I. Introduction

On November 13, 2023, the Financial Industry Regulatory Authority, Inc. (“FINRA”) filed with the Securities and Exchange Commission (“SEC” or “Commission”), pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) ^[1] and Rule 19b-4 thereunder,^[2] a proposed rule change to amend FINRA Rule 2210 (Communications with the Public) (hereinafter, the “proposed rule change” unless otherwise specified). The proposed rule change, as subsequently amended by Amendment No. 1, would allow a member firm to project performance ^[3] or provide a targeted return ^[4] with respect to a security, asset allocation, or other investment strategy in limited circumstances and subject to certain conditions. Specifically, the proposed rule change would permit a member firm to project performance or provide a targeted return in: (1) an institutional communication; ^[5] or (2) a communication that is distributed or made available only to: (A) persons meeting the definition of “qualified purchaser” (“QP”) under the Investment Company Act of 1940 (“Investment Company Act”),^[6] and is a communication that promotes or recommends a member firm's own unregistered securities or those of a control entity that is exempt from the requirements of FINRA Rule 5122 (Private Placements of Securities Issued by Members) pursuant to FINRA Rule 5122(c)(1)(B) (“Member Private ( printed page 60462) Offerings”); ^[7] or (B) QPs or persons meeting the definition of “knowledgeable employee” under Investment Company Act Rule 3c-5 (a “knowledgeable employee”),^[8] and is a communication that promotes or recommends a private placement that is exempt from the requirements of FINRA Rule 5123 (Private Placements of Securities) pursuant to FINRA Rule 5123(b)(1)(B) or FINRA Rule 5123(b)(1)(H), respectively (“Exempted Private Placement”).^[9] The investors who would be eligible to receive communications that include such performance projections or targeted returns under the proposed rule change are hereinafter collectively referred to as “Projection-Eligible Investors.” The proposed rule change also would impose conditions to help ensure that such performance projections or targeted returns have a reasonable basis, are accompanied by certain disclosures, and that member firms communicating such information have written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of their audience.^[10]

The proposed rule change was published for public comment in the Federal Register on November 24, 2023.^[11] The comment period closed on December 15, 2023. The Commission received comment letters in response to the Notice.^[12] On January 5, 2024, FINRA consented to an extension of the time period in which the Commission must approve the proposed rule change, disapprove the proposed rule change, or institute proceedings to determine whether to approve or disapprove the proposed rule change to February 22, 2024.^[13] On February 22, 2024, FINRA responded to the comment letters received in response to the Notice and filed an amendment to modify the proposed rule change (“Amendment No. 1”).^[14] Also on February 22, 2024, the Commission published a notice of filing of Amendment No. 1 and an order instituting proceedings to determine whether to approve or disapprove the proposed rule change, as modified by Amendment No. 1.^[15] The Commission received additional comment letters in response to the OIP.^[16] On May 17, 2024, FINRA consented to an extension of the time period in which the Commission must approve or disapprove the proposed rule change to July 21, 2024.^[17] On July 17, 2024, FINRA responded to the comment letters received in response to the OIP.^[18] This order approves the proposed rule change, as modified by Amendment No. 1.

II. Description of the Proposed Rule Change

FINRA Rule 2210 generally prohibits a member firm's communications from predicting or projecting performance, implying that past performance will recur, or making any exaggerated or unwarranted claim, opinion, or forecast.^[19] As discussed below, there are three exceptions to this general prohibition; the proposed rule change would create a fourth exception to permit the communication of projected performance or targeted returns in certain narrowly-defined circumstances.^[20] After summarizing the current regulatory framework, the Commission describes the proposed rule change.

A. Background

1. FINRA Rule 2210 (Communications With the Public)

FINRA Rule 2210 imposes obligations related to, among other things, the approval, review, recordkeeping, filing, and content of member firms' communications with the public.^[21] FINRA Rule 2210(d)(1) imposes six general standards for the content of a member firm's communications with the public.^[22] For example, member firms' communications must “be based on principles of fair dealing and good faith, . . . be fair and balanced, and . . . provide a sound basis for evaluating the facts in regard to any particular security or type of security, industry, or service.” ^[23] Member firms may not “omit any material fact or qualification if the omission, in light of the context of the material presented, would cause the communications to be misleading.” ^[24] The standards prohibit “any false, exaggerated, unwarranted, promissory[,] or misleading statement or claim in any communication.” ^[25] Member firms also must consider “the nature of the audience to which the communication will be directed” and provide “details and explanations appropriate to the audience.” ^[26]

These standards also include a general prohibition on “predict[ing] or project[ing] performance, imply[ing] that past performance will recur[,] or mak[ing] any exaggerated or unwarranted claim, opinion[,] or forecast.” ^[27] This general prohibition does not apply to three types of communications: hypothetical illustrations of mathematical ( printed page 60463) principles; ^[28] investment analysis tools; ^[29] and price targets in research reports on debt or equity securities.^[30] Unless one of these three exceptions applies, member communications may not predict or project performance.^[31]

2. FINRA's Stated Reasons for the Proposed Rule Change

As stated above, the proposed rule change would permit the presentation of projected performance or targeted returns in institutional communications about a security, asset allocation, or other investment strategy or in communications to QPs and knowledgeable employees about certain private placements. The proposed rule change also would impose conditions to help ensure that such performance projections or targeted returns have a reasonable basis, are accompanied by certain disclosures, and require member firms communicating such information have written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of their audience.

FINRA stated that some of its member firms' customers, especially institutional investors, request projected performance or targeted returns concerning investment opportunities to help them make informed investment decisions.^[32] FINRA explained that institutional investors and QPs “often test their own opinions against performance projections they receive from other sources, including issuers and investment advisers.” ^[33] FINRA stated that for this reason projected performance information “may be useful for [investors] that either have the financial expertise to evaluate investments and to understand the assumptions and limitations associated with such projections, or that have resources that provide them with access to financial professionals who possess this expertise.” ^[34] However, because FINRA Rule 2210 “generally precludes a member from providing projected performance or targeted returns in marketing communications distributed to institutional investors and QPs, these investors cannot obtain a member's potentially different and valuable perspective.” ^[35]

Under these circumstances, FINRA stated that FINRA Rule 2210's general prohibition “creates an incentive for issuers to avoid the registered broker-dealer channel to offer securities and instead either use an unregistered firm[ ] or market securities directly to potential investors.” ^[36] FINRA explained that the proposed rule change “would allow members to provide the same or similar information regarding projected performance or targeted returns that investors are receiving from issuers or other unregistered intermediaries” but would impose on the member firm “substantial requirements that enhance investor protections.” ^[37] FINRA also stated that member firms dually registered as investment advisers or those that employ dually registered persons already may provide performance projections to their customers.^[38]

FINRA stated that any proposal to permit the use of projected performance or targeted returns in member firms' communications “must not increase the risk of potential harm to retail investors.” ^[39] For that reason, according to FINRA, the proposed rule change would “create a new, narrowly tailored[ ] exception” to FINRA Rule 2210's general prohibition applicable only to institutional communications and to communications to QPs and knowledgeable employees about certain private placements.^[40] FINRA explained that, in its experience with broker-dealer communications, institutional investors, QPs, and knowledgeable employees are more likely to understand the risks and limitations of projections or targeted returns.^[41] Indeed, according to FINRA, the proposed rule change “would not alter the current prohibitions on including projections of performance or targeted returns in most types of retail communications.” ^[42] In addition, FINRA stated that “no 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 a retail investor.” ^[43]

FINRA also stated that the proposed rule change is “in many respects consistent with” the Commission's Investment Adviser Marketing Rule ^[44] (“IA Marketing Rule”).^[45] That rule makes it unlawful for any SEC-registered investment adviser to disseminate any advertisement ^[46] that violates the rule's specified general prohibitions.^[47] The IA Marketing Rule's provisions address, among other things, the inclusion of performance in an ( printed page 60464) advertisement, including a general prohibition on the presentation of hypothetical performance information unless certain conditions are met.^[48] These conditions are “designed to address the potential for hypothetical performance to mislead investors.” ^[49] These conditions require investment advisers to: (1) adopt policies and procedures reasonably designed to ensure the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience; (2) provide sufficient information to enable the investor to understand the criteria and assumptions made in calculating such hypothetical performance; and (3) provide (or, if the intended audience is an investor in a private fund, provides, or offers to provide promptly) sufficient information to enable the intended audience to understand the risks and limitations of using such hypothetical performance in making investment decisions.^[50]

B. The Proposed Rule Change

The proposed rule change would create a fourth exception to FINRA Rule 2210's general prohibition on the communication of projected performance or targeted returns. As stated above, this proposed exception would permit the presentation of such information in: (1) institutional communications; and (2) communications to QPs and knowledgeable employees about certain private placements.^[51] This exception would be available for these communications so long as the member firm: (1) adopts and implements written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the audience; (2) has a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return; and (3) provides certain disclosures.^[52] The Commission describes each aspect of the proposed rule change in turn.

1. Scope Limited to Institutional and Certain Private-Placement Communications

The proposed rule change, as modified by Amendment No. 1, would permit a member firm to project performance or provide a targeted return with respect to a security, asset allocation, or other investment strategy in: (1) an institutional communication; or (2) a communication that is distributed or made available only to (A) QPs and is a communication that promotes or recommends a Member Private Offering, or (B) QPs or knowledgeable employees and is a communication that promotes or recommends an Exempted Private Placement.^[53]

FINRA explained that the proposed rule change “must not increase the risk of potential harm to retail investors,” so it limited Projection-Eligible Investors to those who it believes are more likely to have the expertise or resources to understand the risks and limitations of projected performance or targeted returns.^[54] FINRA stated that Projection-Eligible Investors are “well-established categories of persons that have been previously determined to be financially sophisticated or able to engage expertise for purposes of the securities laws.” ^[55] These categories of investors, FINRA stated, “are more likely to understand the risks and limitations of projections or targeted returns.” ^[56]

2. Written Policies and Procedures

The proposed rule change would require any member firm that communicates projected performance or targeted returns to Projection-Eligible Investors to “adopt[ ] and implement[ ] written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations.” ^[57] To meet this obligation, FINRA urged member firms to consider including in their written policies and procedures “content that requires the member to consider the audience that receives a communication presenting projected performance or a targeted return.^[58] FINRA stated that communications pursuant to this proposed rule change “should only be distributed where the member reasonably believes the investors have access to resources to independently analyze this information or have the financial expertise to understand the risks and limitations of such presentations.” ^[59]

FINRA explained that these written policies and procedures could permit a member firm to “rely[ ] on its past experiences with particular types” of investors and consider whether particular investors have previously expressed interest or invested in similar securities.^[60] However, FINRA stated that “the mere fact that an investor would be interested in high returns” would not—standing alone—mean that the projected performance or targeted returns “is relevant to the likely financial situation and investment objectives of the intended audience.” ^[61]

3. Reasonable Basis Requirement

The proposed rule change would require any member firm that communicates projected performance or targeted returns pursuant to this exception to have “a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return, and retain[ ] written records supporting the basis for such criteria and assumptions.” ^[62] FINRA stated that this ( printed page 60465) proposed obligation “follows well-established precedents.” ^[63] Specifically, FINRA stated that FINRA Rules 2210 and 2241 (Research Analysts and Research Reports) require a price target in a research report to have a “reasonable basis,” ^[64] and SEC rules require certain projections of future economic performance “to be based on good faith and have a reasonable basis.” ^[65]

FINRA stated that it “believes that it is important for members to consider appropriate factors in forming a reasonable basis for the criteria used and assumptions made in calculating projected performance or targeted returns.” ^[66] Accordingly, to help guide member firms' reasonable basis determination, the proposed rule change also would include a non-exhaustive list of factors that “members should consider” when meeting this obligation.^[67] These factors—no one of which is determinative—include: (1) global, regional, and country macroeconomic conditions; (2) documented fact-based assumptions concerning the future performance of capital markets; (3) in the case of a single security issued by an operating company, the issuing company's operating and financial history; (4) the industry's and sector's current market conditions and the state of the business cycle; (5) 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; (6) the quality of the assets included in a securitization; (7) the appropriateness of selected peer-group comparisons; (8) the reliability of research sources; (9) the historical performance and performance volatility of the same or similar asset classes; (10) for managed accounts or funds, the past performance of other accounts or funds managed by the same investment adviser or sub-adviser, provided such accounts or funds had substantially similar investment objectives, policies, and strategies as the account or fund for which the projected performance or targeted returns are shown; (11) for fixed income investments and holdings, the average weighted duration and maturity; (12) the impact of fees, costs, and taxes; and (13) expected contribution and withdrawal rates by investors.^[68] FINRA explained that these factors “incorporate[ ] some of the relevant factors that members of the financial research and analysis industry use when considering the basis for a recommendation to a customer.” ^[69]

The proposed rule change also would prohibit member firms from basing projected performance or targeted returns upon: (1) “hypothetical, back-tested performance;” or (2) “the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record.” ^[70] FINRA explained that “back[-]tested performance may pose an increased risk for misleading investors, as it allows hypothetical investment decisions to be optimized by hindsight.” ^[71]

4. Disclosure Requirements

The proposed rule change would impose three disclosure requirements on member firms that communicate projected performance or targeted returns pursuant to this exception. First, any communication of projected performance or targeted returns to a Projection-Eligible Investor must “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.” ^[72]

Second, the proposed rule change would require any member firm communicating projected performance or targeted returns to a Projection-Eligible Investor to “provide[ ] sufficient information to enable the investor to understand . . . the criteria used and assumptions made in calculating the projected performance or targeted return, including whether the projected performance or targeted return is net of anticipated fees and expenses.” ^[73] FINRA explained that this requirement “is not intended to prescribe any particular methodology or calculation of such performance,” and it does not “expect a firm to disclose proprietary or confidential information regarding the firm's methodology and criteria.” ^[74] FINRA stated, however, that firms “would be expected . . . to provide a general description of the methodology used sufficient to enable the investors to understand the basis of the methodology, as well as the assumptions underlying the projection or targeted return.” ^[75] Absent these required disclosures, FINRA explained, “it is more likely that a projection or targeted return would mislead a potential investor.” ^[76]

Third, the proposed rule change would require any member firm communicating projected performance or targeted returns to a Projection-Eligible Investor to “provide[ ] sufficient information to enable the investor to understand . . . the risks and limitations of using the projected performance or targeted return in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.” ^[77] FINRA explained that this requirement “is intended to help ensure that such investors do not unreasonably rely on a projection or targeted return given its uncertainty and risks.” ^[78]

III. Discussion and Commission Findings

After careful review of the proposed rule change, the comment letters, and FINRA's response to the comments, the Commission finds that the proposed rule change, as modified by Amendment No. 1, is consistent with the requirements of the Exchange Act and the rules and regulations thereunder that are applicable to a national securities association.^[79] Specifically, the Commission finds that the proposed rule change, as modified by Amendment No. 1, is consistent with Section 15A(b)(6) of the Exchange Act, which requires, among other things, that FINRA rules 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.^[80]

Specifically, the proposed rule change would create a reasonably tailored exception from FINRA Rule 2210's general prohibition on the dissemination of performance projections or targeted returns in a member firm's communications. The proposed rule change would allow member firms to provide the same or similar information regarding projected ( printed page 60466) performance or targeted returns that are provided to investors by issuers and other intermediaries, subject to requirements reasonably designed to protect investors and the public interest. It would limit the scope of the permissible audience to certain categories of investors that FINRA believes have the expertise or resources necessary to understand the risks and limitations of projected performance or targeted returns. It also would permit communication of projected performance or targeted returns only where the member firm complies with certain conditions reasonably designed to protect investors. In particular, the proposed rule change would require member firms to: (1) adopt and implement written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the audience; (2) have a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return; and (3) provide certain disclosures. Accordingly, and as explained in more detail below, the Commission finds that the proposed rule change is consistent with Section 15A(b)(6) of the Exchange Act. The Commission addresses the proposed rule change's specific provisions, and any related comments, in turn.

A. Scope of the Exception

As originally proposed in the Notice, the proposed rule change would have permitted a member firm to project performance or provide a targeted return with respect to a security, asset allocation, or other investment strategy in: (1) an institutional communication; or (2) a communication that is distributed or made available only to QPs, and is a communication that promotes or recommends a Member Private Offering or a private placement that is exempt from the requirements of FINRA Rule 5123 pursuant to FINRA Rule 5123(b)(1)(B).^[81] In response to commenters, and as discussed below, Amendment No. 1 would also permit knowledgeable employees to receive performance projections or targeted returns about Exempted Private Placements (that is, specified private placements that are sold solely to QPs and knowledgeable employees).^[82]

Multiple commenters asked that FINRA expand the scope of the proposed rule change to include a broader set of investors, a broader set of investments, and a broader set of performance information.^[83] One commenter took no position on the proposed rule change but urged caution in the implementation and enforcement of the proposed rule change.^[84] Another commenter, on the other hand, opposed the provision of projected performance or targeted returns to any investor.^[85] The Commission addresses each of these issues in turn.

1. Scope of Permissible Investors

Many commenters requested that the proposed rule change be expanded to permit the communication of projected performance to: all investors; ^[86] accredited investors; ^[87] or knowledgeable employees.^[88] One commenter opposed the communication of projected performance or targeted returns altogether.^[89]

With respect to expanding the scope of the exclusion to all investors, and not just a subset of investors, one commenter stated that broker-dealers should be permitted to communicate projected performance and targeted returns equally to all investors, “subject to the same conditions as the IA Marketing Rule, which requires investment advisers to consider the intended audience for the communications.” ^[90] A second commenter stated that the protections provided by Regulation Best Interest and FINRA Rule 2210's general content standards justify the extension of the proposed rule change's scope to retail communications.^[91] This commenter stated that, in lieu of limitations on the scope of Projection-Eligible Investors, FINRA could protect retail investors by publishing guidance, similar to that provided by the Commission in the IA Marketing Rule release, that it “intend[s] for advertisements including hypothetical performance information to only be distributed to investors who have access to the resources to independently analyze this information and who have the financial expertise to understand the risks and limitations of these types of presentations.” ^[92]

With respect to expanding to accredited investors, one commenter stated that accredited investors “are also likely to have the sophistication and resources to assess performance projections and targeted returns properly.” ^[93] A second commenter requested that the proposed rule change extend to accredited investors under Regulation D where the broker-dealer recommends (and does not merely promote) private placements offered only to accredited investors, in light of the obligations that apply under Regulation Best Interest, the regulatory filing and review procedures of FINRA Rules 5122 and 5123,^[94] and the due diligence requirements of Regulation D.^[95] A third commenter, however, urged caution about extending the communication of projected ( printed page 60467) performance and targeted returns to accredited investors, explaining that the number of accredited investors has substantially increased since the Commission first established the category in 1982 and expressing concern that it “contains an increasing amount of investors [who] do not have the sophistication or financial wherewithal to adequately ascertain the risks” associated with projected performance and targeted returns.^[96]

With respect to expanding to knowledgeable employees, one commenter requested that the proposed rule change extend to knowledgeable employees of private funds that are excluded from the definition of investment company pursuant to Investment Company Act Section 3(c)(1) and 3(c)(7) (referred to as Section 3(c)(1) or Section 3(c)(7) funds, respectively),^[97] explaining that such employees “are also likely to have the sophistication and resources to assess performance projections and targeted returns properly.” ^[98] A second commenter requested that the proposed rule change extend to knowledgeable employees of Section 3(c)(7) funds because Section 3(c)(7) permits the sale of those funds' securities to both QPs and knowledgeable employees who are not QPs.^[99] This commenter explained that “executive officers and investment professionals with intimate knowledge of the operations of private funds marketed in member communications to the public” are not the intended beneficiaries of the proposed rule change's investor-protection conditions.^[100]

Another commenter, however, urged the Commission to disapprove the proposed rule change.^[101] This commenter stated that FINRA Rule 2210 provides the only “meaningful protection” to investors—regardless of their expertise and resources—in securities exempted from registration and the public disclosure framework.^[102] Without registration and public disclosures, the commenter stated, it is difficult to reliably project performance or provide targeted returns for these investments.^[103]

FINRA disagreed with the commenter opposing the proposed rule change, stating that the proposed rule change “will benefit investors without sacrificing investor protection, similar to the benefits that the Commission outlined in its adoption of the IA Marketing Rule related to investment advisers' presentation of hypothetical performance.” ^[104] Further, FINRA reiterated that “broker-dealers are generally prohibited from using projections of performance and targeted returns in their communications” and that the proposed rule change would allow such projections and targeted returns “under narrow circumstances and only when the safeguarding conditions are met.” ^[105] Importantly, FINRA stated that one such condition is the requirement that the member firm have a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted return.^[106] What is more, FINRA stated that FINRA Rule 2210's general content standards would continue to apply, and projected performance and targeted returns that are “misleading or lack a sound basis will continue to be prohibited” under the proposed rule change.^[107]

FINRA also disagreed with the commenter's assertion that the absence of public disclosure obligations makes it practically impossible to reliably project performance for private placements.^[108] FINRA stated that even without public disclosure obligations, private placements are subject to antifraud provisions of the federal securities laws, they typically do provide disclosures,^[109] and there are generally accepted methods to assess private company valuation ^[110] and forecasts.^[111] In any event, FINRA stated that the proposed rule change would prohibit the communication of projected performance or targeted returns where the member firm “is not satisfied that it can form a reasonable basis [for such information] because of what it perceives as unreliable or unsubstantiated information on the issuer.” ^[112]

FINRA acknowledged that the proposed rule change would impose restrictions not present in the IA Marketing Rule, but it stated that the proposed rule change was an incremental amendment that “would nevertheless be beneficial in furthering regulatory harmonization.” ^[113] With this in mind, FINRA also declined to amend the proposed rule change to permit the use of projected performance or targeted returns in communications with any investor or more narrowly to accredited investors, as requested by some commenters.^[114] FINRA stated that FINRA Rule 2210's general prohibition against performance projections “is intended to protect investors who may lack the capacity to understand the risks and limitations of using projected performance in making investment decisions.” ^[115] FINRA stated that it is appropriate to limit the scope of Projection-Eligible Investors to “specified, well-established categories of persons that have been previously determined to be financially sophisticated or able to engage expertise for purposes of the securities laws” because they “are most capable to understand the risks and limitations of using projected performance.” ^[116] More specifically, with respect to accredited investors, FINRA stated that the percentage of U.S. households that qualified as “accredited investors” has increased from approximately 1.8% in 1983 to approximately 18.5% in 2022.^[117] Unlike the Projection-Eligible Investors covered by the proposed rule change, FINRA stated that accredited investors—as a class—“may not possess the same level of financial expertise to evaluate investments and to understand the assumptions and limitations associated with such projections and targeted returns (or have resources that provide them with access to financial professionals who possess this expertise).” ^[118] FINRA further stated that it “anticipates monitoring how projections of performance and targeted returns are used for the limited categories of investors, as well as the SEC's experience with hypothetical performance in its recently adopted IA Marketing Rule, in considering whether to further expand the use of projections and targeted returns in the future.” ^[119]

However, in response to comments requesting expansion to include knowledgeable employees, FINRA expanded the proposed rule change to permit the communication of projected performance or targeted returns about Exempted Private Placements to knowledgeable employees.^[120] FINRA explained that knowledgeable employees, such as executive officers, directors, trustees, general partners, and advisory board members, “typically have intimate knowledge of the operations of private funds, and thus are less likely not to understand the risks and limitations of projections or targeted returns associated with such funds.” ^[121] FINRA also concluded that this amendment would appropriately align the scope of Projection-Eligible Investors with the scope of investors permitted to invest in Section 3(c)(7) funds: both QPs and knowledgeable employees who are not QPs.^[122] FINRA explained that the proposed rule change's limitation to Projection-Eligible Investors would render it “highly unlikely” that a knowledgeable employee of a Section 3(c)(1) or 3(c)(5) fund would be eligible to receive projected performance or targeted returns.^[123] Although “it is theoretically possible” that a member firm could sell shares of a Section 3(c)(1) or 3(c)(5) fund only to QPs or knowledgeable employees, FINRA reasoned that such a circumstance would be unlikely because those funds are structured “to allow sales to a wider range of investors.” ^[124] In limiting the use of projected performance or targeted returns to QPs and knowledgeable employees in communications that relate to offerings that are sold solely to these types of sophisticated investors, FINRA stated that it “may be limiting the risk that communications that contain projections or targeted returns would be provided erroneously to less sophisticated investors, including retail investors, in contravention of the rule.” ^[125]

One commenter offered “no objection” to Partial Amendment No. 1.^[126]

The scope of the proposed rule change is reasonably limited to communications with Projection-Eligible Investors.^[127] Because FINRA Rule 2210's general prohibition of projected performance is designed to protect investors who may lack the expertise or resources to understand its risks and limitations, it is reasonable for FINRA to limit the proposed rule change to certain categories of investors. Moreover, the purpose of the proposed rule change is not furthering regulatory harmonization, but incrementally expanding FINRA Rule 2210's exceptions to the general prohibition against member firms' communicating projected performance or targeted returns.^[128]

FINRA further reasonably determined to decline requests to extend the scope of the proposed rule change to include any accredited investor. A person may qualify as an accredited investor by falling within one of 13 separate qualification categories.^[129] These categories include a broader range of investors than QPs, including “[a]ny natural person whose individual net worth, or joint net worth with that person's spouse or spousal equivalent, exceeds $1,000,000” ^[130] and “[a]ny natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint ( printed page 60469) income with that person's spouse or spousal equivalent 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.” ^[131] SEC Staff indicated in 2023 that “[l]imited information is available on the financial sophistication of accredited investors, which makes it challenging to assess the effectiveness of the definition's financial thresholds as a proxy for such sophistication.” ^[132] For these reasons, it is reasonable for FINRA to decline requests to extend the scope of the proposed rule change to include any accredited investor.

The potential application of Regulation Best Interest does not justify an extension of the proposed rule change to accredited investors or, more broadly, to all investors. Regulation Best Interest would provide additional protections to retail customers where a member firm's communication of projected performance or targeted returns involves a recommendation. The proposed rule change, however, would permit the communication of projected performance or targeted returns to Projection-Eligible Investors in communications that do not involve recommendations (and thus do not trigger Regulation Best Interest's protections).^[133] Moreover, Regulation Best Interest and the proposed rule change serve different ends—Regulation Best Interest regulates the conduct of member firms and their associated persons in making recommendations to retail customers,^[134] whereas the proposed rule change is designed, among other things, to help equip Projection-Eligible Investors with the information necessary to understand the risks and limitations of projected performance and targeted returns.^[135]

For these same reasons, the proposed rule change reasonably expands the scope of Projection-Eligible Investors to cover knowledgeable employees receiving projected performance or targeted returns about Exempted Private Placements. As stated above, FINRA originally limited the proposed rule change to institutional communications and communications promoting Member Private Offerings and Exempted Private Placements that are sold only to QPs.^[136] However, so-called “knowledgeable employees,” such as executive officers, directors, trustees, general partners, and advisory board members of private funds, should have—because of their positions—knowledge that would equip them to understand the risks and limitations of projected performance or targeted returns.^[137] Indeed, FINRA recognized that “knowledgeable employees typically have intimate knowledge of the operations of private funds, and thus are less likely” to misunderstand “the risk and limitations of projections or targeted returns associated with such funds.” ^[138] Based on the nature of knowledgeable employees' positions, Amendment No. 1's extension of Projection-Eligible Investors to include such knowledgeable employees is reasonable and may also limit the risk of inadvertent disclosure of projections or targeted returns to investors who may lack the resources to understand the risks limitations of such projection information.

2. Scope of Permissible Investments

The proposed rule change would permit the communication of projected performance and targeted returns to QPs so long as the communication promotes or recommends a Member Private Offering or an Exempted Private Placement.^[139] The proposed rule change also would permit the communication of projected performance and targeted returns to knowledgeable employees so long as the communication promotes or recommends an Exempted Private Placement.^[140] Member Private Offerings are private placements sold solely to QPs,^[141] and Exempted Private Placements are private placements sold solely to QPs or knowledgeable employees.^[142]

Three commenters stated that the proposed rule change should permit the communication of projected performance and targeted returns to QPs, regardless of the type of investment.^[143] For example, one of these commenters asked that the proposed rule change be “product agnostic,” allowing QPs to receive projected performance and targeted returns for private funds that are exempt from the definition of investment company under Investment Company Act Sections 3(c)(1) and 3(c)(5) (and other non-3(c)(7) funds) even where those funds are available to non-QPs.^[144] This commenter explained that FINRA could mitigate the risk of indirect distribution of projected performance or targeted returns to non-QP investors by labeling covered materials as “for QPs only” or instructing QP recipients not to disseminate the material to non-QPs.^[145] Two other commenters stated that QP-status alone—regardless of the type of investment—should be sufficient for eligibility to receive projected performance and targeted returns.^[146]

In response, FINRA declined to amend the proposed rule change to permit communication of projected performance or targeted returns of any type of investment to QPs.^[147] FINRA explained that—by limiting the use of projected performance and targeted returns to certain private placements available only to Projection-Eligible Investors—it may limit the risk that the performance information erroneously reaches “less sophisticated investors, including retail investors, in contravention of the rule.” ^[148]

The proposed rule change reasonably limits the scope of investments eligible for projected performance and targeted returns in communications with QPs and knowledgeable employees. As discussed above, the proposed rule change is intended to restrict the audience of communications including such performance information to certain categories of investors who FINRA believes have the expertise or resources to understand their risks and limitations. This limitation in scope is reasonably designed to further that goal. Because communications to QPs that include projected performance or targeted returns would only relate to certain private placements made available only to QPs and knowledgeable employees, the proposed rule change may reduce the risk that the inadvertent disclosure of such communications would harm a wider range of investors. In this way, the proposed rule change is reasonably designed to protect investors and the public interest.

Furthermore, the proposed rule change incrementally expands the exceptions to the general prohibition against member firms' communicating projected performance or targeted returns to investors. It builds upon FINRA's regulatory experience with rules addressing communications with the public and registration exemptions.

3. Scope of Performance Information

The proposed rule change would prohibit member firms from basing projected performance or a targeted return upon: (1) hypothetical, back-tested performance (herein, “back-tested performance”); or (2) the prior performance of a portfolio or model that was created solely for the purpose of establishing a track record (herein, “prior performance of a seed account”).^[149]

Two commenters requested that FINRA permit the use of back-tested performance or the prior performance of a seed account to generate performance projections or targeted returns, stating that not doing so would limit the utility of the proposed rule change.^[150] Both commenters criticized FINRA's divergence from the IA Marketing Rule, asserting that the IA Marketing Rule permits the use of such information. To address any concern that a member firm would misrepresent hypothetical, back-tested performance as actual performance, one of these commenters recommended that FINRA require “prominent identification of targets and projections based on back[-]tests and disclosures regarding the reliability of such information.” ^[151]

In response, FINRA declined to permit member firms to base projected performance or targeted returns upon back-tested performance or the prior performance of a seed account.^[152] FINRA expressed its belief that they “are not sound bases” for projected performance or targeted returns.^[153] In addition, FINRA stated that, based on its experience, “back[-]tested performance may pose an increased risk for misleading investors, as it allows hypothetical investment decisions to be optimized by hindsight.” ^[154] Accordingly, FINRA has interpreted FINRA Rule 2210(d) to prohibit the presentation of hypothetical back-tested performance in communications used with retail investors.^[155] This existing interpretation remains unchanged, and FINRA stated that it “sees little difference between allowing members to use back[-]tested performance as a basis for a projection or targeted return and allowing members to present back[-]tested performance on its own.” ^[156]

With respect to comments requesting alignment with the IA Marketing Rule's treatment of back-tested performance, FINRA stated that the proposed rule change was not intended to be identical to that rule.^[157] FINRA recognized that commenters “continue to advocate for greater regulatory harmony” with the IA Marketing Rule, but it stated that the proposed rule change “is nevertheless a step towards regulatory harmonization.” ^[158]

The proposed rule change reasonably maintains the prohibition on the use of back-tested performance and the prior performance of a seed account in projected performance or targeted returns. Citing studies of back-tested performance and the prior performance of seed accounts,^[159] FINRA explained its belief that such information is not a sound basis for projected performance or targeted returns under the proposed rule change. This is a reasonable interpretation that is consistent with FINRA's position that the presentation of hypothetical back-tested performance may pose a heightened risk of misleading brokerage customers and would violate the content standards in FINRA Rule 2210(d).^[160] For these reasons, FINRA reasonably chose to continue the prohibition on the use of back-tested performance and the prior performance of a seed account in projected performance or targeted returns.

B. Written Policies and Procedures

The proposed rule change would require any member firm that communicates projected performance or targeted returns to “adopt[ ] and implement[ ] written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations.” ^[161]

One commenter asked FINRA to clarify that broker-dealers “can consider the category of investor, rather than an investor's individual characteristics, when ensuring that the communication is relevant to the investor.” ^[162] This commenter explained that such an interpretation would “better align” this obligation with that of the IA Marketing Rule, which requires that the communication be relevant to the intended audience, not the individual investor.^[163]

Other commenters asked FINRA to eliminate or modify this proposed condition, asserting that it is unnecessary or redundant.^[164] Two commenters stated that the separate determination that the performance is relevant to the intended audience is redundant because the proposed rule change—as originally proposed—already would limit the communication of projected performance and targeted returns to institutional investors and QPs.^[165] In addition, two commenters stated that member firms' independent obligations under FINRA Rule 2111(b) ^[166] and Regulation Best Interest also render this condition redundant.^[167]

In response, FINRA declined to amend or eliminate this provision. FINRA explained that the provision is important, as it would help to ensure that member firms focus on the relevance of their communications to their intended audience, and not simply whether or not the audience is a Projection-Eligible Investor.^[168] In addition, FINRA stated that FINRA Rules 2210 and 2111 are “distinct rules with different scopes and objectives,” and it stated FINRA Rule 2111 and Regulation Best Interest only apply when a broker-dealer makes a recommendation of a security or investment strategy.^[169] FINRA Rule 2210, on the other hand, “is broader and governs any communications that a member distributes or makes available to retail customers, regardless of whether the communications contain a recommendation that would also trigger [FINRA] Rule 2111 or Regulation Best Interest.” ^[170] Therefore, in response to requests for guidance on whether the proposed rule change would require member firms to limit the use of performance projections and targeted returns to prospective fund investors who pass the suitability requirements of FINRA Rule 2111 or the standards set forth in Regulation Best Interest, FINRA stated that the proposed rule change would not require member firms to assess their audience under a suitability or Regulation Best Interest standard to determine whether the projected performance or targeted return is relevant to the audience's likely financial situation and investment objectives.^[171]

However, FINRA clarified that it would interpret this condition “consistently with the substantially similar provision in the IA Marketing Rule.” ^[172] Because the proposed rule change requires the adoption and implementation of written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication, FINRA explained that a member firm “is not required to know the actual financial situation or investment objectives of each investor that receives the communication.” ^[173] Instead, the proposed rule change “permits members to comply with this condition by grouping investors into categories or types.” ^[174]

FINRA reasonably determined to require member firms communicating projected performance or targeted returns to Projection-Eligible Investors to “adopt[ ] and implement[ ] written policies and procedures reasonably designed to ensure that the communication is relevant to the likely financial situation and investment objectives of the investor receiving the communication and to ensure compliance with all applicable requirements and obligations.” ^[175] The adoption and implementation of such written policies and procedures would help ensure that member firms focus not only on whether the intended audience is a Projection-Eligible Investor but also that the communication is relevant to that audience's likely financial situation and investment objectives. FINRA also reasonably determined to permit member firms to comply with this obligation by relying upon the member firms' past experiences with specific investors or types of investors to group them into categories of investors, as appropriate.^[176] Moreover, this proposed condition is not redundant of preexisting obligations under FINRA Rule 2111 and Regulation Best Interest, as the proposed rule change applies more broadly to any communications of projected performance or targeted returns, whether or not they contain recommendations.^[177] Finally, FINRA Rule 2111, Regulation Best Interest, and the proposed rule change serve different ends. FINRA Rule 2111 and Regulation Best Interest regulate the conduct of member firms and their associated persons in making recommendations to retail investors, whereas this provision of the proposed rule change would require policies and procedures reasonably designed to help ensure that the communication is relevant to the likely financial situation and investment objectives of the intended audience. Consequently, as FINRA has clarified, the proposed rule change would not require a separate assessment under the suitability or Regulation Best Interest standard.

C. Reasonable Basis Requirement

As stated above, the proposed rule change would require any member firm that communicates projected performance or targeted returns to Projection-Eligible Investors to have “a reasonable basis for the criteria used and assumptions made in calculating the projected performance or targeted ( printed page 60472) return[ ] and retain[ ] written records supporting the basis for such criteria and assumptions.” ^[178] The proposed rule change states that “members should consider multiple factors, with no one factor being determinative,” in forming a reasonable basis for the criteria used and assumptions made in calculating projected performance or a targeted return.^[179] Proposed Supplementary Material .01 includes a non-exhaustive list of factors that member firms may consider in forming a reasonable basis.^[180]

One commenter stressed the importance of this provision—and compliance with it—to FINRA's stated goal of helping to ensure that the proposed rule change would not increase risk to retail investors.^[181] A second commenter suggested removal of this provision to align with the IA Marketing Rule, “which imposes no such requirement.” ^[182]

Commenters also identified compliance challenges associated with a member firm's use of third-party information to comply with the reasonable basis requirement.^[183] Specifically, one commenter asked whether the proposed rule change would require member firms to make their own reasonable-basis determinations about third-party projections.^[184] Other commenters stated that member firms may struggle to comply with this condition—especially its document-retention requirement—as it relates to third-party projections or targeted returns because firms are usually uninvolved in their creation and lack access to the underlying materials.^[185] One of these commenters also questioned the investor-protection benefit associated with a member firm's retention of third-party records about a third-party projection or targeted return.^[186]

In light of these compliance challenges, one commenter asked FINRA to clarify (if it declines to remove the condition) what it expects with respect to third-party performance projections and targeted returns.^[187] This commenter stated that member firms should be able to “rely upon the certification or representations of the sponsor, manager[,] or party calculating this information (who has far greater access to information than the broker-dealer does), absent information to the contrary.” ^[188] Another commenter suggested further streamlining of the condition to “avoid potentially overlapping, ambiguous, and onerous requirements.” ^[189]

As an alternative to FINRA's proposed condition, another commenter recommended that member firms be required to establish a reasonable basis to believe that the criteria used and assumptions made in calculating targeted returns or projected performance are appropriate and not misleading, and to retain records supporting that determination.^[190] This commenter explained that this alternative approach would better address the use of third-party projections, as it would require the retention of records demonstrating the member firms' testing processes.^[191]

One commenter recognized the potential utility of the factors enumerated in the proposed Supplementary Material in making a reasonable basis determination, but asked that FINRA clarify that the consideration of any such factors would depend on the facts and circumstances.^[192] Another commenter, however, stated that the factors could “create potentially overlapping, ambiguous[,] and onerous requirements” that might dissuade member firms from using projected performance or targeted returns.^[193] Another commenter asked FINRA to confirm that a member firm could include projected performance or provide a targeted return relevant to the time horizon of an investment.^[194]

In response, FINRA declined to modify the proposed rule change to eliminate or otherwise amend a member firm's obligation to form a reasonable basis for either its own or a third-party generated projected performance or targeted returns.^[195] Absent this condition, FINRA stated that projected performance or targeted returns “could be based on guesswork, dubious presumptions, and wildly inaccurate or inherently misleading reasoning.” ^[196] This requirement, FINRA stated, would help to ensure that member firms act “with reasonable diligence and good faith” when communicating performance information pursuant to this proposed rule change.^[197]

FINRA stated that the proposed rule change “does not prescribe the manner in which the member forms its reasonable basis” and member firms retain the “flexibility to determine what is reasonable based upon the particular facts and circumstances.” ^[198] Further, FINRA stated that the factors it identified in the proposed Supplementary Material “are meant to be a helpful guide” and “not all factors may be relevant” in every instance. FINRA further stated that it would monitor the implementation of this proposed condition and issue guidance, as necessary, “once FINRA and members have experience with these factors over time.”

With regard to concerns about its interactions with other requirements, FINRA stated the condition's consistency with other requirements.^[199] For example, FINRA Rules 2210 and 2241 (Research Analysts and Research Reports) require price targets in research reports to have a reasonable basis.^[200] In addition, FINRA stated that SEC rules require issuers to have a good faith and reasonable basis for performance projections contained in certain documents,^[201] and that the IA ( printed page 60473) Marketing Rule's general prohibitions would have the effect of prohibiting the advertisement of hypothetical performance for which the adviser lacks a reasonable basis.^[202]

Moreover, FINRA explained that FINRA Rule 2210's content standards apply to all member communications “distributed or made available” to investors, whether or not the firm “created the communication.” ^[203] For that reason, FINRA Rule 2210 and the proposed rule change would apply to a member firm's communication of third-party generated projected performance or targeted returns.^[204] Accordingly, FINRA explained that a member wishing to use a third-party projection or targeted return would need to “obtain enough information to form a reasonable basis as to the issuer's assumptions and the underlying criteria.” ^[205] If the member firm is unable to secure that information, FINRA stated “it should refrain from using the communications.” ^[206] FINRA concluded that modifying this condition for third-party projections would “increase[ ] the risk that “unreasonable, issuer-created projections would be distributed to investors, which is contrary to the public interest.” ^[207]

Finally, with respect to the comment requesting whether a member could provide a performance projection or targeted return based on a time horizon of investment, FINRA stated that this determination will always depend on the facts and circumstances of the projection or targeted return, which may or may not be consistent with an investment's time horizon, or in the case of a debt security, its maturity date.^[208] In addition, FINRA explained that an investment's time horizon may be an unreliable criterion for calculating a projection or targeted return of the investment because it is often uncertain at the time a security is issued and may change due to subsequent events.^[209] FINRA also explained that “a time horizon could be of such a length that it would be unreasonable” to project performance or provide a targeted return for that same period of time.^[210] For these reasons, FINRA stated that there should not be an exception from the reasonable-basis requirement “based solely on an investment's estimated time horizon.” ^[211]

The proposed rule change reasonably requires member firms to have a reasonable basis for the criteria used and assumptions made and to retain relevant records. Projected performance and targeted returns about private placements often rely on unique criteria and assumptions, including the time horizon of the investment.^[212] Under these circumstances, the proposed rule change reasonably requires member firms to have a reasonable basis for such projections and returns; the substance and reasonableness of this determination will depend on the facts and circumstances of the projection or targeted return. Further, in response to concerns that the factors identified in the proposed Supplementary Material would create onerous, ambiguous, and overlapping requirements, the proposed rule change does not mandate the consideration of each factor in every instance, and it only indicates that a member firm should consider multiple factors in its reasonable-basis determination. In light of this flexibility, the proposed rule change would aid member firms in identifying relevant factors for consideration in making the reasonable-basis determination, which should assist firms in compliance.

To eliminate this reasonable basis requirement would allow a member firm to disseminate information without forming a view as to its content. This result would be inconsistent with FINRA Rule 2210's general content standards, which apply broadly to any of a firm's communications with investors, regardless of the source of information in the communication, and would risk—as FINRA states—communications of projected performance or targeted returns “based on guesswork, dubious presumptions, and wildly inaccurate or inherently misleading reasoning.” ^[213]

With regard to third-party information, the reasonable-basis condition also contemplates a principles-based approach and does not mandate a specific method for establishing that the member firm has a reasonable basis for the criteria used and assumptions made regarding such information. Indeed, as FINRA emphasizes, member firms retain the flexibility to determine whether, depending on the facts and circumstances, they have received sufficient information from a third-party to conclude that its projected performance or targeted returns has a reasonable basis; this flexibility should alleviate some of the compliance challenges identified by commenters regarding third-party information.^[214] By extending the reasonable basis obligation to a member firm's use of third-party projected performance or targeted returns, FINRA has reasonably sought to extend the proposed rule change's investor protection benefits to all communications with investors, regardless of the source of information, and to ensure consistency with FINRA Rule 2210, whose general content standards apply broadly to any of a firm's communications with investors, regardless of the source of information in the communication.

In support of this principles-based approach, the proposed rule change requires member firms to “retain[ ] written records supporting” their reasonable-basis determination and does not per se mandate that the firm obtain and maintain third-party records.^[215] Although the records supporting a member firm's determination may, in some circumstances, be third-party records, member firms retain the flexibility to determine whether the circumstances of a particular performance projection or targeted return would require the acquisition and retention of third-party records to support its determination. As a result, the proposed rule change's document-retention provision reasonably helps to ensure that firms substantiate their reasonable basis determinations while simultaneously providing them with the flexibility to determine what the circumstances of a particular case would require. In this way, the proposed rule change is reasonably designed to prevent fraudulent and manipulative acts and practices.

D. Disclosure Requirements

The proposed rule change would impose three disclosure-related ( printed page 60474) requirements on any member firm communicating projected performance or targeted returns to a Projection-Eligible Investor. First, a communication would be required 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.” ^[216] Second, member firms would be required to “provide[ ] sufficient information to enable the investor to understand . . . the criteria used and assumptions made in calculating the projected performance or targeted return, including whether the projected performance or targeted return is net of anticipated fees and expenses.” ^[217] Third, member firms would be required to “provide[ ] sufficient information to enable the investor to understand . . . the risks and limitations of using the projected performance or targeted return in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.” ^[218]

No commenter offered a substantive comment related to these disclosure provisions.

The proposed rule change's disclosure provisions are reasonably designed to provide investors with information that will help them to understand the assumptions, methodologies, risks, and limitations associated with the projected performance or targeted returns.^[219] The disclosures would help to inform Projection-Eligible Investors that projected performance and targeted returns are hypothetical in nature. The disclosures also provide information to Projection-Eligible Investors regarding the criteria and assumptions associated with the calculation of the projected performance or targeted returns. The disclosures would emphasize to Projection-Eligible Investors that such information has inherent risks and limitations. In sum, the disclosure-related provisions are reasonably designed to help Projection-Eligible Investors understand the risks and limitations of relying on projected performance or targeted returns.

IV. Conclusion

For the reasons set forth above, the Commission finds that the proposed rule change, as modified by Amendment No. 1, is consistent with Section 15A(b)(6) of the Exchange Act, which requires, among other things, that FINRA rules be designed to prevent fraudulent and manipulative acts and practices, promote just and equitable principles of trade, and, in general, protect investors and the public interest.^[220]

It is therefore ordered pursuant to Section 19(b)(2) of the Exchange Act ^[221] that the proposed rule change (SR-FINRA-2023-016), as modified by Amendment No. 1, be, and hereby is, approved.