FINRA Kicks Off the Holiday Season With a Proposal to Permit the Use of Some Projections and Targeted Returns

FINRA has offered a gift to member firms and fund managers just in time for the holiday season — but like a new puppy, the gift comes with a lot of responsibility. FINRA filed a proposed rule change to amend FINRA Rule 2210 (Communications with the Public) (Proposal) with the SEC. The Proposal would permit members, subject to certain conditions, to project performance of, or provide targeted returns for, a security, asset allocation, or other investment strategy in (1) an institutional communication or (2) a communication to qualified purchasers (QPs), as defined in Section 2(a)(51)(A) of the Investment Company Act, that promotes or recommends an investment in certain types of nonpublic offerings exempt from FINRA Rules 5122 and 5123 (qualified private offerings). FINRA acknowledges that broker-dealer customers often request this information in order to make informed investment decisions. FINRA also recognizes that projected performance or targeted returns may be useful for institutional investors and QPs that either have the financial sophistication and experience to assess investments and comprehend the assumptions and limitations associated with projected performance or targeted returns or the “resources that provide them with access to financial professionals who possess this expertise.”

The codification of this exception is a meaningful and long-awaited step in the right direction in an effort to reconcile SEC and FINRA rules associated with using projected performance and targeted returns for broker-dealers and investment advisers. The disparate requirements between investment advisers and brokers have not only complicated regulatory oversight, but put certain brokers at a competitive disadvantage compared to their advisory counterparts. The Proposal, if approved by the SEC, would introduce some consistency to a regulatory landscape that has been unbalanced, especially as it relates to the marketing of private funds.

Here are a few things to note about the Proposal:

• Limitation on Communications Provided to QPs. While the exception will permit use of projections and targeted returns in all institutional communications, projections and targeted returns will only be permitted in communications with QPs relating to investment in qualified private offerings. In other words, the exception will not permit the use of projected performance and targeted returns in communications with QPs about investments or strategies other than qualified private funds unless those QPs are also institutional investors.
• User Suitability. Member firms will be required to adopt and implement policies and procedures designed to ensure that the communication containing projected performance or targeted returns “is relevant to the likely financial situation and investment objectives of the investor receiving the communication.” This applies whether the recipient is an institutional investor or a QP. We expect this unnecessarily burdensome requirement to draw significant comment and questions as it would require member firms to analyze and determine whether the recipients of such communications “have access to resources to independently analyze [projected performance or targeted returns] or have the financial expertise to understand the risks and limitations of such presentations,” which could be costly and potentially impractical.
• Reasonable Basis. The exception will require a member firm to have “a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return.” New Supplemental Material .01 to Rule 2210 would list 13 separate factors to be considered by the member in determining whether it has a reasonable basis. In establishing a reasonable basis, members would be expected to consider these factors to the extent they are relevant and material to the analysis, but may consider other factors not listed in the rule as well. Member firms should be prepared to substantiate why they used factors other than the 13 enumerated by FINRA and why they chose not to use one or more of the 13 factors. When projected performance and targeted returns are calculated by fund managers, member firms will need to have access to the criteria and assumptions used by the person(s) creating the projected performance or target, and exercise due diligence in assessing whether there is a reasonable basis for those criteria and assumptions.
• Disclosure and Information for Users. The Proposal would require that the communication prominently disclose that the projected performance or targeted return is hypothetical in nature and that there is no guarantee that it will be achieved. The member must also provide sufficient information to enable the user to understand the criteria used and assumptions made, and the risks and limitations of using the projected performance or targeted return.

Limitation on Recipients of Projected Performance and Targeted Returns in the Proposal and Relationship to SEC Marketing Rule

The Proposal would permit the use of projected performance and targeted returns only in institutional communications and in communications with QPs about qualified private offerings. “Institutional communications” are defined in Rule 2210 as communications solely with institutional investors. “Institutional investor” is defined in FINRA Rule 2210(a)(4) to include persons described in FINRA Rule 4512(c), which are entities such as banks, insurance companies, registered investment companies, registered investment advisers, as well as any person, whether an individual or an entity, with total assets of at least $50 million, and governmental entities and certain employee benefit plans. An individual may qualify as a QP, on the other hand, with as little as $5 million in investments.¹

The Proposal provides that qualified private offerings would be those exempt from Rule 5122 pursuant to Rule 5122(c)(1)(B), or from Rule 5123 pursuant to Rule 5123(b)(1)(B). The exemption in both cases is available for offerings to QPs only. This is a wider universe of offerings than in the interpretive exception to the prohibition on use of prior related performance information. That exception is available only to offerings exempt from registration as an investment company pursuant to Section 3(c)(7) of the Investment Company Act. The Section 3(c)(7) exemption is for offerings to QPs only. However, there are private funds that use other exemptions from the Investment Company Act, such as Section 3(c)(5), but that limit sales to QPs only. Offerings by Section 3(c)(5) funds and other private funds that limit sales to QPs will be qualified private placements under the Proposal.

In an effort to increase the likelihood of SEC approval of the Proposal, FINRA drew from analogous provisions in its own rules and SEC rules, including the Marketing Rule for registered investment advisers.² Despite the similarities between the Proposal and parts of the SEC Marketing Rule, there are also notable differences. For example, whereas the Proposal limits the use of performance projections to institutional communications and communications to QPs related to qualified private offerings,³ the SEC Marketing Rule does not limit the use of hypothetical performance to an intended audience.⁴ Instead, the SEC Marketing Rule requires investment advisers to consider the sophistication of the intended audience of the communication.

Written Policies and Procedures

Akin to the SEC Marketing Rule, the Proposal requires that policies and procedures be “reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations.” Members would only be permitted to distribute communications that present projected performance or targeted returns in circumstances where they “reasonably believe[]… investors [receiving the communication] have access to resources to independently analyze [such] information or have the financial expertise to understand the risks and limitations of such presentations.” Members can satisfy this requirement by relying on past experience with particular types of institutional investors or QPs. FINRA explains that these procedures can also be tailored in such a manner that communications about securities containing projected performance and targeted returns will only be provided to persons or entities that have (1) expressed interest in particular types of securities, or (2) invested in similar securities in the past.

FINRA also reminds members that the requirements associated with this exception are in addition to the requirements set forth under Regulation Best Interest (Reg BI) in circumstances where a member recommends a securities transaction or investment strategy involving securities to an investor who is a “retail customer.” However, unlike FINRA Rule 2210 (by way of FINRA Rule 4512), which defines “retail investor” as “any person other than an institutional investor,” for purposes of Reg BI, a “retail customer” is defined to include any natural person, or the legal representative of such natural person, irrespective of the total assets or investments of such person. The question might be asked whether, with respect to projected performance and targeted returns, Reg BI already covers the duty of brokers to ensure that the information is in the best interest of the customer. The Proposal does not explain what a member firm acting as placement agent should do in a case where it determines that projected performance or targeted returns are appropriate for some potential investors in a qualified private fund but not others. May the member provide projected performance and targeted return information only to prospective investors who pass the user suitability test and not to others? In an interpretive letter on an analogous prohibition, FINRA declined to permit the use of prior related performance in marketing material for a private fund offering in communications to qualified institutional buyers (which are virtually all institutional investors), and not prospective retail investors.⁵

Reasonable Basis Requirement

Like FINRA Rules 2210 and 2241 and SEC Regulation S-K, the Proposal requires members to form and document a reasonable basis for the criteria and assumptions used in determining the projected performance or targeted returns. FINRA sets forth a nonexhaustive list of 13 factors for members to consider in a new Supplementary Material 2210.01. The factors listed in new Supplementary Material 2210.01 are:

1. “global, regional, and country macroeconomic conditions;
2. documented fact-based assumptions concerning the future performance of capital markets;
3. in the case of a single security issued by an operating company, the issuing company’s operating and financial history;
4. the industry’s and sector’s current market conditions and the state of the business cycle;
5. if available, reliable multi-factor financial models based on macroeconomic, fundamental, quantitative, or statistical inputs, taking into account the assumptions and potential limitations of such models, including the source and time horizon of data inputs;
6. the quality of the assets included in a securitization;
7. the appropriateness of selected peer-group comparisons;
8. the reliability of research sources;
9. the historical performance and performance volatility of the same or similar asset classes;
10. for managed accounts or funds, the past performance of other accounts or funds managed by the same investment adviser or sub-adviser, provided such accounts or funds had substantially similar investment objectives, policies, and strategies as the account or fund for which the projected performance or targeted returns are shown;
11. for fixed income investments and holdings, the average weighted duration and maturity;
12. the impact of fees, costs, and taxes; and
13. expected contribution and withdrawal rates by investors.”

New Supplementary Material 2210.01(b) explains that members would not be permitted to base projected performance or targeted returns on “hypothetical, back-tested performance or … the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record.”

Disclosure Requirements

FINRA does not propose a specific methodology or calculation for projected performance or targeted return. Instead, similar to the SEC Marketing Rule for registered investment advisers, FINRA expects members would provide investors with “a general description of the methodology used sufficient to enable the investors to understand the basis of the methodology as well as the assumptions underlying the projection or targeted return” (e.g., whether it is net of fees and expenses). The Proposal also requires members to include information regarding “the risks and limitations of using the projected performance or targeted return in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.”

Request for Comments

We anticipate comments from industry participants requesting additional clarity with respect to the application of the proposed amendment, and we hope changes will be made to the Proposal that will reduce the compliance burden. For example, the requirement that the member adopt and implement written policies and procedures “reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor” seems to us unnecessarily burdensome and could be removed when taking into account (1) that the material is only used with institutional investors and QPs, and (2) the independent suitability requirements of FINRA Rule 2111 and SEC Reg BI. All comments related to this Proposal are due by December 15, 2023.

 

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^[1] 15 USC § 80a-2(a)(51).
^[2] 17 CFR § 275.206(4)-1.
^[3] FINRA Rule 2210 (d)(1)(F)(iv)(A).
^[4] 17 CFR § 275.206(4)-1(d)(6).
^[5] FINRA Interpretive Letter to Budge Collins, Collins Bay/Island Securities, Sept. 14, 2004. (“By restricting the dissemination of such information to QIBs, there is the possibility that those potential investors who qualify as QIBs will be treated differently than other potential investors and will have access to information that is not available to others.”)

 

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.