Due Diligence: The Life Cycle of a Product Thursday, May ... · PDF fileOverview – Private Placement Rules ... an entity composed exclusively of qualified institutional buyers, as

© 2015 Financial Industry Regulatory Authority, Inc. All rights reserved.

Due Diligence: The Life Cycle of a Product Thursday, May 28 4:15 p.m. – 5:15 p.m. Topics:

Understand and apply FINRA Rules 5122 (Private Placements of Securities Issued by Members) and 5123 (Private Placements of Securities).

Learn about members’ supervision and due diligence procedures when vetting complex products, including structured products, Business Development Company (BDCs) and Real Estate Investment Trusts (REITs).

Discuss the statutory and regulatory basis and scope of members’ due diligence obligations.

Speakers: Joseph Price (moderator)

Senior Vice President and Counsel FINRA Corporate Financing/Advertising Regulation Nathan Headrick Managing Director and President Triloma Securities Kenneth Josselyn Managing Director and General Counsel, Finance and Corporate Goldman, Sachs & Co. Elizabeth Page Vice President and District Director FINRA Boston District Office

Due Diligence: The Life Cycle of a Product

FINRA Annual ConferenceMay 28, 2015 • Washington, DC

2015 FINRA Annual Conference © 2015 FINRA. All rights reserved.

Panelists

Moderator: Joseph Price, Senior Vice President and Counsel, FINRA

Corporate Financing / Advertising Regulation

Panelists:Nathan Headrick, Managing Director and President, Triloma

Securities

Kenneth Josselyn, Managing Director and General Counsel, Finance and Corporate, Goldman, Sachs & Co.

Elizabeth Page, Vice President and District Director, FINRA Boston District Office

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Overview – Private Placement Rules

FINRA Rule 5123 (Private Placements of Securities) became effective in December 2012. We’ve received over 7,000 private placement filings since then.

The essential purpose of the rule is to ensure that members are meeting their due diligence responsibilities when they recommend private placements to retail customers. Firms have up to 15 days after the first sale to make a filing.

Rule 5122 became effective in June 2009. This rule applies to offerings of a Broker Dealer’s (BD) securities or a control entity of a BD.

We receive approximately 250 MPO (member private offerings) filings per year. MPOs are now filed through the same private placement system as Rule 5123 filings.

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Proportion of Filings under Rules 5122 and 5123

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Private Placement Rule 5122 (MPOs)

Definitions

1) Member Private Offering (MPO) A "member private offering" means a private placement of unregistered

securities issued by a member or a control entity.

2) Control Entity A "control entity" means any entity that controls or is under common

control with a member, or that is controlled by a member or its associated persons.

3) Control The term "control" means beneficial interest, as defined in Rule

5130(i)(1), of more than 50 percent of the outstanding voting securities of a corporation… Control will be determined immediately after the closing of an offering, and in the case of an offering with multiple intended closings, immediately following each closing.

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Private Placement Rule 5122 – Continued

Disclosure RequirementsA. Private placement memorandum or term sheet: must be provided to

each prospective investor and must contain disclosures addressing: (i) intended use of the offering proceeds; and (ii) offering expenses and the amount of selling compensation that will be paid to the member and its associated persons.

B. No private placement memorandum or term sheet: the member must prepare an offering document that contains the disclosures required and provide such document to each prospective investor.

Filing RequirementsA member must file the private placement memorandum, term sheet or such other offering document with the Corporate Financing Department at or prior to the first time the document is provided to any prospective investor.

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Private Placement Rule 5122 – Continued

Any amendment(s) or exhibit(s) to the private placement memorandum, term sheet or other offering document also must be filed with the Department within ten days of being provided to any investor or prospective investor.

Use of Offering Proceeds

For each MPO, at least 85% of the offering proceeds raised must be used for business purposes, which shall not include offering costs, discounts, commissions or any other cash or non-cash sales incentives. The use of the offering proceeds also must be consistent with the disclosures required in paragraph (b)(1).

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Private Placement Rule 5123

FINRA Rule 5123. Private Placements of Securities

Filing Requirements

Each member that sells a security in a non-public offering in reliance on an available exemption from registration under the Securities Act (“private placement”) must:

(i) submit to FINRA, or have submitted on its behalf by a designated member, a copy of any private placement memorandum, term sheet or other offering document, including any materially amended versions thereof, used in connection with such sale within 15 calendar days of the date of first sale; or

(ii) indicate to FINRA that no such offering documents were used.

Members may file on behalf of other participating members

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Rule 5123 – Continued

Rule 5123 became effective on December 3, 2012. The rule requires that a member file with FINRA any private placement memorandum, term sheet or other offering document for a private placement in which the member participates. The rule exempts the types of private placements that have not

been characterized by widespread abuse, such as Regulation S offerings, offerings of investment grade rated debt and offerings to institutional accounts. The rule exempts an offering sold solely to institutional

accredited investors (e.g. a bank). We have issued an FAQ to clarify that private placements sold to individual accredited investors must be filed. There are two types of filing exemptions – firm specific and

offering specific. The two Rules have many similar filing exemptions.

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Exemptions of FINRA Rule 5123

Firm Specific Exemptions: a filing need not be made if sold by the member or person associated with the member solely to any one or more of the following categories of investors: institutional accounts, as defined in Rule 4512(c);

qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;

qualified institutional buyers, as defined in Securities Act Rule 144A;

investment companies, as defined in Section 3 of the Investment Company Act;

an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;

banks, as defined in Section 3(a)(2) of the Securities Act;

employees and affiliates, as defined in Rule 5121, of the issuer;

knowledgeable employees as defined in Investment Company Act Rule 3c-5;

eligible contract participants, as defined in Section 3(a)(65) of the Exchange Act; and

accredited investors described in Securities Act Rule 501(a)(1), (2), (3) or (7).

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Offering Specific Exemptions of FINRA Rule 5123

Offerings of exempted securities;

Offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;

Offerings of exempt securities with short term maturities;

Offerings of subordinated loans under SEA Rule 15c3-1, Appendix D (see NASD Notice to Members 02-32 (June 2002));

Offerings of “variable contracts,” as defined in Rule 2320(b)(2);

Offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in Rule 5110(b)(8)(E); and

Offerings of non-convertible debt or preferred securities that meet the transaction eligibility criteria for registering primary offerings of non-convertible securities on Forms S-3 and F-3;

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Offering Exemptions of FINRA Rule 5123 –Continued Offerings of securities issued in conversions, stock splits and

restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor;Offerings of securities of a commodity pool operated by a

commodity pool operator, as defined under Section 1a(11) of the Commodity Exchange Act;Business combination transactions as defined in Securities

Act Rule 165(f);Offerings of registered investment companies;Standardized options, as defined in Securities Act Rule 238;

andOfferings filed with FINRA under Rules 2310, 5110, 5121 and

5122, or exempt from filing thereunder in accordance with Rule 5110(b)(7).

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Filing Process Data Intake Triage Staff Review Investigation

Rules 5122 / 5123 Form filing via Firm Gateway

One page form designed to be non-burdensome to members

Collects structured data and Private Placement Memoranda (PPMs) in searchable pdf format

We select offerings to review based on the information provided and what we know about the firm and the issuer.

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FINRA Regulatory Notice 13-26

The following 6 questions were added to the form effective July 1st:

Is this a contingency offering?

Does the user have any independently audited financial statements for the issuer’s most recent fiscal year?

Is the issuer able to use offering proceeds to make or repay loans to, or purchase assets from, any officer, director or executive management of the issuer, sponsor, general partner, manager, advisor or any of the issuer’s affiliates?

Does the issuer have a board of directors comprised of a majority of independent directors or a general partner that is unaffiliated with the firm?

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FINRA Regulatory Notice 13-26 – Continued

Has the issuer engaged, or does the member anticipate that the issuer will engage in a general solicitation in connection with the offering or sale of the securities?

Has the issuer, any officer, director or executive management of the issuer, sponsor, general partner, manager, advisor, or any of the issuer’s affiliates been the subject of SEC, FINRA, or state disciplinary actions or proceedings or criminal complaints within the last 10 years?

The questions are not intended to set new standards of disclosure, due diligence or information gathering requirements for firms involved in the private placement offerings.

The form assists FINRA in prioritizing its review of the filings.

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Staff Review

We do not have the resources to follow up every problem that we see. The review team meets to discuss issues identified in the filings. We assign filings to team members and meet as a team or

individually to discuss the issues raised.

The team decides which problems to pursue and which we cannot.

We contact the district staff or we conduct research to fill gaps in filing information. We minimize need to contact firms but sometimes filing errors have to be corrected.

We document our reviews in an internal system available to FINRA staff.

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Staff Review – What do we look for?

Disclosures that raise red flags Inconsistent or unsupported statements, claims and

projections

False information; addresses, locations, names or other information

Guarantees of high returns, high fees and high risks

Problematic or missing disclosures

Evidence of due diligence problemsHas the broker-dealer made a reasonable inquiry on the issuer

and its management, and have a reasonable basis to offer the security to any investor? Disclaimers and questionable backgrounds.

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Staff Review – What do we look for? – Continued

Use of proceeds – potential misappropriation of fundsPaying back previous investors and lenders

Payments or loans to management, employees or promoters

Expenses of management or control persons unrelated to business

Unsustainable financial conditionsHistory of negative financial performance

Defaults

Going concern opinion from an auditor

Other financial red flags

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What Are We Seeing – Problematic Filing Examples

Deficient escrow procedures

Guaranteed or unsupported high projected returns

Unclear or problematic use of proceeds

Proceeds to pay or repay prior investors or debt-holders

Disciplinary history of broker or management

Distressed financial condition of issuer

Potential misrepresentation, omission of information, or conflicting disclosures

Exaggerated projections or “cherry picked” performance history

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Problems Continued

Sales to non-accredited investors

Problems with Regulation D and Form D compliance

Advertising and Communications With the Public

“Crowdfunding” offerings

Due diligence and suitability disclaimers

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Due Diligence Obligations – Regulatory Notice 10-22

Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D OfferingsBroker-Dealers may not rely blindly upon the issuer or the

issuer’s counsel in lieu of conducting its own reasonable investigation.

Firms must exercise a high degree of care in investigating and verifying the issuer’s representations and claims.

Reasonable basis suitability in addition to customer specific suitability apply.

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Regulatory Notice 10-22

Reasonable investigations include, at a minimum: Issuer and management;

Business prospects;

Assets held by or to be acquired by the issuer;

Claims being made; and

Intended use of proceeds of the offering.

The firm’s role in the transaction may impact the scope of the firm’s investigation.Affiliate of the Issuer

Firm that prepared the PPM

Wholesaler

Retailer

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Reasonable investigations require the firm to follow up on “Red Flags”. Firms cannot rely upon:Representations by the issuer’s management;

Disclosure in an offering document; or

Due diligence reports of the issuer’s counsel.

Reliance on counsel and syndicate managers Firms may retain counsel or experts to assist in investigations.

Firms have an obligation to follow up on issues or concerns identified by counsel or expert.

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Reasonable Investigation Practices Issuer and Management

– Governing documents

– Financial statements of the issuer and affiliates

– Business affiliates

– Audit controls

– Outreach to customers and suppliers

– Reviewing contracts

– Reviewing past securities offerings

– Inquires into litigation or regulatory problems

– Inquires into the issuer’s management, compensation and business.

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Issuer’s business prospectsViability of any patent or rights

Inquiry into the industry, prospects and regulatory restrictions

Reviewing business plans and expectations

Requesting financial models

Issuer’s assetsVisiting and inspecting assets or facilities

Examining geological, land use, engineering or other reports

For energy exploration and development, obtaining expert opinions from engineers, geologists and others in determining the suitability of the investment.

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Resources

Regulatory Notice 09-27, SEC Approves New FINRA Rule 5122 Relating to Private Placements of Securities Issued by a Member Firm or a Control Entity; Effective Date: June 17, 2009

Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D OfferingsRegulatory Notice 12-40, SEC Approves New FINRA Rule 5123

Regarding Private Placements of Securities; Effective Date: December 3, 2012

Regulatory Notice 13-26, FINRA Updates Form for Filing Private Placements of Securities Pursuant to FINRA Rules 5122 and 5123Sale of Private Placements Frequently Asked Questions (FAQ) www.finra.org/industry/compliance/regulatoryfilings/privateplacements/faq/

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Product Due Diligence –New Forms of Alternative

Investments

FINRA Annual ConferenceMay 28th, 2015

Build Your Process

• Know the Big 3 and Fix Your WSPs

• FINRA Regulatory Notice 12‐03, Heightened Supervision of Complex Products, (January 2012)

• FINRA Regulatory Notice 10‐22, Obligation of Broker‐Dealers to Conduct Reasonable Investigations in Regulation D Offerings (April 2010)

• Notice to Members 05‐26, NASD Recommends Best Practices for Reviewing New Products, (April 2005)

Due Diligence Step 1

• Before you start your due diligence, review the due diligence done already

• Get a third party due diligence report– New players are emerging

• Look at the work the managing dealer has done– Even proprietary product requires managing dealer due diligence

Due Diligence Step 2

• Know the product– Move toward the 40 Act over time on public side– BDCs– Closed End Funds

• Ex key difference: Semi annual financial reporting

– Interval Funds• Sales Charge Rule vs Corporate Financing Rule

– Master Feeders– DST Series Funds– Private Equity – Regulation A+

• Redo your checklist!

Key Due Diligence Points

• Backgrounds of the key players– Relationships transcend transactions– Don’t go for one‐and‐done market entrants

• How transparent is the offering and the process?• Don’t forget your new product process (NTM 05‐26)

Watch For Regulatory Change

• NTM 15‐02 and Customer Account Statements– April 2016 effective date

• NASAA Suitability Requirements• DOL Fiduciary Proposal• Definition of Accredited Investor• Bad Boy Provisions• FINRA Syndicate Filing Requirement for Privates• General Solicitation

Operational Issues

• Closed End Funds: AIP vs FundServe– How will your firm classify the product?

• Private Equity: UBTI and Blocker Corporations– Separate Custodians

New Product Due Diligence –Securitized Derivatives

FINRA Annual ConferenceMay 28th, 2015

Key Elements of the Process

• Key Elements:– Business– Legal and Compliance– Accounting and Tax– General Suitability– Reputational– Operational– Distribution Channels– Index Approvals/Licenses– Offering Materials

• The process is not necessarily sequential and it is definitely overlapping.

Business Due Diligence

• Before Legal, Compliance and various Divisional and Firmwide Committees get fully involved, the Business does their own due diligence.

• While primarily commercial, the Business considers reputational and client relationship issues, and will take advice from Legal, Compliance, Tax, Accounting and others to determine if the new product is potentially viable.

• The Business also attempts to ascertain the costs associated with selling the new product, as well as estimating potential revenues, in order to determine if the selling the product is potentially worth the investment of time and effort.

Legal and Compliance Review

• Internal and external legal review the product:– Can the proposed issuer legally issue the product and distribute it in

the manner proposed (marketing materials and distribution channels) to the proposed class of buyers in the jurisdictions where they are located, including, but not limited to:

• SEC disclosure requirements re underlyers, including estimated value• Commodities, futures, options, gambling and other similar issues.• Dodd‐Frank issues re hedging• Currency and exchange controls• Investment company issues• Insurance issues• Corporate authority and regulatory approval issues, especially for financial

institutions• Listing requirements

Disclosure Requirements

• Clear plain English disclosure is the essential element to insuring that investors know what they are buying, including the key risks associated therewith.

• Regardless of the outcome of the rest of the new product review process, if the Business, Legal and Compliance cannot draft a disclosure document that clearly conveys this information to the class of potential buyers, the new product will not be issued or underwritten.

• The SEC’s Morgan Stanley no‐action letter (2 pages) is the starting point for determining underlyer disclosure in SEC registered offerings.

Accounting and Tax

• How will the issuer account for the new product and the related hedge?

• How will the investor, particularly institution investors account for the new product? – Post‐Enron, this is an issue to be considered by financial institutions

issuing and distributing structured products.

• Similarly, what are the tax implications to the issuer?• The tax implications to investors may impact their ability or

willingness to purchase the securities, as well as suitability. – The tax impact of purchasing the new structured product will need to

be disclosed and may require a tax opinion.

General Suitability

• General suitability issues are addressed by our Structured Investment Products Committee and may be referred to other firmwide committees.– The Committee has a 70 plus page Global Framework for the

Distribution of Structured Investment Products which addresses such subjects as:

• Payout and underlyer combinations, maturity, principal protection levels, assets and issuance platforms

• Distributor selection and due diligence• Marketing materials and practices• Fees and fee disclosures.

– New and existing products must comply with the framework and new products and distribution channels must be reviewed by the Committee.

Reputational Issues

• All individuals and all divisional and firmwide committees are charged with considering the reputational impact of new structured products.

• Many products are turned down at various points in the approval process (including by the Business when first considering the product), despite passing legal and other hurdles.

• Ultimately, new products raising heightened potential reputational issues are addressed by a senior reputational risk committee.

Operational Issues

• Every new product must be reviewed by Divisional and Firmwide New Activities Committees.

• These committees must determine if operationally and technologically we can:– Issue the security in the manner intended, including legal and

compliance review of issuances and offering materials– Hedge the security– Pay interest on and redeem the security– Value and account for the securities and provide all required

regulatory and other reports on a timely basis.

• In other words, is all the necessary plumbing in place to enter this business/issue the new product.

Distribution Channels

• A significant portion of the structured products sold by financial institutions are through third‐party distributors.

• They are the ones that have the know your customer and individual suitability requirements.

• When selling structured products, Compliance does additional due diligence (which is periodically updated) on such dealers.

• Compliance monitors approved distributors and distribution channels, as well of regulatory pronouncements for potential problems.

• Legal enters into dealer specific structured product distribution agreements with approved distributors.

Index Approvals and Licenses

• Use of third‐party indexes requires a license.– More importantly, use of a third‐party index as an underlyer in SEC

registered products requires a detailed analysis of:• Is the product is consistent with the Morgan Stanley letter?• How extensive is the publicly available index disclosure?• What needs to be included in the offering materials about the index, especially in

risk factors?

• To the extent proprietary indexes are used, they must be reviewed by a firmwide index committee.– Disclosure and reputational issues associated with being the index

sponsor and calculation agent (if that is the case) must be addressed.

Offering Materials

• As referenced before, disclosure is key to issuing structured products.

• The marketing materials proposed to be used in connection with a any new structured product must be reviewed to determine whether or not they comply with SEC and FINRA requirements.

• To the extent required, these materials need to be filed with and sometimes reviewed by, regulators.

• Compliance must insure that training and surveillance is in place to insure that only approved materials are used in the appropriate manner.

© 2015 Financial Industry Regulatory Authority, Inc. All rights reserved.

Due Diligence: The Life Cycle of a Product Thursday, May 28 4:15 p.m. – 5:15 p.m. Resources Rules

FINRA Rule 5122 (Private Placements of Securities Issued by Members)

http://finra.complinet.com/en/display/display.html?rbid=2403&record_id=14224&element_id=6837

FINRA Rule 5123 (Private Placements of Securities)

http://finra.complinet.com/en/display/display_main.html?rbid=2403&record_id=15199 Notices

FINRA Regulatory Notice 13-26, FINRA Updates Form for Filing Private Placements of Securities Pursuant to FINRA Rules 5122 and 5123 (August 2013)

www.finra.org/sites/default/files/NoticeDocument/p325359.pdf

FINRA Regulatory Notice 12-40, SEC Approves New FINRA Rule 5123 Regarding Private

Placements of Securities; Effective Date: December 3, 2012 (September 2012)


FINRA Regulatory Notice 10-22, Obligation of Broker-Dealers to Conduct Reasonable Investigations in Regulation D Offerings (April 2010)


FINRA Regulatory Notice 09-27, SEC Approves New FINRA Rule 5122 Relating to Private

Placements of Securities Issued by a Member Firm or a Control Entity; Effective Date: June 17, 2009 (May 2009)


Documents

Due Diligence: The Life Cycle of a Product Thursday, May ... · PDF fileOverview – Private Placement Rules ... an entity composed exclusively of qualified institutional buyers, as