United States: FINRA Proposes Lighter Regulatory Regime For Limited Corporate Financing Brokers

Last Updated: March 24 2014
Article by Edward G. Eisert


The Financial Industry Regulatory Authority ("FINRA") recently issued a Regulatory Notice1 (the "Notice") requesting comment on a Proposed Rule Set for "Limited Corporate Financing Brokers" ("LCFBs"). (The comment period expires on April 28, 2014.) This Alert provides an overview of the Rule Set and its merits.

The Rule Set would provide a somewhat lighter regulatory regime for LCFBs, defined as a broker that solely engages in one or more of the following activities (collectively, "LCFB Activities"):

  1. advising an issuer, including a private fund, concerning its securities offerings or other capital raising activities;
  2. advising a company regarding its purchase or sale of a business or assets or regarding its corporate restructuring, including a going-private transaction, divestiture or merger;
  3. advising a company regarding its selection of an investment banker;
  4. assisting in the preparation of offering materials on behalf of an issuer;
  5. providing fairness opinions; and
  6. qualifying, identifying or soliciting potential institutional investors.

Of equal importance to the scope of LCFB Activities is the scope of the activities that would not be permitted (collectively, "Prohibited LCFB Activities"). The term LCFB would not include any broker or dealer that:

  1. carries or maintains customer accounts;
  2. holds or handles customers' funds or securities;
  3. accepts orders from customers to purchase or sell securities either as principal or as agent for the customer;
  4. possesses investment discretion on behalf of any customer; or
  5. engages in proprietary trading of securities or market-making activities.

There are two primary aspects of the Rule Set that must be considered in assessing whether registering as a LCFB might be sufficiently beneficial to justify the regulatory burdens.

First, as regards the potential benefits, one must consider whether the scope of LCFB Activities is sufficiently broad to capture the financing activities of brokers that do not engage in Prohibited LCFB Activities, and whether the scope of Prohibited LCFB Activities is overly broad. Second, as regards the regulatory burdens, one must consider both the regulatory and commercial risks of engaging in LCFB Activities without being registered and whether the Rule Set provides appropriate relief from the regulatory scheme that otherwise would be applicable to a registered corporate financing broker.

Based upon this analysis, as discussed below, we conclude that the Rule Set represents a significant step forward in providing regulatory relief to limited corporate financing brokers, particularly those who source financing for their clients from institutional investors, but the scope of the proposed relief is limited and falls far short of that long sought by limited purpose and private placement brokers.


FINRA requests comment, among other issues, on the following: "Does the proposed rule set appropriately accommodate the scope of LCFB business models? If not, what other accommodations are necessary and how would customers be protected?" Another issue is:

Is the definition of "limited corporate financing broker" appropriate? Are there any activities in which broker-dealers with limited corporate financing functions typically engage that are not included in the definition? Are there activities that should be added to the list of activities in which an LCFB may not engage?

If the scope of LCFB Activities is clarified, as suggested below, then the scope of Prohibited LCFB Activities would not appear to be overly broad.

  1. Advisory Activities vs. Active Engagement in Transactions.

    We note that the enumerated LCFB Activities, generally, focus on advice or assistance to a client directly, but do not explicitly address the active involvement of a broker with others, such as arranging a transaction, facilitating the negotiation of the terms of a transaction, and assistance in the consummation of a transaction. For the avoidance of doubt, we suggest that these activities be explicitly included in the definition of LCFB Activities because they often raise concerns that an entity is acting as a broker.2
  2. Investment Banking Activities of the Manager, or an Affiliate, of Private Equity Funds.

    The managing member or general partner of a private equity fund, organized as a limited liability company or limited partnership, or an affiliate, often provides services to the fund in connection with the acquisition or disposition (including an initial public offering) of a portfolio company or a recapitalization of the portfolio company. The Staff of the Securities and Exchange Commission ("SEC") has raised concerns that such activities could require the entity providing such services to be registered as a broker-dealer if it is separately compensated therefor, particularly if "the fees are described as compensating the private fund adviser or its affiliates or personnel for 'investment banking activities,' including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions."3

    It would be helpful, for the avoidance of doubt, for such investment banking activities to be explicitly included in the definition of LCFB Activities.
  3. Acting as a "Finder;" the Definition of "Institutional Investor."

    Also, of particular concern is the scope of relief proposed for a "finder" of potential "institutional investors" (although the word "finder" is not used in the rule proposal), i.e., "qualifying, identifying or soliciting potential institutional investors." The benefit of this proposed relief is tempered by the narrow definition of "institutional investor" and accompanying commentary of FINRA:

    An LCFB would not be permitted to qualify, identify or solicit potential purchasers of securities unless the purchaser meets the definition of "institutional investor." However, an LCFB would be allowed to serve clients (such as individuals or entities seeking advice on securities offerings or sales of businesses) who do not meet the "institutional investor" definition.

    The term [institutional investor] would include any:

    • bank, savings and loan association, insurance company or registered investment company;
    • governmental entity or subdivision thereof;
    • employee benefit plan, or multiple employee benefit plans offered to employees of the same employer, that meet the requirements of Section 403(b) or Section 457 of the Internal Revenue Code and in the aggregate have at least 100 participants, but does not include any participant of such plans;
    • qualified plan, as defined in Section 3(a)(12) (C) of the Exchange Act, or multiple qualified plans offered to employees of the same employer, that in the aggregate have at least 100 participants, but does not include any participant of such plans;
    • other person (whether a natural person, corporation, partnership, trust, family office or otherwise) with total assets of at least $50 million; and
    • any person acting solely on behalf of any such institutional investor.4
    FINRA discouraged proposals to expand the definition of "institutional investor" by stating that it "purposely does not propose to define 'institutional investor' based on a more inclusive standard, such as the definition of 'accredited investor' in Regulation D under the Securities Act of 1933."5

    In this context FINRA also emphasized its ongoing concern with the sale of private placements to accredited investors by stating:

    FINRA's regulatory programs have uncovered serious concerns with the manner in which firms market and sell private placements to accredited investors. Application of the LCFB Rules to firms that market and sell private placements to accredited investors would require FINRA to expand the applicable conduct rules and other provisions. Therefore, lowering the threshold of "institutional investor" would eviscerate the benefits of a streamlined rule set.6

    These proposed limitations on the regulatory relief provided LCFBs significantly detract from the benefits of the Rule Set. The fact that FINRA has "uncovered serious concerns with the manner in which firms market and sell private placements to accredited investors," of course, must be addressed. We suggest, however, that these concerns could be reconciled with expanding the scope of "institutional investor" by employing one or both of the following mechanisms. First, the scope of the definition of "institutional investor" might be expanded to include a person (whether a natural person, corporation, partnership, trust, family office or otherwise) who must satisfy a higher financial standard than that of an "accredited investor," as defined in Rule 501 under the Securities Act of 1933, such as a "qualified purchaser," as defined in the Investment Company Act of 1940.7 Second, an entity might be prohibited from soliciting transactions with "accredited investors," unless it satisfies higher regulatory standards than otherwise would be applicable, for example, that it has no recent disciplinary history.

To read this article in full, please click here.


1 FINRA Regulatory Notice 14-09, http://www.finra.org/Industry/Regulation/Notices/2014/P449587

2 See SEC Guide to Broker-Dealer Registration http://www.sec.gov/divisions/marketreg/bdguide.htm

3 "A Few Observations in the Private Fund Space," David W. Blass Chief Counsel, Division of Trading and Markets U.S. Securities and Exchange Commission, American Bar Association, Trading and Markets Subcommittee, Washington, D.C., April 5, 2013 http://www.sec.gov/News/Speech/Detail/Speech/1365171515178

4 Notice at Endnote 3.

5 The Notice at Endnote 3 further states that:

LCFB Rules are intended to govern the activities of firms that engage in a limited range of activities, such as advising companies and private equity funds on capital raising and corporate restructuring. As part of these activities, an LCFB would be permitted to qualify, identify and solicit potential institutional investors, as defined by the LCFB Rules.

"Accredited investor," as most relevant to this discussion, is defined in Rule 501(a) under the Securities Act of 1933 as follows:

Accredited investor shall mean any person who comes within any of the following categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person:

. . .

(3) Any organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;

. . .

(5) Any natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1,000,000.

(i) Except as provided in paragraph (a)(5)(ii) of this section, for purposes of calculating net worth under this paragraph (a)(5):

(A) The person's primary residence shall not be included as an asset;

(B) 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 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

(C) 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;

. . .

(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;

(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person as described in §230.506(b)(2)(ii); and

(8) Any entity in which all of the equity owners are accredited investors.

6 Endnote 4, supra.

7 "Qualified purchaser," as most relevant to this discussion, is defined in Section 2(a)(51) of the Investment Company Act of 1940 as follows:

(i) any natural person (including any person who holds a joint, community property, or other similar shared ownership interest in an issuer that is excepted under section 3(c)(7) with that person's qualified purchaser spouse) who owns not less than $5,000,000 in investments, as defined by the Commission;

(ii)any company that owns not less than $5,000,000 in investments and that is owned directly or indirectly by or for 2 or more natural persons who are related as siblings or spouse (including former spouses), or direct lineal descendants by birth or adoption, spouses of such persons, the estates of such persons, or foundations, charitable organizations, or trusts established by or for the benefit of such persons;

(iii) any trust that is not covered by clause (ii) and that was not formed for the specific purpose of acquiring the securities offered, as to which the trustee or other person authorized to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a person described in clause (i), (ii), or (iv); or

(iv) any person, acting for its own account or the accounts of other qualified purchasers, who in the aggregate owns and invests on a discretionary basis, not less than $25,000,000 in investments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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