Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Act”) ^[1] and Rule 19b-4 thereunder,^[2] notice is hereby given that on October 28, 2020, the Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“SEC” or “Commission”) the proposed rule change as described in Items I, II, and III below, which Items have been prepared by FINRA. The Commission is publishing this notice to solicit comments on the proposed rule change from interested persons.

I. Self-Regulatory Organization's Statement of the Terms of Substance of the Proposed Rule Change

FINRA is proposing to amend FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities) that would require members to file retail communications concerning private placement offerings that are subject to those rules' filing requirements.

The text of the proposed rule change is available on FINRA's website at http://www.finra.org, at the principal office of FINRA and at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

In its filing with the Commission, FINRA included statements concerning the purpose of and basis for the proposed rule change and discussed any comments it received on the proposed rule change. The text of these statements may be examined at the places specified in Item IV below. FINRA has prepared summaries, set forth in sections A, B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and Statutory Basis for, the Proposed Rule Change

1. Purpose

FINRA Rules 5122 and 5123

Rule 5122 applies to private placements of unregistered securities issued by a member or a control entity ^[3] (“member private offerings”). The rule requires the member or control entity to provide prospective investors with a private placement memorandum (“PPM”), term sheet or other offering document that discloses the intended use of the offering proceeds, the offering expenses and the amount of selling compensation that will be paid to the member and its associated persons.

The rule also requires a member to file the PPM, term sheet or other offering document with the FINRA Corporate Financing Department (“Corp Fin”) at or prior to the first time the document is provided to any prospective investor.^[4] Many member private offerings are exempt from the rule's requirements, including among others, offerings sold only to institutional accounts, as defined in FINRA Rule 4512(c),^[5] qualified purchasers, as defined in the Investment Company Act of 1940,^[6] and qualified institutional buyers,^[7] as defined in Rule 144A under the Securities Act of 1933 (“Securities Act”).^[8]

Rule 5123 requires members to file with FINRA any PPM, term sheet or other offering document, including any material amended versions thereof, used in connection with a private placement of securities within 15 calendar days of the date of first sale. Rule 5123 exempts private placements that are filed under other FINRA Corporate Financing Rules, as well as most of the same categories of private placements that are exempt from filing under Rule 5122.^[9] As a result of these exemptions, both rules apply predominately to private placements sold to retail investors.

FINRA received 2,509 unique Rule 5122 and 5123 filings in 2019. FINRA uses analytics to conduct a risk-based review for each filing. This analysis of an offering's risk to investors and its ability to identify potential rule violations and other potential problems begins with the information and documents submitted. Members that sell private placements may use a PPM or term sheet alone, or may use a variety of other offering documents in addition to, or instead of, a PPM or term sheet.

Because members use a wide variety of materials, Rules 5122 and 5123 do not enumerate the types of information that might be considered “offering documents.” FINRA has stated previously that an example of “other offering document” is “[a]ny other type of document that sets forth the terms of the offering.” ^[10] The terms of an offering include facts such as the amount of proceeds that the issuer intends to raise, the type of security, descriptions or illustrations of the intended use of proceeds, and explanations of tax benefits or other information that would be relevant to an investor when deciding whether to make an investment.

While Rules 5122 and 5123 do not require retail communications governed by Rule 2210 (Communications with the Public) to be filed, many members file these communications with their required documents.^[11] Examples of these retail communications can include web pages that promote the offering, slide presentations, pitch decks, one-page “teasers,” fact sheets, sales brochures, executive summaries, and investor packets. Corp Fin often forwards these retail communications to FINRA's Advertising Regulation Department (“AdReg”) for review.

Corp Fin staff triages the filings it receives under Rules 5122 and 5123 using a variety of criteria and selects a subset for further analysis and review based on the relative risk of the offering. In some cases, FINRA opens investigations of particular offerings, which may lead to follow-up examinations by Member Supervision staff, and potentially, referrals to the Department of Enforcement.

Advertising Regulation Review of Private Placement Retail Communications

In addition to reviewing private placement retail communications that are filed under Rules 5122 and 5123 and referred by Corp Fin, AdReg reviews private placement retail communications that it receives through one of four other channels: (i) New member and voluntary filings with AdReg; (ii) referrals from the Member Supervision examination program and other surveillance groups; (iii) AdReg spot checks; and (iv) assistance in Enforcement cases.

AdReg has observed that retail communications that have been directly filed by new members ^[12] or voluntarily with AdReg for private placements raise more compliance issues than those for other products. Between January 1, 2017, and March 31, 2020, AdReg reviewed 1,726 new member and voluntary filings of private placement retail communications. Of these filings, 41% required revisions to comply with applicable standards, and 4% were so noncompliant with the rules that FINRA issued “do not use” (DNU) review letters. In comparison, during this same period, only 8% of overall AdReg filings reviewed required revisions, and only 0.1% received a DNU letter.^[13]

In 2018, AdReg conducted a spot check of the private placement retail communications provided to Corp Fin in connection with filings under Rules 5122 and 5123 during the second and third quarters of 2018. The review revealed significant and pervasive violations of Rule 2210; overall, 806 of the 1,062 retail communications reviewed (76%) did not comply with Rule 2210.

The most common violation was the inclusion of prohibited projections of performance or unreasonable forecasts, e.g., “Return 4-6x invested capital net of fees” and “Management projects a $100 million revenue stream can be built in 5 years.” Numerous others contained false or misleading statements, e.g., “Safety of Principle” ( printed page 71122) [ sic] and “UTILIZES AI & MACHINE LEARNING TECHNOLOGY SIMILAR TO THAT USED BY ONLINE GIANTS SUCH AS FACEBOOK, NETFLIX, AMAZON AND STITCH FIX.” Another common issue was the failure to balance promotional content with the key risks associated with the investment, such as a real estate offering touting the benefit of purchasing properties leased by “investment grade” tenants without discussing that such holdings do not assure a profit or protect against loss. Others failed to disclose general risks, such as the speculative nature of the securities and the lack of liquidity of the investment.

Private placement retail communications also feature prominently in FINRA's Enforcement program. Since January 1, 2014, FINRA has initiated 49 disciplinary actions related to non-compliant retail communications concerning private placements. This number represents 21% of all actions involving private placements.

Filing Proposal

Given the comparatively high rate of non-compliance of private placement retail communications, and the increased risk of investor harm associated with those communications, FINRA proposes to amend Rules 5122 and 5123 to require such retail communications to be filed, in addition to the currently required PPMs, term sheets, and other offering documents.

Rules 5122 and 5123 focus on the private placements that raise the greatest concerns—those sold to retail investors, whether or not accredited. FINRA proposes to limit the new filing requirement to the same offerings; it would not apply to any offerings that are currently exempt from filing.^[14] A member would be required to file with FINRA such retail communications no later than the date on which a filing is required under Rules 5122 and 5123.^[15] The proposal would not require members to file private placement retail communications for offerings that are not subject to the filing requirements in Rules 5122 or 5123, such as sales exclusively to institutional accounts. Moreover, because Rules 5122 and 5123 do not impose any filing fees, members would not be subject to higher fees because of this additional filing requirement.

FINRA anticipates that members would be able to file most retail communications at the same time and in the same manner that they file their PPMs, term sheets, and other offering documents. The rules' requirements that material amendments to offering documents must be filed also would apply to retail communications.

If the Commission approves the proposed rule change, FINRA will announce the effective date of the proposed rule change in a Regulatory Notice to be published no later than 60 days following Commission approval. The effective date will be no later than 180 days see publication of the Regulatory Notice announcing Commission approval.

2. Statutory Basis

FINRA believes that the proposed rule change is consistent with the provisions of Section 15A(b)(6) of the Act,^[16] which requires, among other things, that FINRA rules must be designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, and, in general, to protect investors and the public interest. FINRA believes that requiring the filing of retail communications under Rules 5122 and 5123 will improve members' compliance and understanding of the application of FINRA's communications with the public rules and reduce the likelihood that retail investors would receive false or misleading sales material for private placements.^[17]

B. Self-Regulatory Organization's Statement on Burden on Competition

FINRA does not believe that the proposed rule change will result in any burden on competition that is not necessary or appropriate in furtherance of the purposes of the Act.

Economic Impact Assessment

FINRA has undertaken an economic impact assessment, as set forth below, to analyze the regulatory need for the proposed rule change, its potential economic impacts, including anticipated costs, benefits, and competitive effects, relative to the current baseline, and the alternatives FINRA considered in assessing how best to meet FINRA's regulatory objectives.

Regulatory Need

As discussed above, FINRA has seen significant problems with the retail communications that have been voluntarily filed under Rules 5122 and 5123. In addition, as noted above, the 2018 spot check revealed that 76% of retail communications filed under Rules 5122 and 5123 during the spot check review period involved significant violations of Rule 2210.^[18] It is possible that significant violations may be even more prevalent among retail communications that have not been voluntarily filed or reviewed. Moreover, high-risk retail communications concerning private placements feature prominently in FINRA's Enforcement program.^[19] These communications often present false or misleading information regarding the underlying offering, which could result in significant losses to investors and could undermine public trust in the private placement markets. The proposed amendments, therefore, are intended to promote investor protection and market integrity by expanding FINRA's oversight of high-risk retail communications concerning private placements.

Economic Baseline

The economic baseline includes the current regulation of retail communications under Rule 2210 and current regulation of specified private placements under Rules 5122 and 5123. All retail communications are required to comply with the general, fair and balanced standards detailed in Rule 2210; however, Rule 2210 generally does not require members to file with FINRA the materials they use to communicate with retail investors concerning private placements. Under Rules 5122 and 5123, members are required to file with FINRA any PPM, ( printed page 71123) term sheet, or other offering document used in connection with specified private placements, although these rules do not currently require retail communications governed by Rule 2210 to be filed. Therefore, firms currently have no regulatory obligation to submit these communications for review by FINRA.

The economic baseline also includes members' existing practices under Rules 2210, 5122 and 5123. Currently, some members submit retail communications as part of their Rules 5122 and 5123 private placement filings with Corp Fin; some members file these communications through AdReg's filings review program under Rule 2210 either voluntarily or as new members; and some members submit these communications to both or neither of these departments.

As discussed above, upon receiving filings under Rules 5122 and 5123, Corp Fin triages the filings to select a subset for further review based on the relative risk of the offering. Corp Fin notifies AdReg when it receives retail communications in connection with the higher-risk offerings it assigns for reviews. AdReg then conducts its own triage program based on the relative risk of these retail communications.

Once high-risk retail communications are identified, AdReg requests Corp Fin to refer them to AdReg and opens a complex review matter to assess whether the communications meet applicable communication standards. If apparent rule violations are identified, AdReg will, as needed, provide an analysis for an existing Corp Fin investigation or contact the member firm to explain the concerns, ask the firm to remediate the communications, and determine the extent of the communications' use. AdReg may resolve the matter with informal disciplinary action or, if severe violations are identified, may refer the matter to FINRA's Department of Enforcement.^[20]

The existing regulatory procedure concerning private placement retail communications that are filed with AdReg under Rule 2210 voluntarily or by new members adopts a different approach from the above. AdReg conducts a review in response to each retail communication filing and provides a review letter indicating whether the communication appears to be consistent with the applicable standards, and if not, the bases for this determination.^[21]

FINRA has collected information for assessing the specified private placement market under Rules 5122 and 5123. On average, FINRA receives approximately 2,400 new offering filings annually, with approximately 10-15% of the filings representing a duplicate filing by separate firms with respect to the same offering. As a reference, the Regulation D data published by the SEC's Division of Economic and Risk Analysis in August 2018 provided that approximately 20,000 new offering filings on average were submitted via EDGAR each year from 2015 to 2017. Of this total, roughly 4,000 (or 20%) of the new offerings that SEC identified involved “intermediaries” such as brokers or finders, some of which may not be FINRA members. Accordingly, FINRA's private placement review program under Rules 5122 and 5123 accounts for approximately half of the new offerings filed with the SEC that involve intermediaries and approximately 10% of all new offering filings annually.

To assess how likely the specified private placements use retail communications, FINRA has analyzed information pertaining to 1,327 offerings filed with Corp Fin under Rules 5122 and 5123 during the second and third quarters of 2018.^[22] Approximately 781 (or 59%) of the offerings did not include retail communications as part of the filing. There were 1,062 retail communications submitted by 132 members for the remaining 546 offerings.^[23] The average (maximum) number of retail communications submitted per member among these offerings was eight (260), respectively. The average (maximum) number of retail communications per offering was approximately two (23) retail communications.

To further assess the existing regulatory procedure under Rules 5122 and 5123, FINRA collected review information regarding the 708 private placement filings with Corp Fin over the period February 1, 2020 to April 17, 2020.^[24] Corp Fin identified 274 (or 38.7%) of filings that contained retail communications during this period. Among these 274 filings, 37 (or 13.5%) were deemed by Corp Fin to be high risk. AdReg triaged the retail communications in these 37 filings and determined that 14 represented likely significant violations of Rule 2210 and opened 14 complex review matters. These 14 matters represented 5% of all filings containing retail communications under Rules 5122 and 5123 during this period.^[25]

Economic Impacts

The proposed rule change would directly impact members that distribute retail communications concerning specified private placements by requiring them to submit these communications to Corp Fin at the time they file the PPM, term sheet, or other offering document. Such an impact would be more pronounced for members that have not been voluntarily filing private placement retail communications with Corp Fin or AdReg. FINRA anticipates a considerable increase in the number of retail communications filed under Rules 5122 and 5123 as a result of the proposal. As was found during the 2018 spot check, approximately 41% of the offerings included retail communications voluntarily submitted concerning these offerings. If each offering is associated with an average of two retail communications, then the number of retail communications could be increased by 3,124 retail communications annually, totaling 5,308 retail communications per year.

The estimate of two retail communications per offering may overstate or understate the true amount. Note that the average of two retail communications per offering found during the spot check may understate the true average if members did not voluntarily file all retail communications associated with these offerings. Alternatively, the average retail communications per offering could be lower than two if there were many offerings that did not submit any retail communications because they did not distribute any such communications. ( printed page 71124)

In developing the proposal, FINRA staff does not expect it to have a significant impact on AdReg's existing filings review program. Members will continue to have the option (but not the obligation) to file these communications through AdReg's filings review program following the proposal.^[26]

The primary benefit of the proposed rule change would arise from FINRA's enhanced insight into and oversight of retail communications concerning high-risk private placements.^[27] Specifically, the proposed amendments would enable FINRA to review all retail communications concerning the specified private placements through its triage program and if warranted, open cases for complex review, thereby extending FINRA's ability to potentially uncover significant violations of Rule 2210. In addition, retail communications that have not been filed voluntarily with Corp Fin or AdReg may have contained violations of greater severity or presented novel regulatory issues unknown to FINRA. By allowing access to retail communications concerning private placements from all filing members, the proposal would help FINRA staff understand the scope and severity of existing issues in a more accurate and efficient manner, which would further enhance FINRA's surveillance and enforcement program.^[28]

The proposal likely would increase members' incentives to distribute retail communications concerning private placements that are fair and balanced and deter them from presenting false or misleading information that may cause investor harm. The proposed change may also likely increase issuers' incentives to disclose the risks of private placements in a fair and balanced manner in connection with retail communications, thereby enhancing the capabilities of investors and other related parties to assess these risks as part of their investment decisions.

FINRA believes that greater regulatory oversight, together with changes in members' and issuers' incentives, would help promote greater investor protection and public trust in the private placement markets. The benefit from enhanced incentives and regulatory oversight would more likely accrue with respect to members that frequently file private placements that include retail communications. FINRA recognizes that the proposal's investor protection benefits may be limited given that members are required to file private placement offerings within 15 calendar days of the date of first sale under Rule 5123. (Rule 5122 requires member private offerings to be filed at or prior to the date of first sale.) The proposal's investor protection benefits also may vary depending on how long the Corp Fin triage process takes and how quickly AdReg triages and reviews the communications and the available remedying tools.

FINRA believes that the proposal would impose a minimal increase in direct costs to members that have not already been voluntarily filing private placement retail communications with Corp Fin. Specifically, the proposal would require these members to file any additional retail communications that promote the offering at the time they file the PPM or term sheet. Members also would be required to file retail communications subsequent to the initial filing if they distribute new retail communications promoting the offering or make material changes to any previously filed retail communications. FINRA believes such increases in direct costs would be minimal as Rules 5122 and 5123 do not impose filing fees, and most filing members are already familiar with the Corp Fin filing system.^[29]

FINRA recognizes that members that distribute high-risk retail communications concerning private placements may be subject to additional regulatory review by FINRA as FINRA anticipates an expansion in its complex review program following the proposal.^[30] FINRA believes the overall increase in regulatory costs and uncertainty to members associated with the additional review would likely be low because only a very small percentage of retail communications with the highest risk profile would be subject to the review. FINRA does not expect increases in direct and indirect costs will deter firm entry or private placement offerings or result in any significant burden on competition that is not necessary or appropriate in furtherance of the purpose of the Exchange Act.

Alternative Considered

FINRA considered proposing an amendment to Rule 2210 that would require members to submit private placement retail communications through AdReg's filings review program. AdReg would review all private placement retail communications filed under the alternative proposal. The alternative, therefore, would enhance FINRA's oversight of both high-risk and low-risk private placement retail communications, leading to significant improvement in members' compliance and understanding of applicable rules and greater benefit from market integrity and investor protection.

The alternative, however, would impose higher costs on members for several reasons. First, members would be subject to filing fees under Rule 2210, which would not apply to filings made under Rules 5122 or 5123. Second, members would have to file retail communications and offering documents separately with AdReg and Corp Fin using different filing systems. Third, all filing members would face additional regulatory costs and uncertainty while the review is pending.^[31] FINRA is also concerned that the alternative approach may divert limited regulatory resources from high-risk matters. Overall, FINRA believes that the current proposal would build on the risk-based regulatory approach for private placements thereby promoting regulatory consistency and impose lower costs to members than the alternative FINRA has considered.

C. Self-Regulatory Organization's Statement on Comments on the Proposed Rule Change Received From Members, Participants, or Others

Written comments were neither solicited nor received.

III. Date of Effectiveness of the Proposed Rule Change and Timing for Commission Action

Within 45 days of the date of publication of this notice in the Federal Register or within such longer period (i) as the Commission may designate up to 90 days of such date if it finds such longer period to be appropriate and publishes its reasons for so finding or (ii) as to which the self-regulatory organization consents, the Commission will:

(A) By order approve or disapprove such proposed rule change, or

(B) institute proceedings to determine whether the proposed rule change should be disapproved.

IV. Solicitation of Comments

Interested persons are invited to submit written data, views and arguments concerning the foregoing, including whether the proposed rule change is consistent with the Act. Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's internet comment form (http://www.sec.gov/​rules/​sro.shtml); or
• Send an email torule-comments@sec.gov. Please include File Number SR-FINRA-2020-038 on the subject line.

Paper Comments

• Send paper comments in triplicate to Secretary, Securities and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2020-038. This file number should be included on the subject line if email is used. To help the Commission process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's internet website ( http://www.sec.gov/​rules/​sro.shtml). Copies of the submission, all subsequent amendments, all written statements with respect to the proposed rule change that are filed with the Commission, and all written communications relating to the proposed rule change between the Commission and any person, other than those that may be withheld from the public in accordance with the provisions of 5 U.S.C. 552, will be available for website viewing and printing in the Commission's Public Reference Room, 100 F Street NE, Washington, DC 20549, on official business days between the hours of 10 a.m. and 3 p.m. Copies of such filing also will be available for inspection and copying at the principal office of FINRA. All comments received will be posted without change. Persons submitting comments are cautioned that we do not redact or edit personal identifying information from comment submissions. You should submit only information that you wish to make available publicly. All submissions should refer to File Number SR-FINRA-2020-038 and should be submitted on or before November 27, 2020.