United States: FINRA Proposes Rule Change To Permit Projections Of Performance In Private Placement Communications With Qualified Purchasers And In Institutional Communications

The Financial Industry Regulatory Authority, Inc. ("FINRA") has proposed long-awaited changes to FINRA Rule 2210 (Communications with the Public) that would permit FINRA member broker-dealers to include performance projections and target returns in institutional communications and in communications to qualified purchasers regarding private placements.¹ If approved by the SEC, the proposed changes to FINRA Rule 2210 (the "Proposal") would resolve a significant difference between FINRA's Rule 2210, applicable to FINRA member broker-dealers, and the SEC's marketing rule, applicable to SEC-registered investment advisers (the "Advisers Act Marketing Rule").² The changes would be a particularly welcome development for private fund sponsors that market their funds through placement agents and other registered broker-dealers and for broker-dealers that market private funds.

Background

Current FINRA Rule 2210 expressly prohibits the use of projections of performance in broker-dealer communications.³ Projections of performance reflect an estimate of the future performance of an investment or investment strategy and are commonly established through mathematical modeling based on historical data and assumptions about future conditions. Although targeted returns are commonly considered to be distinguishable from projections because targets are aspirational and do not necessarily reflect all of the same inputs and assumptions as projections, FINRA has generally viewed targeted returns as a species of projection that is likewise prohibited.⁴

FINRA's prohibition on the use of projections (and targets) has created challenges for private fund investors, sponsors and broker-dealers. Private fund investors often want to know the targeted return to which a fund will be managed and are also interested in performance projections for the fund or its underlying investments. Such investors – who are often institutional investors such as foundations, endowments and family offices and other sophisticated investors who are "qualified purchasers" ("QPs") under § 2(a)(51) of the Investment Company Act – may find targets and projections to be important components of their determination whether to invest in a private fund, and generally have professional staff or access to professional advisers who are capable of critically analyzing the targets or projections. Moreover, private fund sponsors that offer their funds through a broker-dealer (and, thus, may not show projections and targets) may be at a competitive disadvantage to private fund sponsors that do not offer their funds through a broker-dealer.

The Proposal

Projection Eligible Investors. The Proposal would permit FINRA member broker-dealers to use targets and projections in certain communications with specified "projection eligible investors." Targets and projections would be permitted in (i) institutional communications and (ii) communications distributed to QPs that promote or recommend private placements.

"Institutional communications" include any written (including electronic) communication of a broker-dealer that is distributed or made available only to "institutional investors" as defined in FINRA Rule 2210, which includes investors with total assets of at least $50 million.⁵ Under the Proposal, projections and targets would no longer be prohibited in institutional communications regarding any type of investment. In addition, projections and targets would no longer be prohibited in communications with non-institutional investors who are QPs if the communication relates to a private placement that is sold exclusively to QPs.⁶ The Proposal otherwise would not alter existing prohibitions on including targets or projections in most types of retail communications. In other words, the Proposal would continue to prohibit the use of targets with investors who are not QPs, including in connection with private placements (e.g., many private funds that rely on Section 3(c)(1) of the Investment Company Act).

Conditions. To be eligible to include targets or projections in communications with projection eligible investors, the Proposal provides that FINRA member broker-dealers would be required to meet all of the following conditions:

1. Written Policies and Procedures. The broker-dealer would be required to adopt and implement written policies and procedures reasonably designed to ensure, among other things, that the communication is relevant to the likely financial situation and investment objectives of the intended audience. The Proposal specifies that the broker-dealer should have a reasonable belief that investors either have (i) the financial expertise to digest targets and projections and understand the associated risks and limitations or (ii) resources to access financial professionals that have such expertise.
2. Reasonable Basis Standard. The broker-dealer would be required to have a reasonable basis for the criteria used and assumptions made in calculating the target or projection, and to retain written records supporting the basis for such criteria and assumptions. In furtherance of this requirement, the Proposal would add Proposed Supplementary Material .01 to FINRA Rule 2210, which would list various factors that broker-dealers might appropriately consider when forming a reasonable basis for the criteria used and assumptions made in calculating targets or projections. Several of the factors include:
   • global, regional, and country macroeconomic conditions, as well as the industry's and sector's current market conditions and the state of the business cycle;
   • documented fact-based assumptions concerning the future performance of capital markets;
   • the historical performance and performance volatility of the same or similar asset classes and the appropriateness of selected peer-group comparisons;
   • if available, reliable multi-factor financial models based on macroeconomic, fundamental, quantitative, or statistical inputs, taking into account the assumptions and potential limitations of such models, including the source and time horizon of data inputs;
   • for funds or managed accounts, the actual past performance of other funds or accounts managed by the same investment adviser or sub-adviser, provided such funds or accounts had substantially similar investment objectives, policies and strategies as the fund or account for which the projected performance or targeted returns are shown;⁷
   • in the case of a single security issued by an operating company, the issuing company's operating and financial history;
   • the impact of fees, costs, and taxes; and
   • expected contribution and withdrawal rates by investors.⁸

   This condition may prove difficult to meet for a broker-dealer selling a product sponsored by a third party that is not affiliated with the broker-dealer. For example, many private fund sponsors sell their funds through unaffiliated placement agents. In this case, the fund sponsor typically creates the marketing materials, including any projections or targets contained therein, and provides those materials for use by the broker-dealer. Under those circumstances, it is unclear whether the broker-dealer would be required to form its own independent reasonable basis for projections and targets provided by the fund sponsor or whether the broker-dealer could delegate that responsibility to the fund sponsor.

3. Investor Information. The broker-dealer would be required to provide sufficient information to enable the investor to understand:
   • the criteria used and assumptions made in calculating the target or projection, including whether the target or projection is net of anticipated fees and expenses;⁹ and
   • the risks and limitations of using the target or projection in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.
4. Required Disclosure. The communication would be required to prominently disclose that the target or projection is hypothetical in nature and that there is no guarantee that the target or projection will be achieved.

Comparison to Marketing Rule's Hypothetical Performance Standards

The Advisers Act Marketing Rule permits investment advisers to present hypothetical performance, which includes "targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to the securities offered," under certain conditions.¹⁰ The Proposal is in many respects consistent with the Advisers Act Marketing Rule, with a few key differences. The Proposal notes that FINRA anticipates it would interpret overlapping requirements consistently with how the SEC has interpreted the Advisers Act Marketing Rule's requirements.

The key similarities and differences between the Proposal and the Advisers Act Marketing Rule include the following:

Observations

If approved as proposed, the Proposal would narrow the gap between FINRA Rule 2210 and the Advisers Act Marketing Rule by permitting FINRA member broker-dealers to provide target returns and performance projections under the circumstances described above. Harmonization would be a positive development for investors who desire such information as well as for broker-dealers (and fund sponsors who sell through broker-dealers) that otherwise have lacked a clear path to providing this critical information.

The initial public comment period on the Proposal expires on December 15, 2023. While the SEC is permitted to act on the Proposal as early as December 24, 2023, there is likely to be a robust volume of comments for the SEC and FINRA to consider, and interim amendments to the Proposal are possible. The exercise of statutory extensions could push the final deadline out as far as July 21, 2024.¹¹

Footnotes

1. Notice of Filing of a Proposed Rule Change To Amend FINRA Rule 2210 (Communications With the Public) To Permit Projections of Performance of Investment Strategies or Single Securities in Institutional Communications, 88 Fed. Reg. 82482 (Nov. 24, 2023) available here.

2. See 17 C.F.R. § 275.206(4)-1.

3. FINRA Rule 2210(d)(1)(F) ("Communications may not predict or project performance, imply that past performance will recur or make any exaggerated or unwarranted claim, opinion or forecast."). There are four limited exceptions from the prohibition on projections: hypothetical illustrations of mathematical principles, interactive investment analysis tools, price targets in research reports and certain projections concerning security futures and options. See FINRA Rule 2210(d)(1)(F)(i)-(iii), FINRA Rule 2215 and FINRA Rule 2220.

4. See Frequently Asked Questions About Advertising Regulation (FAQ D.7.1, Dec. 8, 2021), available here. See also, MD Sass Securities, LLC, FINRA Letter of Acceptance, Waiver and Consent No. 2009018187701 (Mar. 22, 2013) at 3; Hedge Fund Capital Partners LLC, FINRA Disciplinary Proceeding No. 2006004122402 (Jan. 26, 2011) at 16.

5. Rule 2210(a)(4) provides that "institutional investor" means (A) a bank, savings and loan association, insurance company or registered investment company, (B) an investment adviser registered either with the SEC or with a state securities commission, (C) a governmental entity or subdivision thereof, (D) an 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, (E) a 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, (F) a FINRA member or registered person of such a member, (G) any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million or (H) any person acting solely on behalf of any such institutional investor.

6. Qualifying private placements include private placements that are exempt from the filing requirements of FINRA Rule 5123 pursuant to Rule 5123(b)(1)(B), the provision relied upon by most private funds that rely on Section 3(c)(7) of the Investment Company Act. The Proposal does not address whether investment in a Section 3(c)(7) fund by "knowledgeable employees" who are not QPs would preclude the use of targets and projections in broker-dealer communications to QPs regarding the fund.

7. Targets or projections would not be permitted to be based upon hypothetical, back-tested performance or the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record.

8. Additional factors listed in the Proposal are the reliability of research sources, the quality of the assets included in a securitization and, for fixed income investments and holdings, the average weighted duration and maturity.

9. The Proposal does not affirmatively require targets or projections to be presented on a net basis in addition to gross, nor does it specify a form or manner for the required disclosures (other than the requirement to "prominently" disclose that the projected performance or targeted return is hypothetical in nature and that there is no guarantee that the projected or targeted performance will be achieved). We expect that commenters are likely to seek clarification.

10. See 17 C.F.R. § 275.206(4)-1(e)(8).

11. See Section 19(b)(2) of the Securities Exchange Act of 1934.

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.