FINRA recently refiled its proposed rule change to amend FINRA Rule 5110 (Corporate Financing Rule – Underwriting Terms and Arrangements). FINRA previously filed, and later withdrew, a proposed rule change to amend FINRA Rule 5110 in October 2018, which we discussed in a Legal Update at that time. The updated proposal reflects only minor updates from the October 2018 proposal and continues to include changes to (1) general filing requirements; (2) filing requirements for shelf offerings; (3) exemptions from filing and substantive requirements; (4) underwriting compensation; (5) venture capital exceptions; (6) treatment of non-convertible or non-exchangeable debt securities and derivatives; (7) lock-up restrictions; (8) prohibited terms and arrangements; and (9) defined terms. These changes are substantially as described in the prior proposed rule change and Legal Update except that, after comments to the prior proposal, FINRA is no longer proposing to eliminate the itemized disclosure of underwriting compensation or the three percent non-accountable expense cap. Of particular note to structured products issuers are the revisions to the exemptions to the FINRA filing requirements, the treatment of derivatives acquired in connection with public offerings, and the revised definitions.
Most structured note issuers currently rely on either the pre-1992 Form S-3 or F-3 eligibility criteria exemption or the investment grade debt exemption to the FINRA filing requirements, both of which have been modified by the proposed rule. The proposed rule removes the reference to Forms F-3 and S-3 and defines an "experienced issuer" as an issuer with a 36-month reporting history and at least $150 million aggregate market value of voting stock held by non-affiliates or, alternatively, an aggregate market value of voting stock held by non-affiliates of at least $100 million and an annual trading volume of three million shares. The proposed rule also expands the investment grade debt exemption to explicitly include banks; however, the definition of a "bank" has also been modified (discussed further below).
The proposed rule also addresses the treatment of derivatives in the context of underwriting compensation and the lock-up provisions. Specifically, it clarifies that derivatives that are acquired in transactions related to public offerings, such as in hedging transactions related to structured notes offerings, are underwriting compensation and, for offerings that are subject to the FINRA filing requirements, a description of the derivative instruments and a representation that the derivatives transaction was executed at a fair price must also be filed with FINRA. Additionally, the proposed rule clarifies that derivatives acquired at a fair price, while considered underwriting compensation, would not be considered to have any compensation value and therefore their value would not need to be disclosed in the applicable prospectus. Derivatives acquired at a fair value in connection with a public offering are also explicitly exempt from Rule 5110's lock-up provisions under the proposed rule. The term "public offering" as it is used in both the underwriting and lock-up provisions has been modified as part of the new consolidated definitions.
The revised rule provides a consolidated set of definitions, including the terms "bank" and "public offering," with the intent of creating consistent definitions across Rule 5110's provisions. "Bank" has been defined by reference to Section 3(a)(6) of the Exchange Act and to include only those foreign banks which have been specifically granted an exception from FINRA under Rule 5110, and it does not include branches or agencies of foreign banks. As a result, the investment grade debt exemption commonly relied upon by non-U.S. issuers of structured notes, would only be available under the proposed rule to those foreign banks which have received an exception from FINRA. Branches and agencies of foreign banks, which have relied on the conditions in the SEC's 1986 no-action letter (Release 33-6661 (Sept. 23, 1986)) to be within the exemption from registration under the Securities Act of 1933 provided by Section 3(a)(2) thereunder in order to be treated on an equal footing with U.S. banks, would now have to apply to FINRA for an exception from Rule 5110. The term "public offering" has also been revised to exclude offerings exemption from SEC registration pursuant to Regulation S or Rule 144A, explicitly clarifying that these offerings are exempt from Rule 5110.
The full text of the proposed rule change is available here. The notice of the proposed rule change appeared in the Federal Register on May 1, 2019 and the SEC comment period expired on May 22, 2019. The status of this proposed rule change may be monitored via FINRA's Rule Filing Status Report.
Originally published in REVERSEInquiries Volume 2, Issue 5.
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