatory purposes.

The exemptions in Rule 5123(b) are extensive, and their theme is the investor. An offering sold SOLELY to certain categories of buyer need not be filed: institutional accounts; qualified purchasers; qualified institutional buyers; investment companies; entities composed exclusively of QIBs; banks; employees and affiliates of the issuer; knowledgeable employees; eligible contract participants; and — note this one — accredited investors described in Rule 501(a)(1), (2), (3), (7), (9) or (12).

Read that last exemption carefully, because it is a trap. Those are the INSTITUTIONAL accredited investor categories: banks and registered entities, private business development companies, large organisations and corporations, large trusts, the five-million-dollar investments catch-all, and family offices. The natural-person categories — 501(a)(5) net worth, (a)(6) income, (a)(10) professional certification — are NOT in the list. An offering sold to individual accredited investors is filed. Selling only to accredited investors does not exempt you from Rule 5123.

Further exemptions cover exempted securities, Regulation S offerings, short-term debt, subordinated loans, variable contracts, certain annuities, non-convertible debt meeting registration-form criteria, conversions and stock splits, commodity pools, business combinations, registered investment companies, standardized options, and offerings already filed under other FINRA rules.

Rule 5122: when the member is the issuer

FINRA Rule 5122 governs a MEMBER PRIVATE OFFERING — a private placement of unregistered securities issued by a member or by a control entity of a member. Control means beneficial ownership of more than 50 percent of the outstanding voting securities of a corporation, or the right to more than 50 percent of distributable profits or losses in another form of entity.

The concern is obvious. When the firm selling the securities is also the issuer, every check on the offering is inside one organisation.

So Rule 5122 imposes three requirements.

DISCLOSURE. The member must provide prospective investors with a private placement memorandum, term sheet or other offering document that discloses the intended use of the offering proceeds, the offering expenses, and the selling compensation payable to the member and its associated persons.

FILING. The document must be filed with FINRA's Corporate Financing Department at or prior to the first time it is provided to any prospective investor — before use, not after sale, which is the opposite of the Rule 5123 timing. Amendments must be filed within ten days of being provided to any investor or prospective investor.

USE OF PROCEEDS. At least 85 percent of the offering proceeds raised must be used for the business purposes disclosed — and the rule specifies that business purposes do NOT include offering costs, discounts, commissions or any other cash or non-cash sales incentives. In other words no more than 15 percent of what investors put in may go to the cost of raising it.

Rule 5122(c) exempts, among others, offerings sold solely to the institutional categories listed in the previous section, offerings under Rule 144A or Regulation S, offerings where the member acts in a wholesaling capacity selling less than 20 percent through affiliates, subordinated loans, variable contracts, investment-grade rated debt, offerings to employees and affiliates, conversions and restructurings, commodity pools, and offerings already filed under Rules 2310, 5110 or 5121.

The two rules are easy to confuse and the distinction is simple. 5123 is about a member SELLING somebody else's private placement, filed within 15 calendar days after first sale. 5122 is about a member selling ITS OWN, filed before the document is first shown to anyone, and carrying the 85 percent floor.

The issuer's own people: Rule 3a4-1

A private placement is often sold in part by the issuer's own management. Exchange Act Section 15(a) requires brokers to register, so the question is when an issuer's employee selling the issuer's securities becomes a broker.

Rule 3a4-1 is a non-exclusive safe harbour. An associated person of an issuer is not deemed a broker solely by reason of participating in the sale of the issuer's securities if THREE preliminary conditions are met and then any ONE of three alternative conditions.

The preliminary conditions: the person is not subject to a statutory disqualification; the person is NOT COMPENSATED by commissions or other remuneration based directly or indirectly on transactions in securities; and the person is not at the time an associated person of a broker or dealer.

The second of those is the heart of it. Transaction-based compensation is the classic hallmark of a broker. An issuer's CFO may talk to investors on a salary; the moment they are paid a percentage of what they raise, the safe harbour is gone.

The alternative conditions, any one of which suffices:

First, the person restricts participation to offers and sales to specified institutions — registered broker-dealers, registered investment companies, insurance companies, banks, savings and loans, trust companies, and certain trusts — or to transactions exempt under Securities Act Sections 3(a)(7), 3(a)(9) or 3(a)(10), or to reclassifications and mergers submitted to security holders, or to employee benefit and stock plans.

Second, the person primarily performs substantial duties for the issuer other than in connection with securities transactions; was not a broker or dealer or associated person of one within the preceding 12 months; and does not participate in selling an offering for any issuer MORE THAN ONCE EVERY 12 MONTHS. That once-every-twelve-months limit is the tested number.

Third, the person restricts participation to preparing or delivering written communications without oral solicitation, with the content approved by a partner, officer or director of the issuer; responding to inquiries the potential purchaser initiated, limited to information in the offering document; or performing ministerial and clerical work.

Note what the rule does not say. Paragraph (b) provides that no presumption of a Section 15(a) violation arises merely because someone falls outside the safe harbour. Failing 3a4-1 is not automatically unlawful — it just means the analysis is open rather than settled.

Finders, and why they are a problem

The content outline lists "prohibited compensation practices associated with unregistered introducer or finder" as a Function 1 knowledge area, and it is one of the most litigated questions in the private markets.

The issue: someone who is not a registered broker-dealer introduces investors to an issuer and is paid a percentage of what those investors put in. Under the same logic as Rule 3a4-1, transaction-based compensation for soliciting securities investors is broker activity, and doing it without registration violates Exchange Act Section 15(a).

FINRA Rule 2040(a) closes the loop on the member's side: no member or associated person may directly or indirectly pay any compensation, fees, concessions, discounts, commissions or other allowances to any person that is not registered as a broker-dealer but is required to be, or to any person suspended or barred.

So a member cannot solve the problem by paying the finder itself. Both ends are prohibited.

The supplementary material tells a member how to satisfy itself: it must have a reasonable basis for its determination that the recipient need not register, supported by SEC guidance, no-action letters, or an independent legal opinion.

Rule 2040 does permit two things. Paragraph (b) allows continuing commissions to a RETIRING registered representative from accounts they previously serviced, provided a bona fide contract was in place before retirement prohibiting the retiree from soliciting new business, opening new accounts or servicing the accounts generating the payments. Paragraph (c) allows payments to NON-REGISTERED FOREIGN FINDERS on seven conditions, including that the finder is a foreign national or entity domiciled abroad, the customers are foreign nationals or entities domiciled abroad, the customers receive a descriptive disclosure document and acknowledge the compensation in writing, records are kept, and the transaction confirmation states that a referral or finder's fee is being paid.

There is also a narrow statutory route worth knowing. Securities Act Section 4(c), added by the JOBS Act, exempts certain persons operating a platform for Rule 506 offerings from broker registration — but only where that person and every associated person receives NO COMPENSATION in connection with the purchase or sale, holds no customer funds or securities, and is not statutorily disqualified. No compensation. It is not a paid-finder exemption.

The representative-level takeaway is simple. If someone outside your firm wants to be paid for bringing investors into your deal, that is a compliance question before it is a commercial one, and the answer is usually no.

Selling away: Rule 3280

One more rule belongs in this lesson, because private placements are the setting in which it is almost always broken.

FINRA Rule 3280 governs PRIVATE SECURITIES TRANSACTIONS — defined as any securities transaction outside the regular course or scope of an associated person's employment with a member, including, but not limited to, new offerings of securities not registered with the Commission.

Read that definition again. Unregistered new offerings are named in it. A Series 82 representative works in exactly the category the rule was written about.

Before participating in any private securities transaction, the associated person must give WRITTEN NOTICE to their firm describing in detail the proposed transaction and their proposed role in it, and stating whether they have received or may receive selling compensation.

What happens next depends on that last answer.

Where SELLING COMPENSATION is or may be involved, the firm must give written approval or disapproval. If it approves, the transaction goes on the FIRM'S BOOKS AND RECORDS and the firm supervises it as if it had been executed on the firm's own behalf. If it disapproves, the person may not participate in the transaction in any manner, directly or indirectly.

Where no selling compensation is involved, the firm must provide prompt written acknowledgment and may impose conditions at its discretion.

"Selling away" is the industry name for doing this without the notice, and it is a career-ending violation for a straightforward reason: it puts a customer into a securities transaction that the firm never reviewed, never supervised, and cannot make good. It rarely begins as dishonesty. It begins with a friend's company that needs money, a customer who wants in, and a representative who does not think of it as a securities transaction because it is a favour.

The related rule is FINRA Rule 3270, which requires prior written notice to the firm of any outside business activity — serving as an officer or director of a private company, for instance. The two rules run together in practice: a representative sitting on the board of a start-up owes notice under 3270, and owes notice under 3280 the moment they help that start-up raise money.