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How to be a broker dealer

how to be a broker dealer

Authors: Julia D. Corelli. Gregory J. Nowak and Brian S. Korn

New FINRA Rule 5123 is now applicable and investment funds need to be cognizant of its requirements. Approved last June, 1 Rule 5123 requires FINRA member firms (principally broker-dealers) participating in private placements of securities to file with FINRA any private placement memorandum, term sheet or other offering document the FINRA member used in the transaction. The documents must be filed within 15 calendar days following the date of first sale. However, there are – of course – a number of important exclusions, described below, which may except the broker-dealer from the reach of Rule 5123.

Requirements of New FINRA Rule 5123

FINRA Rule 5123 is effective for any transaction that began selling efforts on or after December 3, 2012. Under the Rule, the FINRA member firm must upload any relevant disclosure documents or term sheets in searchable PDF format to FINRA through a new online Private Placement Filing System available through the FINRA Firm Gateway.

If no disclosure documents were used in the private placement, the firm must upload a statement on the Firm Gateway that no such documents were used. For transactions with multiple member firms, only one firm needs to submit the responsive documents on behalf of all firms in the transaction. The firms, not the issuer, designate the one with the responsibility. However, failure by the designated firm to make the required filing will be considered a violation of Rule 5123 by all participating firms.

If a submitted document undergoes material changes, the member firm must file the revised document. All filings will be afforded confidential treatment. Exemptions from filing are available for good cause. Noncompliance can result in fines and suspensions for the FINRA member.

Exclusions to Rule 5123 Filings

Importantly, the following types of private placements, among others, 2 are excluded from the filing requirements of Rule 5123:

  • placements of exempt securities under Section 3(a)(12) of the Securities Exchange Act of 1934, as amended
  • placements made pursuant to Rule 144A (among qualified institutional buyers or “QIBs” 3 ) or Regulation S (offshore) under the Securities Act of 1933, as amended (Securities Act)
  • placements solely to:
    • institutional accounts (as defined in FINRA Rule 4512(c))
    • qualified purchasers (as defined in Section 2(a)(51)(A) of the Investment Company Act of 1940, as amended (Investment Company Act))
    • investment companies
    • banks
    • employees and affiliates of the issuer
    • knowledgeable employees (under Rule 3c-5 of the Investment Company Act), and
    • institutional accredited investors under Rule 501 of Regulation D under the Securities Act.

Pepper Points:

  • Natural persons who are accredited investors must meet an exception other than the “accredited investor” exception that is part of Rule 5123 (such as the qualified purchaser, knowledgeable employee or institutional account ($50 million or more) exceptions) for sales to such persons not to trigger the requirements of Rule 5123.
  • A sale to even one person not meeting the exception requirements requires a filing under Rule 5123 – there is no de minimis exception.

Implications for Funds in the Fundraising Process

Rule 5123 raises important questions for private equity, venture, hedge and other pooled investment funds that rely on Regulation D’s private placement exceptions. Hedge funds generally engage in more prolonged fundraising efforts, whereby investing clients can periodically or episodically invest funds at net asset value. Private equity and venture funds tend to raise capital on an intensive basis early in the life of the fund, and then deploy the capital before again entering fundraising mode. While neither of these, in our view, presents risks associated with the high-pressure private placement sales that the rule was designed to address, FINRA members are nonetheless often involved in sales and marketing efforts on behalf of funds. Absent clarification to the contrary from FINRA, 4 we recommend that fund clients – other than those that are so-called “qualified purchaser funds” exempt from Investment Company Act registration by reason of Section 3(c)(7) under the Investment Company Act of 1940 – take a broad view of Rule 5123 and require compliance by brokers who serve as formal or informal private placements agents.

Fund Compliance with Rule 5123

Commencement Date

Rule 5123 does not apply to private placements that began selling efforts prior to December 3, 2012. Therefore, filings would only apply for new funds and new fundraising starting on or after December 3, 2012. Nevertheless, we would caution funds that any new marketing push or initiative for an existing fund may be viewed as a new private placement by FINRA, and therefore a filing might be appropriate out of an abundance of caution. Filings must be made within 15 calendar days after the date of first sale by that FINRA member.

Pepper Point:

  • As noted above, a filing can be made by a FINRA member on behalf of all other members participating in the private placement, so long as it is made within 15 calendar days after the date of first sale by any FINRA member in the group covered by the filing. This will be particularly helpful for fund families that may have multiple broker-dealers or in situations where multiple broker-dealers act as placement agents for a fund. While it is incumbent on the FINRA members to coordinate which of them will make the filings through the FINRA Firm Gateway, fund managers need to pay attention to their compliance so that they are not later tripped up when they have to give representations (to investors, lenders or others) or obtain legal opinions that an offering was made in compliance with all laws.

Filing Requirements

FINRA members who are or who work with funds, including affiliate funds, in connection with marketing and fundraising efforts will need to ensure they employ procedures for compliance with Rule 5123. All marketing materials, private placement memoranda, offering memoranda, term sheets and other fund disclosure, whether on paper or in an electronic format, should be assembled into a PDF format and filed with FINRA on the new Private Placement Filing System available on FINRA’s Firm Gateway within 15 calendar days after the date of first sale. In addition, Web site content that may fall into any of the above categories should also be similarly filed, whether on the fund’s or the member’s Web site. Although the filings are afforded confidential treatment

by FINRA, funds and FINRA members alike should take special precaution in preparing their marketing and offering materials (including online content), as it may receive closer scrutiny by a regulator.

  • Issuers will want to ensure that only the most current versions of selling materials are sent to FINRA by their placement agents. While offering documents can be updated anytime – and must be updated for material changes – it is customary for a selling document to be in use for quite some time for consistency in the offering. The filing requirement of an issuer’s broker is yet another reason that the issuer will want to prepare timely updates.
  • Whenever there is a material supplement or addendum, the rule requires the selling broker to file the amendment or supplement with FINRA to the extent that sales by the broker covered by Rule 5123 (or another broker in the group covered by the filing) occur after the date of the amendment or supplement. To be clear, the subsequent sale after the adoption of the supplement or amendment is what triggers the filing update.
  • For private equity funds, Rule 5123’s update requirement is less likely to represent a significant consideration since fundraising periods are finite (though they may not feel that way) and usually have relatively few amendments and supplements; but material updates and corrections may highlight information for use in an SEC exam if the fund manager is a registered adviser.
  • For broker-dealer-sold funds that engage in ongoing, open-ended offerings, brokers are likely to require periodic updates of offering materials that are still being used and to submit those amendments to FINRA. While the rule breaks no new ground (other than the filing/notice requirement)i.e.. issuers were always required to ensure that their offering materials were up-to-date and not materially misleading – the very placement of documents with FINRA makes them subject to greater scrutiny. It will be much harder for a fund to sell off of a “stale” but materially correct PPM, if the fund is using a FINRA-registered placement agent (as it must for placements in the United States).
  • The SEC’s proposed relaxation of the prohibition on general solicitation and general advertising in connection with Regulation D Rule 506 private placements, 5 as required by Section 201(a) of the JOBS Act, 6 is expected to result in an increase in fund marketing and advertising, especially online. FINRA members participating in such efforts should be mindful of the requirements of Rule 5123 when enhancing or updating sales materials or online content.
  • FINRA members must be mindful of the information that will have been published by the fund on its Web site and undertake an analysis of whether Web site material also needs to be filed.

Best Practices When Engaging a Placement Agent

Funds engaging in fundraising with a FINRA broker-dealer or member should remind such firm of its obligations under Rule 5123. Placement agent agreements that call for the placement agent to comply with all applicable laws and regulations may need to be supplemented to specifically refer to Rule 5123, and the agent’s obligation to update its filings under the rule. It may be necessary for the fund to agree to cooperate with the agent in filing the correct materials. Exoneration and indemnification provisions may need tailoring so that liability for failure to comply clearly remains with the non-performing party (the broker if it fails to file the necessary information; the fund if it fails to provide the memorandum supplements as may be necessary). Credit facility agreements may also need to take Rule 5123 into account in covenants that address compliance with laws. A broker’s failure to comply with Rule 5123 or an issuer’s failure to provide supplements as necessary to enable them to do so could trigger a breach of covenant and loan default.

Changes to FINRA Rule 5122 Filing Process

In Regulatory Notice 12-40 announcing the implementation of Rule 5123, FINRA also noted that filings required by FINRA Rule 5122 must also be made by uploading documents to the new Private Placement Filing System. Rule 5122 was enacted in June 2009 and requires that FINRA members who undertake private placements of their own securities (called “member private offerings”) must provide prospective investors with either a private placement memorandum, term sheet or statement setting forth at a minimum the use of proceeds, offering expenses and selling compensation to be paid to the member or its affiliate. At least 85 percent of the proceeds must be used for business purposes, which does not include offering compensation, costs or expenses. Rule 5122 contains a list of excluded transactions that is similar (but not identical) to the excluded transactions list contained in Rule 5123.

Pepper Point:

  • Note that unlike Rule 5123, Rule 5122 affirmatively requires investor disclosure of use of proceeds and offering expenses of a member private offering, and caps total fees and expenses. FINRA confirmed in adopting Rule 5123, however, that it is not adopting enhanced disclosure beyond what would be required by the securities laws. Therefore, in many private placements a disclosure document will not be required, but still may be advisable. The original proposal of Rule 5123 would have required the same delivery of a term sheet or use of proceeds statement to prospective investors in non-member private offerings as Rule 5122 requires in member private offerings.

Key Takeaway for Funds

Both FINRA Rules 5122 and 5123 are post-closing notice filings, which will not be reviewed, commented on or approved by FINRA. Filings will also not be required for most private placements made solely to institutions. But the rules are an attempt to systematically track processes that were previously supervised on a one-off basis through complaint investigations and compliance examinations. Look for this trend to continue as regulators grapple with balancing efficient capital-raising with investor protection.

Please contact any of the authors or your regular Pepper Hamilton contact with any questions regarding this Fund Services Alert.


3 Generally, a QIB is an institutional investor with at least $100 million of investment securities of non-affiliates, or an entity comprised solely of QIBs. For the complete definition of a QIB, please follow this link to Rule 144A(a)(1):


4 FINRA has recently published a “frequently asked questions” relating to Rule 5123, which can be found on the FINRA Web site by following this link: Unfortunately, the applicability to funds is not addressed.

Category: Forex

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