SEC approves FINRA rule change permitting broker-dealers to communicate projected performance and targeted returns

The final rule is meaningfully more streamlined than FINRA’s original proposal of this rule change. In response to comments, FINRA, through Partial Amendment No. 1, eliminated the proposed “reasonable basis” requirement, pared back two express disclosure items, and substituted a narrower recordkeeping requirement. The resulting framework rests on three conditions: (1) written policies and procedures addressing the intended audience; (2) disclosure of criteria, assumptions, risks, and limitations; and (3) records of the source of the projection or target.

This alert summarizes the new exception and the key changes made during the rulemaking process, with a focus on the practical implications for broker-dealers, including their use of projections and targets in marketing materials and communications with prospective private fund investors. We also discuss practical implications for placement agent agreements and identify where compliance with the IA Marketing Rule will not satisfy Rule 2210, and vice versa.

Background: the existing prohibition

Rule 2210’s general content standards prohibit member communications from predicting or projecting performance, implying that past performance will recur, or making any exaggerated or unwarranted claim, opinion, or forecast. FINRA has interpreted this prohibition to cover targeted returns as well as projections. Before this change, Rule 2210 itself provided only three narrow exceptions: (1) hypothetical illustrations of mathematical principles; (2) investment analysis tools (and reports they produce) that comply with FINRA Rule 2214; and (3) price targets in research reports on debt or equity securities. (Separate FINRA rules permit projected performance figures for options and security futures communications, subject to specified conditions, and certain FINRA interpretative guidance allows for the use of related performance in specified circumstances.)

In this rulemaking, FINRA explained that institutional and other sophisticated customers ask their broker-dealers for projected performance and targeted returns, but that members could not provide that information, even though the same investors could obtain it from registered investment advisers, unregistered intermediaries, and issuers. According to FINRA, this disparity gave issuers an incentive to distribute offerings outside the broker-dealer channel and caused investor confusion when the same investment was described differently depending on the financial professional involved. Commenters made the same point about private offerings specifically, noting that the prohibition encouraged issuers to bypass registered placement agents.

The new exception: Rule 2210(d)(1)(F)(iv)

The rule change adds a fourth exception permitting members to communicate projected performance or targeted returns, provided the following conditions are satisfied.

1. Written policies and procedures tied to the intended audience

A member must 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 intended audience. This standard deliberately tracks the corresponding hypothetical performance condition in the IA Marketing Rule (Rule 206(4)-1(d)(6)(i)).

• Audience. Under reasonably designed procedures, such communications should be distributed only to investors the member reasonably believes have the resources and financial expertise to independently analyze the information and understand its risks and limitations. FINRA expects the rule to primarily affect institutional and other sophisticated investors and the members that serve them, which makes institutional sales desks and private placement businesses the most likely early users.
• No mass or general retail distribution. The exception generally will not permit projections or targets in communications for a mass audience or general circulation, including a general retail investor audience.
• Flexibility, not prescription. The rule does not prescribe how to meet the requirement. A placement agent may, for example, draw on past experience with particular investor types, group prospective fund investors into categories, or limit distribution to investors who have expressed interest in, or previously invested in, particular types of securities. An investor’s interest in high returns, by itself, is not sufficient.
• No safe harbors. FINRA and the SEC declined requests for categorical safe harbors (for example, for qualified purchasers, accredited investors, or individually assessed high-net-worth clients) and declined to make IA Marketing Rule-compliant materials presumptively compliant.
• Relationship to other obligations. Satisfying institutional suitability under FINRA Rule 2111(b) does not automatically satisfy this requirement, although firms may adopt dual-use procedures that address both rules. Where a projection accompanies a recommendation to a retail customer, Regulation Best Interest also applies.

2. Disclosure of criteria, assumptions, risks and limitations

A member must provide sufficient information to enable the intended audience to understand (1) the criteria used and assumptions made in calculating the projected performance or targeted return, and (2) the risks and limitations of using it in making investment decisions. FINRA does not prescribe a calculation methodology; it expects a general description sufficient for the audience to understand the basis of the methodology and its underlying assumptions.

Partial Amendment No. 1 removed the express requirements to disclose whether the figure is net of anticipated fees and expenses and the reasons why it might differ from actual performance. Firms should not read this as eliminating those disclosures in practice. The SEC’s approval order states that a member is expected to disclose whether a projection or target is net of fees and/or why it might differ from actual results to satisfy the rule, while allowing the content to be tailored to the communication and the sophistication of the audience. Rule 2210’s general content standards, which prohibit omissions of material facts that would make a communication misleading, continue to apply.

Importantly for placement agents distributing sponsor-prepared materials and for dual registrants, FINRA stated that it cannot categorically conclude that disclosures compliant with the IA Marketing Rule will always satisfy Rule 2210, because the wording of the two rules’ general content standards is not identical and advisers operate under a separate regulatory regime. The SEC agreed that IA Marketing Rule disclosures will not automatically satisfy Rule 2210. These differences are discussed further below.

3. Recordkeeping of the source of the projection or target

FINRA dropped the proposed requirement that members have a reasonable basis for, and retain written records supporting, the criteria and assumptions used. Instead, Rule 2210(b)(4)(A)(iv) is amended to require members to maintain records including information concerning the source of any projection of performance or targeted return used in a communication.

FINRA stated that it could not identify facts under which a projection lacking a reasonable basis could comply with the general content standards, and the SEC observed that, as a practical matter, members will need to substantiate the basis of any projection or target before communicating it, since it would be difficult to demonstrate compliance without records supporting the underlying criteria and assumptions.

Placement agents and sponsor-prepared materials

Placement agents and other broker-dealers frequently distribute pitch books and offering materials prepared by issuers, fund sponsors, or third-party advisers. FINRA stated that it would not generally expect a member to independently verify all of the criteria and assumptions underlying a third-party projection. It would, however, expect the member to evaluate the source of the information, assess whether the available information in the projection is supported, and satisfy itself that the presentation meets Rule 2210’s content standards. Members must also consider whether the issuer or sponsor makes available the information the member needs to meet its own obligations. The level of diligence will depend on the facts and circumstances. Commenters had argued that requiring broker-dealers to independently rederive a sponsor’s IA Marketing Rule-compliant targets would not benefit investors, and FINRA’s approach largely accepts that view.

From the sponsor’s side, the IA Marketing Rule treats marketing material that an adviser provides to a third party, such as a placement agent, for distribution to prospective investors as the adviser’s own indirect communication, so the adviser remains responsible for its compliance regardless of who disseminates it. Where a placement agent distributes a sponsor’s pitch book, both regimes therefore apply to the same document: the sponsor must satisfy the IA Marketing Rule and the placement agent must satisfy Rule 2210.

Where Rule 2210 and the IA Marketing Rule diverge

FINRA modeled its policies and procedures condition on the IA Marketing Rule, and both regimes use the same “resources and financial expertise” audience concept and generally bar mass or general circulation. The rules nonetheless differ in ways that matter for placement agents and dual registrants:

• One-on-one and unsolicited communications. Under the IA Marketing Rule, hypothetical performance provided to a private fund investor in a one-on-one communication, or in response to an unsolicited request, is excluded from the definition of advertisement and is not subject to the hypothetical performance conditions or any other aspect of the IA Marketing Rule (although the general anti-fraud prohibitions under the Advisers Act would apply). The Rule 2210 exception contains no comparable carve-out, and FINRA stated that its applicable conditions apply to all communications, regardless of how many investors receive them. Therefore, a targeted return that a sponsor may share one-on-one without satisfying the IA Marketing Rule’s conditions would still require a placement agent to meet each applicable Rule 2210 condition.
• Risk disclosure for private fund investors. The IA Marketing Rule permits an adviser marketing to private fund investors to offer to provide promptly, rather than actually provide, information about the risks and limitations of hypothetical performance. Rule 2210 contains no offer-to-provide alternative; a member must provide sufficient information on risks and limitations. Sponsor materials that rely on an offer to provide risk information on request will generally need to be supplemented before a placement agent distributes them.
• Targets with no underlying assumptions. The SEC has indicated that, because targeted returns are aspirational, an adviser’s disclosure could state that no criteria and assumptions were used. Neither FINRA nor the SEC has confirmed that the same approach satisfies Rule 2210’s criteria and assumptions disclosure, and FINRA has declined to treat targets more leniently than projections. Firms should not assume the IA approach carries over.
• Different records. The amendments that the SEC made to Rule 204-2 under the Advisers Act concurrently with the adoption of the IA Marketing Rule require advisers to make and keep a record of who the intended audience is for hypothetical performance, along with copies of all information provided or offered under the hypothetical performance conditions and the records necessary to form the basis for the performance. Rule 2210 instead requires records of the source of each projection or target. Neither set of records satisfies the other requirement, so dual registrants will need both.
• More hypothetical performance can be used under the IA Marketing Rule. The IA Marketing Rule’s hypothetical performance definition covers model and backtested performance as well as targets and projections, and the SEC has stated that performance extracted from a composite of multiple portfolios can also be shown to investors if an adviser complies with the hypothetical performance conditions of the rule. The Rule 2210 exception covers only projections and targeted returns. Adviser materials that include backtested or model results cannot be repurposed for broker-dealer use simply because they satisfy the IA Marketing Rule, and the IA Marketing Rule release itself acknowledged that FINRA may view certain related performance presentations as inconsistent with Rule 2210.
• IA Marketing Rule compliance does not necessarily satisfy Rule 2210. The reverse is also true. A dual registrant or affiliated adviser cannot rely on a Rule 2210-compliant communication to meet any IA Marketing Rule requirement that has no Rule 2210 counterpart.

What this means for broker-dealers and placement agents

The approval allows members to use targets and projections in the private placement and institutional sales process, subject to conditions. Broker-dealers may wish to consider the following:

• Reviewing communications containing targets and projections against Rule 2210, rather than treating them as compliant because a sponsor has signed off under the IA Marketing Rule.
• Updating written supervisory procedures to require the documentation of how eligible audiences are identified (for example, by investor category or prior investment history) and the source of each projection or target.
• Negotiating engagement letters and selling agreements to obtain needed access to the sources, assumptions, methodology, fee treatment, and risk information regarding projections and targets in issuer-produced marketing materials and to ensure that such issuers keep the required source records.
• Ensuring that disclosures appropriately address calculation criteria and assumptions, whether figures are net of fees, and the reasons results may differ from projections, tailored to the audience. Sponsor materials that only offer risk information on request should be supplemented.

These amendments are part of FINRA Forward, FINRA’s broader initiative to modernize its rulebook. FINRA requested comment in Regulatory Notice 26-14 on a proposal to further modernize Rule 2210, including by replacing the principal pre-use approval requirement for retail communications with a risk-based supervisory standard, streamlining certain filing requirements, and more closely aligning the standard for communications containing recommendations with the IA Marketing Rule.

What this means for private fund managers

• Expect more information requests from distributors. Placement agents may ask for sources, assumptions, and risk information to meet their own obligations. Managers may wish to prepare a standard diligence package for each target or projection.
• Build a dual-channel version of materials. Pitch books intended for placement agent use should present risk information in full rather than on request, and should omit backtested, model, and other hypothetical performance that the new Rule 2210 exception does not cover.
• Remain responsible for distributed materials. A sponsor remains responsible under the IA Marketing Rule for materials it provides to a placement agent for distribution. Compliance by the placement agent with Rule 2210 does not discharge that responsibility.
• Dual registrants. Firms operating under both regimes can use existing IA Marketing Rule audience controls as a starting point, but should run a gap analysis covering one-on-one communications, risk disclosure delivery, and recordkeeping.

___________

If you have any questions about this Legal Briefing, please feel free to contact any of the attorneys listed or the Eversheds Sutherland attorney with whom you regularly work.