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FINRA Amends Rules 5110 and 5121 Related to Corporate Financing and Conflicts Of Interest

 On April 28, 2014 and on May 7, 2014, the SEC approved the Financial Industry Regulatory Authority’s (FINRA) amendments to Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements) and 5121 (Public Offerings of Securities with Conflicts of Interest) in order to simplify and refine the scope of the rules.  FINRA is the self-regulatory body that regulates and governs securities firms.  All securities firms are required to be licensed broker-dealers and are required to be members of FINRA.

FINRA rules and regulations are subject to review and approval by the SEC.  Section 15A of the Securities Exchange Act of 1934, as amended, requires that FINRA rules be “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and in general, to protect investors and the public interest.”

Together the Rule 5110 and 5121 amendments:

  • Amend the definition of “participation or participating in a public offering” to exclude members that act as a financial advisor or consultant to an issuer without direct involvement in the distribution of securities;
  • Exclude from the current lock-up restrictions of Rule 5110 certain securities acquired or converted by a member as a result of an issuer reorganization or to prevent dilution;
  • Amend affiliation disclosures to only include affiliations with participating members using the new narrower definition of “participating”;
  • Amend the definition of “control” in Rule 5121 related to conflicts of interest; and
  • Expand the circumstances under which participating members may receive termination fees and rights of first refusal for future services.

Rule 5110 – Corporate Financing Rule – Underwriting Terms and Arrangements

In General

Rule 5110 regulates underwriting compensation and prohibits unfair arrangements in connection with the public offerings of securities.  The Rule prohibits member firms from participating in a public offering of securities if the underwriting terms and conditions, including compensation, are unfair as defined by FINRA.  The Rule requires FINRA members to make filings with FINRA disclosing information about offerings they participate in, including the amount of all compensation to be received by the firm or its principals, and affiliations and relationships that could result in the existence of a conflict of interest.  In addition, the Rule limits certain compensation such as termination or tail fees and rights of first refusal and imposes lock-up restrictions related to the sale or transfer of securities received as compensation.  The lock-up restrictions apply to a period beginning six months prior to the initial filing of a registration statement with the SEC and end 90 days following the effectiveness of the registration statement.

The Rule 5110 amendments (i) narrow the scope of the definition of “participation or participating in a public offering”; (ii) modify lock-up restrictions to exclude securities acquired or converted to prevent dilution; and (iii) clarify that information required to be filed with FINRA only apply to “participating” members.  One of the goals of the rule change is to allow issuers to seek advice, including investment banking advisory services, from member securities firms without that member being deemed to be participating in an offering.

Independent Financial Advisor Exception

Specifically, amended Rule 5110 provides that an “independent financial adviser” that provides advisory or consulting services to the issuer would not meet the definition of “participation in a public offering” as defined in Rule 5110(a)(5) and would therefore not be subject to the compensation limitations of Rule 5110, lock-up period and information filing requirements. The amended Rule defines an independent financial adviser as “a member that provides advisory or consulting services to the issuer and is neither engaged in, nor affiliated with any entity that is engaged in, the solicitation or distribution of the offering.”  The Rule will allow issuers to engage member firms to provide advice and consultation regarding financing options, the advantages and disadvantages of these options, the terms and conditions of an underwriting proposed by another member firm (assuming the advisory and underwriter firm are independent of each other), and all matters of corporate finance without automatically being deemed to be engaged in a public offering should one ensue.  If the securities firm also engages in solicitation or distribution activities in addition to providing advisory or consulting services, the exclusion of the advisory-related compensation would not be available and all of the compensation received by that firm in connection with the offering would be subject to the compensation limitations and disclosure requirements.

Lock-Up Provisions

Rule 5110 generally includes all items of value as underwriting compensation including restricted securities received or to be received in the six months prior to the filing of a registration statement, subject to certain exceptions.  The Rule provides five exceptions that permit participating members to acquire securities of the issuer during that 6-month period without the securities being deemed to be underwriting compensation.  In particular, excluded from the definition of underwriting compensation is the receipt of additional securities to prevent dilution of the investor’s investment (e.g., securities acquired as a result of a stock-split or a pro-rata rights or similar offering) as long as the original securities were acquired before the six-month period.  Although these securities have been excluded from the definition of underwriter’s compensation, they were previously included in lock-up restrictions.  The amended Rule also excludes these securities from the lock-up provisions.

Information Filing Requirements

Rule 5110 requires members “participating in an offering” to make certain filing and disclosures to FINRA including affiliations between the member and any officer, director or control shareholder of the issuer, or beneficial ownership of securities of the issuer and control relationships with the issuer.  For purposes of determining “control,” Rule 5121 is cross-referenced.  The Rule amendment narrows the definition of “participating” and therefore narrows the scope of member firms that must file affiliation disclosures with FINRA.  Firms that provide independent financial advisory services to issuers without participating in an offering will not be required to make filings with FINRA to disclose affiliations.

In addition, as discussed below, Rule 5121 is amended to narrow the definition of “control” and therefore narrow Rule 5110 related reporting requirements.

Termination (“Tail”) Fees and Rights of First Refusal

On May 7, 2014, the SEC approved changes to Rule 5110 related to certain underwriting compensation.

The Rule amendment expands the circumstances under which member firms may charge termination fees and may include rights of first refusal as part of their underwriting compensation.  A termination fee is a fee charged when a public offering is not completed in accordance with the agreement between the underwriter and issuer.  Generally termination or “tail” fees are prohibited.

The Rule amendment permits termination fees where: (i) the agreement between the participating member and the issuer specifies that the issuer maintains the right to terminate “for cause” without the imposition of a fee; (ii) a termination “for cause” eliminates any obligations with respect to the payment of a termination fee; (iii) the amount of the termination fee is reasonable in relation to the services to be performed; and (iv) the fee is not payable unless the issuer completes an offering with a different member firm within two years from the termination date (the “tail” fee).

A right of first refusal generally provides a member firm with the right to underwrite or participate in future public offerings, private placements or other financings of the issuer.  Rule 5110 prohibits rights of first refusal that extend beyond three (3) years from the date of the current public offering or grant the member firm more than one opportunity to charge a fee to waive or terminate such right of first refusal.

The Rule amendment permits rights of first refusal where: (i) the agreement between the participating member and the issuer specifies that the issuer maintains the right to terminate “for cause”’ (ii) a termination “for cause” eliminates any obligations with respect to the right of first refusal; and (iii) any fees arising from services provided under the right of first refusal are customary for those types of services.  The three (3)-year limitation is unchanged and is counted from the date the public offering commences or is terminated as the case may be.

Rule 5121 – Public Offerings of Securities with Conflicts of Interest

Where Rule 5110 requires the disclosure of affiliations, Rule 5121 goes further and prevents member firms from participating in offerings where certain conflicts of interest exist.  Member firms are prohibited from participating in a public offering where certain conflicts exist, including where the issuer is controlled by or under common control with the FINRA member firm or is associated persons.  Control historically included being a holder of 10% or more of the debt of the issuer.  The amended Rule narrows the scope of the definition of “control” by eliminating the debt holder provision.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

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