No Comment
SEC Proposes Rule Amendments to Allow General Solicitation and General Advertising in Rule 506 Offerings

The Securities and Exchange Commission proposed yesterday, August 29, 2012, amendments to Rule 506 of Regulation D and Rule 144A under the Securities Act of 1933 as directed by the Jumpstart Our Business Startups Act. The SEC proposed new Rule 506(c) which allows general solicitation and general advertising, provided that all purchasers are accredited investors, the issuer takes reasonable steps to verify that the purchasers are accredited investors, and the satisfaction of certain other terms and conditions of Regulation D. The SEC also proposed amendments to Rule 144A allowing offers to persons other than qualified institutional buyers, including through general solicitation, provided that the securities are sold only to persons that the seller or its representative reasonably believe are qualified institutional buyers.

I. Background

A. Current Framework

Section 5 of the Securities Act of 1933 (“Securities Act”) requires that every time a security is sold, it either must be registered with the Securities and Exchange Commission (“SEC”) or exempt from registration. Section 4(a)(2) of the Securities Act exempts transactions by an issuer “not involving any public offering.”

Rule 506 of Regulation D, one of the safe harbors available under Section 4(a)(2), exempts private offerings from registration requirements of the Securities Act of 1933. Currently, Rule 506 allows offers and sales by issuers without any limitation on the offering amount, to an unlimited number of “accredited investors”[1] and up to 35 non-accredited sophisticated investors,[2] subject to certain requirements and conditions, including Rule 502(c)’s requirement that any offer or sale may not be through any form of “general solicitation or general advertising.” By rule and interpretation, examples of “general advertising” include newspaper and magazine, communications broadcast over television and radio, seminars whose attendees were invited by general solicitation, and other uses of publicly available media, such as unrestricted websites. To demonstrate that a general solicitation has not occurred, the issuer or its agent must have a pre-existing, substantive relationship with the potential investor. A substantive relationship exists when the issuer has information regarding a potential offeree such that the issuer can evaluate the prospective offeree’s sophistication and financial circumstances. A relationship is pre-existing if it existed for some duration prior to the current private offering.[3]

Rule 144A is a safe harbor exemption from the registration requirements of the Securities Act for resales of certain “restricted securities”[4] to qualified institutional buyers (“QIBs”). Currently, Rule 144A provides offers of securities only to QIBs, which has the practical effect of a prohibition against general solicitation.

The estimated capital raised in 2011, based off of debt and equity Form D filings, through Rule 506 and Rule 144A offerings was $895 billion and $168 billion, respectively (or approximately $1,063 billion combined), compared to $984 billion raised in registered offerings.

B. Section 201(a) of the JOBS Act

The Jumpstart Our Business Startups Act (the “JOBS Act”) was enacted on April 5, 2012. Section 201(a) thereof directed the SEC to modify certain rules within 90 days of its enactment.

Section 201(a)(1) of the Jumpstart Our Business Startups Act (the “JOBS Act”) directed the SEC to amend Rule 506 of Regulation D to permit general solicitation or general advertising in offerings made under Rule 506, provided that all purchasers of the securities are accredited investors, and that the issuer shall be required “to take reasonable steps to verify that purchasers of the securities are accredited investors[.]”

Section 201(a)(2) of the JOBS Act directed the SEC to revise Rule 144A(d)(1)11 under the Securities Act to permit offers of securities pursuant to Rule 144A to persons other than QIBs, including by means of general solicitation or general advertising, provided that the securities are sold only to persons that the seller and any person acting on behalf of the seller reasonably believe are QIBs.

II. Proposed Amendments to Rule 506 and Related Issues

A. Proposed New Rule 506(c)

Proposed Rule 506(c) would permit the use of general solicitation, and not be subject to compliance with Rule 502(c), to offer and sell securities under Rule 506,[5] provided the following conditions are satisfied:

  • the issuer must take reasonable steps to verify that the purchasers of the securities are accredited investors;
  • all purchasers of securities must be accredited investors, either by way of one of the enumerated categories in Rule 501(a) or the issuer reasonably believes that they do, at the time of the sale of the securities;
  • and all terms and conditions of Rule 501 and Rules 502(a) and 502(d) must be satisfied.

NOTE: Broker-dealers participating in offerings relying on proposed Rule 506(c) would continue to be subject to the rules of FINRA regarding communications with the public. See FINRA Rule 2210.

B. Reasonable Steps to Verify Accredited Investor Status

The SEC proposes an objective standard, based on the particular facts and circumstances, that issuers are required to “take reasonable steps to verify” that the purchasers are accredited investors. Examples of the non-exclusive and interconnected factors include:[6]

  • the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
    • Verification varies depending on type of accredited investor – e.g. a broker-dealer’s status could be checked on FINRA’s BrokerCheck website
  • the amount and type of information that the issuer has about the purchaser; and
    • The more information an issuer has indicating that a prospective purchaser is an accredited investor, the fewer steps it would have to take, and vice versa
    • Examples of information include: publicly available information in filings with a federal, state or local regulatory body; W-2, personal bank and brokerage account statements; average annual compensation as provided in industry/trade publications; and reasonable reliance on verification by broker-dealer, attorney or accountant.
  • the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
    • The more public the offering (e.g. website or media versus pre-screened database by reasonably reliable third-party), the more information to verify
    • Ability to meet high minimum investment, not through financing

In addition, the SEC provides the following additional guidance for compliance: (i) issuers should retain adequate records that document the steps taken to verify that a purchaser was an accredited investor[7] and (ii) many practices currently used by issuers in connection with existing Rule 506 offerings are anticipated to satisfy the proposed verification requirements.

C. Reasonable Belief that All Purchasers Are Accredited Investors

The proposal clarifies the intent that the reasonable belief standard will continue to apply to Rule 506(c). If a person purchases securities who does not meet the criteria for any category of an accredited investor in a Rule 506(c) offering, the SEC believes that the issuer would not lose the ability to rely on the proposed Rule 506(c) exemption, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor.

D. Form D Check Box for Rule 506(c) Offerings

SEC proposal only adds or amends check boxes on Form D relating to the type of federal exemptions and exclusions claimed, including Rule 506(c) under Item 6 of Form D.

E. Specific Issues for Privately Offered Funds

The SEC interprets the directive contained in the JOBS Act to apply to the two common exemptions claimed by hedge funds from the provisions of the Investment Company Act of 1940.[8] Section 3(c)(1) excepts from the definition of investment company a fund that meets two requirements: (i) it must be beneficially owned by less than 100 persons and (ii) “which is not making and does not presently propose to make a public offering of its securities.” Section 3(c)(7) applies to any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are “qualified purchasers,” and which is not making and does not at the time propose to make a public offering of such securities. As the SEC has historically regarded Rule 506 transactions as non-public offerings for the purposes of Sections 3(c)(1) and 3(c)(7), they believe the effect of the JOBS act is to permit such privately offered funds to make a general solicitation under the proposed Rule 506(c) without losing the exclusions under the Investment Company Act.

IV. Proposed Amendment to Rule 144A – Offers to Persons Other Than Qualified Institutional Buyers

SEC proposes to amend Rule 144A(d)(1) to eliminate the references to “offer” and “offeree,” which would allow for general solicitation, but the limitation as to the purchasers remain – securities must be sold to a QIB or a purchaser that the seller and any person acting on behalf of the seller reasonably believe is a QIB.

IV. Integration with Offshore Offerings

The SEC clarifies that, consistent with historical treatment, concurrent offshore offerings that are conducted in compliance with Regulation S would not be integrated with domestic unregistered offerings that are conducted in compliance with Rule 506 or Rule 144A, as proposed to be amended. Therefore, in a global offering where the United States portion is conducted in accordance with proposed rule 506(c) or proposed amended Rule 144A, it would not run afoul of the second of the two general conditions for safe harbor under Regulation S – no directed selling effort in the United States.[9]

V. Comments

The SEC requests comments within 30 days of publication on the proposal, including its operation, procedure and alternatives.

Full Text of Proposal: Release No. 33-9354


[1] Rule 501(a) of Regulation D

[2] Rule 506(b)(2)(ii) requires non-accredited investors, up to 35, to have “such knowledge and experience in financial and business matters that he [or she] is capable of evaluating the merits and risks of the prospective investment.”

[3] E.F. Hutton & Company Incorporated, SEC No Action Letter, December 3, 1985.

[4] “Restricted securities” include, in part, “[s]ecurities acquired directly or indirectly from the issuer, or from an affiliate of the issuer, in a chain of transactions not involving a public offering.” Rule 144(a)(3) of the Securities Act.

[5] Existing Rule 506(b) would be preserved for issuers not interested in general solicitation or that wish to sell privately up to 35 non-accredited investors meeting its sophistication requirements.

[6] The SEC specifically avoided any exclusive or non-exclusive list and further provides that the factors are interconnected – the information gained by looking at factors would help assess likelihood of being an accredited investor and thus, affect the types of steps required to verify.

[7] An issuer claiming an exemption from the registration requirements of Section 5 of the Securities Act has the burden of showing that it is entitled to that exemption.

[8] Section 3(a)(1) of the Investment Company Act of 1940 defines an investment company as any issuer of securities which “is or holds itself out as being engaged primarily or proposes to engage primarily, in the business of investing, reinvesting or trading in securities.”

[9] Rule 902(c)(1) “directed selling effort” is broadly defined as “conditioning the market” in the U.S. for any of the securities offered in reliance on Regulation S, which includes placing an advertisement in a publication “with a general circulation in the United States” referring to the Regulation S offering.

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No Comment
FINRA Requests Comment on Proposed Regulation of Crowdfunding Activities – Regulatory Notice 12-34

On July 5, 2012, FINRA published Regulatory Notice 12-34 requesting public comment on the scope of FINRA regulation that would be appropriate for member firms active in crowdfunding offerings.


The Jumpstart Our Business Startups Act (JOBS Act) contains key provisions relating to securities offered or sold through “crowdfunding.” The crowdfunding provisions of the JOBS Act provide an exemption from registration under the Securities Act of 1933 (Securities Act) for securities offered by issuers in amounts of up to $1 million over a 12-month period provided that the amount raised from any single investor adheres to strict limits (ranging from $2,000 to $100,000) based on the investor’s annual income or net worth.

The crowdfunding exemption establishes specific eligibility and sales practice standards for issuers and intermediaries that engage in crowdfunding. Intermediaries that seek to engage in crowdfunding must be registered as a broker or a funding portal, a newly created entity. The regulatory scheme established by the JOBS Act requires that each registered funding portal be a member of an applicable self-regulatory organization (such as FINRA), but limited authority to rules “written specifically for registered funding portals.”

Comments Requested

Funding Portals – possible rules concerning:

  • Supervision
  • Advertising
  • Anti-money laundering
  • Fraud and manipulation
  • Just and equitable principles of trade

Broker-Dealers – application of existing FINRA Rules to broker-dealer’s crowdfunding activities:

  • Relaxing existing rules for crowdfunding activities
  • Isolate crowdfunding activities from other activities
  • Implement the limitation on crowdfunding similar to funding portals
  • Special conflicts, such as a registered representative referring a client to the crowdfunding portal of the broker-dealer

Comments requested by August 31, 2012.

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No Comment
Net Worth Standard for Accredited Investors – Securities Act Release No. 9287

On December 21, 2011, the Securities and Exchange Commission, in Securities Act Release No. 9287, amended net worth standard in the definition of “accredited investor” excluding the value of a person’s home from net worth calculations in order to participate in unregistered securities offerings as required by the Dodd-Frank Wall Street Reform Act and Consumer Protection Act (the “Dodd-Frank Act”). The amendments clarify the treatment of borrowing secured by a primary residence for purposes of the net worth calculation and under limited circumstances, permit persons who previously qualified as accredited investors pre-Dodd-Frank Act to use the prior net worth standard definition for certain follow-on investments.


The most significant revisions from the proposed rule include the addition of (i) a grandfathering provision that permits the application of the former accredited investor net worth test in certain limited circumstances and (ii) a provision addressing the treatment of incremental debt secured by the primary residence that is incurred in the 60 days before the purchase of securities.

Grandfather Provision

The grandfather provision allows an investor to re-invest in a particular security under the pre-Dodd-Frank Act definition of net worth if the following requirements are satisfied: (i) the right to purchase was held by the person on July 20, 2010 (day before the effectiveness of the Dodd-Frank Act); (ii) person qualified as an accredited investor on the basis of net worth at the time of acquiring such right; and (iii) person actually held securities of the same issuer, other than such right, on July 20, 2010.

Mortgage Debt

Under the amended net worth calculation, indebtedness secured by the person’s primary residence, up to the estimated fair market value of the primary residence, is not treated as a liability. Exceptions include indebtedness secured by a person’s primary residence in excess of the property’s estimated fair market value or borrowing that occurs in the 60 days preceding the purchase of securities in the exempt offering and is not in connection with the acquisition of the primary residence. In both cases, the excess debt or the recent debt acquired must be treated as a liability in the net worth calculation.

Of importance, the 60 day look-back provision was intended to prevent manipulation of the net worth standard by eliminating the ability of individuals to artificially inflate net worth by borrowing against home equity shortly before participating in an exempt securities offering. Further, the rules do not require a third party opinion on valuation of the primary residence or for any other assets or liabilities – only an estimate of fair market value.

Amended Net Worth Standard 

The individual net worth standard in the accredited investor definition in Rule 501 and 215 of the Securities Act of 1933 is:

Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000.

(1) Except as provided in paragraph (2) of this section, for purposes of calculating net worth under this paragraph:

(i) The person’s primary residence shall not be included as an asset;

(ii) Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of the sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and

(iii) Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability.

(2) Paragraph (1) of this section will not apply to any calculation of a person’s net worth made in connection with a purchase of securities in accordance with a right to purchase such securities, provided that:

(i) such right was held by the person on July 20, 2010;

(ii) the person qualified as an accredited investor on the basis of net worth at the time the person acquired such right; and

(iii) the person held securities of the same issuer, other than such right, on July 20, 2010.

Other Issues Considered

The SEC determined to not change the proposed rules to:

  • Define “primary residence”
  • Generally, exclude debt secured by a primary residence whether or not the proceeds were used to invest in securities (except for the 60 day look-back provision)

Effective Date: 60 days after publication in the Federal Register

If you have any questions on Securities Act Release No. 9287 or any other legal matter, please contact any of the partners at Evans & Kob, PC at info@eklawpc.com.

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No Comment
Updated: New Account Application Template

FINRA recently updated the New Account Application Template to reflect FINRA’s new suitability rule. The template is a voluntary model that was designed for firms to use when creating or modifying their own account applications.

Some of the significant features of the template include:

  • Instructions and other information presented in plain-English,
  • Highlights of key disclosures, and
  • Incorporation of related investor education information.

This voluntary template can be customized, so that firms can modify the form to meet their own branding, business practices and operational requirements. Keep in mind that use of the voluntary template in whole or in part does not guarantee compliance with or create any safe harbor with respect to FINRA Rules, the federal securities laws or state laws.

Contact Evans & Kob PC for experienced regulatory and legal counsel regarding broker-dealer operations counsel, including drafting new account forms and customer agreements, or any broker-dealer and investment adviser, arbitration, regulatory or securities matter at info@eklawpc.com.

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No Comment
FINRA Cannot Collect Fines Against Barred Members through Court

On October 5, 2011, the Second Circuit in Fiero v. Financial Industry Regulatory Authority, Inc. held that FINRA was not authorized under the Securities Exchange Act of 1934 to enforce disciplinary fines through judicial enforcement.


Apellants, Fiero Brothers, Inc., was a FINRA member firm and broker-dealer registered with the SEC and John J. Fiero was the sole registered representative of Fiero Brothers, and both were subject to FINRA, and its predecessor, the NASD.

In 1998, the Department of Enforcement initiated disciplinary proceedings against Appellants with a hearing panel holding that Appellants violated Section 10(b) of the Securities Exchange Act of 1934, Rule 10b-5 thereunder, and FINRA Conduct rules 2110, 2120 and 3370 and as a result, barred Fiero from association with any member firm and issued a fine of $1 million, jointly and severally. FINRA National Adjudicatory Council (“NAC”) affirmed the decision in its entirety.

Procedural History

Appellants refused to pay the fine and FINRA instituted an action in New York Supreme Court. NY Supreme Court upheld the fines based on ordinary principles of contract law recognizing the right of a private membership organization to impose fines on its members, when authorized to do by statute, charter or by-laws.

Appellate courts in New York initially upheld the Superior Court decision, but granted leave to appeal, and in February 2008, reversed the decision on the ground that state courts lacked jurisdiction – the FINRA complaint constituted an action to enforce a liability or duty created under the Exchange Act, and therefore, fell within the exclusive jurisdiction of the federal courts pursuant to 15 U.S.C. § 78aa.

The United States District Court for the Southern District of New York entered judgment for FINRA based on applicable state contract law.


The Exchange Act does not provide FINRA with the necessary authority

While Section 15A(b) of the Exchange Act, FINRA and other self-regulatory organizations (SROs) have a statutory authority and obligation to appropriately discipline members for violations, there is no express authority or Congressional intent for SRO’s to bring judicial actions to enforce the collection of fines.

1990 Rule Filing does not provide FINRA with authority

FINRA filed a rule proposal with the SEC pursuant to Section 19(b)(1) of the Exchange Act NASD stated its intent “to pursue other available means for the collection of fines and costs imposed…in disciplinary decisions.” The NASD reiterated the policy Notice to Members 90-21.

However, the court determined that for “FINRA to have obtained authority [thereunder], the rule must have been properly promulgated under the procedures established by the Exchange Act [and it] was not.” Section 19(b) of the Exchange Act requires SRO’s must file any proposed rule change with the SEC, with a general statement of the basis and purpose, and then the SEC is required to publish notice and give interested individuals an opportunity to comment prior to either approving or disapproving the rule.

While FINRA (then NASD) defined such rule as “House-Keeping,” whereby FINRA was just stating a current policy of an existing rule, the Court determined that this was not “simply a stated policy change…that could bypass the required notice and comment period of Section 19(b)[, but rather,] it was a new substantive rule.” Therefore, the rule was never properly promulgated and “cannot authorize to judicially enforce the collection of its disciplinary fines.”

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No Comment
SEC’s Whistleblower Program is Officially Launched

On Friday, August 12, 2011, the Securities and Exchange Commission’s much discussed whistleblower program became effective with the launch of a new webpage for people to report a violation of the federal securities laws and apply for a financial award and the introduction of the new Office of the Whistleblower.

To be considered for an award, the final rules require that a whistleblower must:

  • Voluntarily provide the SEC …
    • In general, a whistleblower is deemed to have provided information voluntarily if the whistleblower has provided information before the government, a self-regulatory organization or the Public Company Accounting Oversight Board asks for it directly from the whistleblower or the whistleblower’s representative.
  • … with original information …
    • Original information must be based upon the whistleblower’s independent knowledge or independent analysis, not already known to the SEC and not derived exclusively from certain public sources.
  • … that leads to the successful enforcement by the SEC of a federal court or administrative action …
    • A whistleblower’s information can be deemed to have led to a successful enforcement action if:
    1. The information is sufficiently specific, credible and timely to cause the Commission to open a new examination or investigation, reopen a closed investigation, or open a new line inquiry in an existing examination or investigation.
    2. The conduct was already under investigation when the information was submitted, and the information significantly contributed to the success of the action.
    3. The whistleblower reports original information through his or her employer’s internal whistleblower, legal, or compliance procedures before or at the same time it is passed along to the SEC; the employer provides the whistleblower’s information (and any subsequently-discovered information) to the SEC; and the employer’s report satisfies prongs (1) or (2) above.
  • … in which the SEC obtains monetary sanctions totaling more than $1 million.
    • The rules permit aggregation of multiple SEC cases that arise out of a common nucleus of operative facts as a single action. These may include proceedings involving the same or similar parties, factual allegations, alleged violations of the federal securities laws, or transactions or occurrences.

A successful blower may be entitled to 10-30% of the SEC sanctions over $1 million.

Contact Evans & Kob for experienced regulatory and legal counsel regarding whistleblower claims or any broker-dealer and investment adviser, arbitration, regulatory or securities matter at info@eklawpc.com.

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No Comment
SEC, FINRA Warn Retail Investors About Investing In Structured Notes With Principal Protection

On June 2, 2011, the Securities and Exchange Commission’s Office of Investor Education and Advocacy and the Financial Industry Regulatory Authority (FINRA) have issued an investor alert called Structured Notes with Principal Protection: Note the Terms of Your Investment to educate investors about the risks of structured notes with principal protection, and to help them understand how these complex financial products work.

For investors considering such an investment, one should be mindful that structured notes with principal protection can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth, the lack of liquidity on your principal and the possibility of no profit on their initial investment.

For more information, please review “Structured Notes with Principal Protection: Note the Terms of Your Investment” on the Securities and Exchange Commission’s website, which includes a list of suggested questions investors should ask before investing in these type of products.

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No Comment
Focus on Sales Literature and Advertising: Tips, Procedures and the BD Use Only Legend

In this, the second of a two-part series, the focus is on communications with the public.(1)  While many of these points below appear more important to managing broker-dealers and product manufacturers (sponsors), retail broker-dealers may value the information in connection with their own materials and review of materials provided by sponsors. Retail firms’ obligations are independent – if your registered reps are distributing a piece of marketing material, you are on the hook for it. A retail firm may have some mitigating factors that help it avoid a big problem (like pointing back at the sponsor), but use of problematic material nonetheless will cause the firm grief.

Picking up from last week’s comments about balance, context, proximity and do’s and don’ts, here are a few more tips before we tackle more substance:

  • If you are highlighting something like a calculated number, consider whether there is anything that the reader should know about that number. What are the underlying assumptions, what could throw it off, what could change? Are the underlying assumptions or leaning too aggressive? Did the market do something special in the period you are presenting?
  • If you are making a positive performance statement (in numbers or words), is there a negative statement nearby to provide balance?(2)
  • Completely identify the source to data or a quote, e.g., Source: Wall Street Journal, June 1, 2010 at page A1; Source: Name of Story, Washington Post Online, May 1, 2010, www.washingtonpost.com/business/story.html (visited May 15, 2010).
  • You may not predict or project performance, imply that past performance will reoccur or make any exaggerated or unwarranted claim, opinion or forecast.(3)
  • Certain hypothetical illustrations of mathematical principles are permitted, provided that they do not predict or project the performance of an investment or strategy.(4)
  • Any comparison between investments must disclose all material differences between them, including (as applicable) investment objectives, costs and expenses, liquidity, safety, guarantees or insurance, fluctuation of principal or return, and tax features.(5)   While comparisons sound easy and straightforward, comparisons are one of those areas where an after-the-fact regulatory reviewer will always find something to be unhappy about.
  • All material should disclose the name of the broker-dealer – not just the name of a sponsor or issuer which is not a broker-dealer. When the goal of the material in question is to promote the sale of a security, name the broker-dealer (plus Member SIPC to comply with the SIPC Bylaws).

Clarity counts and you should strive to make the material clear. Obviously, a statement made in an unclear manner can cause a misunderstanding. Likewise, a complex or overly technical explanation may be more confusing than providing too little information. Find a good balance and put yourself in the shoes of the reader.(6)

I’ve heard the excuse many times from sales and marketing departments, “…but, it is broker-dealer use only.” Broker-dealer use only material is generally subject to the same requirements as material that is distributed to customers.(7)   There is a slight amount of flexibility because you are able to consider the nature of the audience to which the communication will be directed. Different levels of explanation or detail may be necessary depending on the audience to which a communication is directed. However, you must keep in mind that it is not always possible to restrict the audience that may have access to a particular piece of material.(8)  Additional information or a different presentation of information may be required depending upon the medium used for a particular communications and the possibility that the communication will reach a larger or different audience that the one initially targeted.

The bottom line on BD Use Only material – don’t expect to get a free pass. Also, consider whether it is really worth it to have separate BD Use Only material. Since your customer material is so well written, balanced and chock full of appropriate disclosure, why is it that you need separate BD Use Only material? To tell them what their commission is? They probably know that already. Spend your resources creating useful and compliant investor materials and then train the sales team and registered representatives how to use them to make sales.

What about BD Use Only’s cousin: Internal Use Only? Firms need to train their sales forces. However, for a long time stretching back to the 1980’s partnership issues, regulators have become wise to focus on materials that are used to train the sales people. Instead of having one problem here and there with a rogue salesperson, problematic Internal Use Only material can pollute an entire sales force. Think more recently about how auction rate securities were sold. It was not that all of those registered reps individually decided to sell them incorrectly; the problem was that the firms trained their reps to sell them incorrectly. Train your sales team, but keep in mind the balance and content standards. Also, make sure that Internal Use Only material is clearly marked – and downright ugly; no pictures and fancy layouts. If it looks like marketing material, there is a higher probability that it will leak beyond the intended audience.

Document security is another tip. Lock those PDFs. Now that you have created a great piece of marketing material with good disclosure, don’t fall to people who cut it up, paste and forward. As above, if it is Internal Use Only – make it ugly and lock it. If it is BD Use Only – mark it prominently and lock it. This is especially important if it is the kind of material that could be used with a customer. While you cannot absolutely prevent a registered rep from showing a customer improper material, you can slow them down with prominent markings and by combining documents in a single file. This latter technique is important with electronic documents. If you want to ensure that the prospectus goes with the color brochure – combine them in the same PDF and lock it down. Don’t distribute separate files if you don’t have to. Consider how your material could be misused and devise ways to make it difficult. Be ready to trumpet your controls to examiners along with proving up your in-house material flow procedures and approval system (documented with control sheets).

To file or not to file, that is the question. Filing will not make you completely bullet-proof, but it is close. Filing comes with risks and headaches and delays, but the “appears consistent with applicable standards” letter is a great thing to have in the file at exam time. Filing helps you learn the boundaries. While certain items are subject to mandatory filing, many are not. You may file some optional material, but not all; you may file more up front and less as time goes on and you build a library of disclosure and templates. Consider it. (Also, if you have never filed anything, file something to get the clock on the one year rule ticking).(9)   You should know your advertising analyst’s name. It is as important for your firm to have a relationship with its advertising analyst in Rockville as it is with your local FINRA district office.

I’d like to wrap up with a question that we occasionally receive: “Can’t you just give me some standard language that I can use on everything?” No. That is not just to sell more legal services. Rather, it gets to the heart of one of the most important tips: customization of disclosure and analysis of each piece is important – because that is the way that the regulators and plaintiff’s lawyers are going to look at it after the fact…

  1. To review the previous practice update, please visit the Resources Section of Evans & Kob’s website at http://eklawpc.com/resources/.
  2. NASD Rule 2210(d)(1)(A).
  3. NASD Rule 2210(d)(1)(D).
  4. Id.
  5. NASD Rule 2210(d)(2)(B).
  6. Remember, you must consider the nature of the reader or audience – different levels of explanation or detail may be necessary depending on the audience to which a communication is directed. See NASD IM 2210-1.
  7. NASD Rule 2211(d)(1).
  8. Keep in mind, NASD Rule 2211 states that “[n]o member may treat a communication as having been distributed to an institutional investor if the member has reason to believe that the communication or any excerpt thereof will be forwarded or made available to any person other than an institutional investor.”
  9. NASD Rule 2210(c)(5)(A).

Contact Evans & Kob for experienced regulatory and legal counsel regarding any sales literature or advertising review and filing, responding to any regulatory inquiry, or any other regulatory or arbitration related legal matter at info@eklawpc.com.

Link: Broker-Dealer Advisory Services

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No Comment
FINRA Issues Further Guidance on Know Your Customer and Suitability Rule and Extends Effective Date – Regulatory Notice 11-25

On May 18, 2011, FINRA issued Regulatory Notice 11-25, which provides further guidance on new consolidated consolidated FINRA rules governing Know Your Customer (Rule 2090) and Suitability (Rule 2111) and extending the implementation date to July 9, 2012 (previously, October 7, 2011).


FINRA Rule 2090 (Know Your Customer) requires firms to “use reasonable diligence, in regard to the opening and maintenance of every account, to know (and retain) the essential facts concerning every customer….” The rule explains that essential facts are “those required to (a) effectively service the customer’s account, (b) act in accordance with any special handling instructions for the account, (c) understand the authority of each person acting on behalf of the customer, and (d) comply with applicable laws, regulations, and rules.”

FINRA Rule 2111 (Suitability) requires that a firm or associated person “have a reasonable basis to believe that a recommended transaction or investment strategy involving a security or securities is suitable for the customer, based on the information obtained through the reasonable diligence of the member or associated person to ascertain the customer’s investment profile.

Discussion and Guidance

FINRA provided guidance on the following:

Know Your Customer

Authority of Person Acting on Behalf of the Customer – firms need to know: (1) names of persons authorized to act and (2) any limits on their authority. (FINRA notes that firms may decide to limit business to persons without limited scope of authority).


Customer’s Investment Profile

Updating Documentation – firms are not required to update all customer account documentation, and does not contain any explicit documentation requirements, but allows firms to take a risk-based approach with respect to documenting suitability determinations.” The suitability rule applies to recommendations, but the extent to which a firm needs to evidence suitability generally depends on the complexity of the security or strategy in structure and performance and/or the risks involved. However, firms must keep in mind that when suitability is not evident from the recommendation itself, lack of documentation may create examination and enforcement issues.

As a reminder, Rule 2111 adds additional, specific factors to consider in making suitability determinations prior to any recommendation, including customer’s age, other investments, financial situation and needs, tax status, investment objectives, investment experience, investment time horizon, liquidity needs, risk tolerance, and any other information the customer may disclose to the member or associated person in connection with such recommendation ((old rule only included financial status, tax status, and investment objectives).

Lack of Certain Customer-Specific Information – absence of some customer information that is not material under the circumstances generally should not affect a firm’s ability to make a recommendation. To meet its suitability obligations, a firm must obtain and analyze enough customer information to have a reasonable basis to believe the recommendation is suitable. The significance of specific types of customer information generally will depend on the facts and circumstances of the particular case, including the nature and characteristics of the product or strategy at issue. Firms should document the rationale for factors not requiring analysis.

Guidance on Terms:

  • Liquidity Needs: extent of customer’s desired ability or financial obligations that dictate the need to quickly and easily convert to cash all or a portion of an investment or investments without experiencing significant loss in value
  • Time Horizon: expected number of months, years, or decades of planned customer investment to achieve a particular financial goal
  • Risk Tolerance: ability and willingness to lose some or all of the original investment in exchange for greater potential returns.

Different Investment Profiles on Separate Accounts – possible, but firm should evidence customer’s intent and must not allow factors from other accounts to justify recommendations

Terminology – specific terminology is not required when seeking relevant information


Scope of Term “Strategy” – interpreted broadly, including recommendations that: (i) do not result in a securities transaction, (ii) do not reference a specific security, (iii) explicit recommendation to hold a security regardless of involvement in original purchase (but not an implicit one)

Reasonable-Basis Suitability

Firm Approval Does Not Mean Suitable for Particular Customer – Even if a firm’s product committee has approved a product for sale, an individual broker’s lack of understanding of a recommended product or strategy could violate the obligation. Reasonable-basis suitability has two main components: a broker must (1) perform reasonable diligence to understand the potential risks and rewards associated with a recommended security or strategy and (2) determine whether the recommendation is suitable for at least some investors based on that understanding. A broker can violate reasonable-basis suitability under either prong of the test. Firms should educate its associated persons on the potential risks and rewards of the products that the firm permits them to recommend.

Contact our firm for experienced regulatory and legal counsel regarding broker-dealer operations, including drafting new account forms and customer agreements, subscription agreements, written supervisory procedures or any broker-dealer and investment adviser, arbitration, regulatory or securities matter at info@eklawpc.com.

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Focus on Sales Literature and Advertising

In this, the first of a two-part series, the focus is on communications with the public. While many of these points below appear more important to managing broker-dealers and product manufacturers (sponsors), retail broker-dealers may value the information in connection with their own materials and review of materials provided by sponsors. Retail firms’ obligations are independent – if your registered reps are distributing a piece of marketing material, you are on the hook for it. Don’t let anybody tell you otherwise. A retail firm may have some mitigating factors that help it avoid a big problem (like pointing back at the sponsor), but use of problematic material nonetheless will cause the firm grief.

In the broker-dealer business, marketing materials are a formidable source of risk exposure. What you say – and what your registered representatives hand out – can and will be used against you in… an arbitration brought by the formerly nicest little old lady who trots out her old and tattered Salvation Army uniform to wear at every hearing session for the all-public panel of arbitrators (new rule!).(1)  Our firm has been assisting several clients and hearing from industry friends of FINRA’s focus of late on sales literature and advertising material.(2)  Given the aggressiveness that we have seen in connection with both routine examinations and more focused reviews, we thought that we would take this opportunity to cover some general principles of marketing and disclosure.

At the risk of grossly oversimplifying the complex regulatory requirements surrounding sales literature and advertising, you should strive to create and use material that is fair, balanced, accurate and complete. The rules and regulations are designed to push you in that direction,(3)  so it is good to know where you are trying to go.

In general, all communications with the public (you know the difference between advertising, sales literature, correspondence, institutional sales material and independently prepared reprints, right?) are to be based on principles of fair dealing and good faith, must be fair and balanced and must provide a sound basis for evaluating the facts in regard to any particular security, industry or service. You may not:

  • Omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communication to be misleading;
  • Make any false, exaggerated, unwarranted or misleading statement or claim; or
  • Produce any communication that you know or have reason to know contains any untrue statement of a material fact or is otherwise false or misleading.

You should seek to weave balancing information and disclosure into the text of the material. Do not try to relegate the disclosure to a little space on the bottom of the last page – it does not work. The rules provide that information may be placed in a legend or footnote only in the event that such placement would not inhibit the recipient’s understanding of the communication. Better results are achieved by drafting in a balanced manner from the start and then sprinkling disclosure throughout; some on the front, some in the middle and some on the back. Make disclosure proximate to what it is balancing and also consider different techniques to cause disclosure to be more prominent where warranted. Boxes, borders, bolding, typeface and color changes and other types of ‘set-off’ should be considered where disclosure is separated and not incorporated in with text. And, don’t cheat on the size of the text – your disclosure should be near the size of the main text or maybe just a point or two smaller.

Should you have bullet point disclosures? Regulators have been known to ignore claims that the PPM/prospectus “always accompanied the color marketing material” when alleging that same marketing material had thin disclosure. Reasonable or not, there have been enforcement actions basically asserting that the marketing material must be able to stand on its own. I call the remedy “Altegris factors” after the enforcement case from many years ago.(4)  Where appropriate, it may be helpful to bullet point the biggest and most relevant risk factors right in the marketing material. While I am sure that every PPM/prospectus always stays together with the color materials, just in case they get separated on accident there are sufficient risks disclosed in the color materials to give an investor – or a regulator wanting to bring an enforcement action – pause before they decide to come after you.

Context counts. You must ensure that statements in the material are not misleading within the context in which they are made. A statement made in one context may be misleading even though such a statement could be appropriate in another context. An essential test in this regard is the balanced treatment of risks and potential benefits. Communications should be consistent with the risks of fluctuating prices and the uncertainty of distributions and rates of return inherent to investments.

Speaking of context, I found it to be helpful to always consider the “Mom Test,” whether working on an issuer communication or something subject to FINRA rules. If mom isn’t going to understand it, then you have an ineffective piece of communication that you should change before wasting your money. If it is not clear, make it clear. If mom is going to be misled or duped by what is in the material, you’ll need to fix it. If you are going to feel guilty because mom is missing some key facts that have been omitted, you’ll need to include them.

Simple? Unfortunately, simple-sounding concepts obscure the complexity of communications with the public. Also working against you is a relatively short rule containing somewhat mushy language that gives the regulators a lot of flexibility to find a part of the material to be unhappy about.

More to follow next week…

  1. As of January 31, 2011, FINRA Rule 12403 allows customers the option in three panel member arbitrations to either choose the customary “majority public panel” with one non-public arbitrator or the “optional all public panel” that guarantees that any party could select an all public panel.
  2. See also FINRA’s Targeted Examination Letters regarding the “Sale and Promotion of Non-Traded REITs” (located at http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P118545) and “Spot-check of Hedge Fund Advertisements and Sales Literature” (http://www.finra.org/Industry/Regulation/Guidance/TargetedExaminationLetters/P118544)
  3. In particular, see NASD Rule 2210 and related interpretative material.
  4. See “NASD Fines Altegris Investments for Hedge Fund Sales Violations” (located at http://www.finra.org/Newsroom/NewsReleases/2003/p002940)

Contact Evans & Kob for experienced regulatory and legal counsel regarding any sales literature or advertising review and filing, responding to any regulatory inquiry, or any other regulatory or arbitration related legal matter at info@eklawpc.com.

Link: Broker-Dealer Advisory Services

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