Notice2024-16304
Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Order Approving a Proposed Rule Change, as Modified by Amendment No. 1, To Amend FINRA Rule 2210 (Communications with the Public) To Permit Projections of Performance in Institutional Communications and Specified Communications to Qualified Purchasers and Knowledgeable Employees
Primary source
Metadata and text below are from the Federal Register, a public-domain U.S. government work. Always verify the official published version before relying on it for any legal matter.
Published
July 25, 2024
Issuing agencies
Securities and Exchange Commission
Full Text
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<title>Federal Register, Volume 89 Issue 143 (Thursday, July 25, 2024)</title>
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[Federal Register Volume 89, Number 143 (Thursday, July 25, 2024)]
[Notices]
[Pages 60461-60474]
From the Federal Register Online via the Government Publishing Office [<a href="http://www.gpo.gov">www.gpo.gov</a>]
[FR Doc No: 2024-16304]
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SECURITIES AND EXCHANGE COMMISSION
[Release No. 34-100561; File No. SR-FINRA-2023-016]
Self-Regulatory Organizations; Financial Industry Regulatory
Authority, Inc.; Order Approving a Proposed Rule Change, as Modified by
Amendment No. 1, To Amend FINRA Rule 2210 (Communications with the
Public) To Permit Projections of Performance in Institutional
Communications and Specified Communications to Qualified Purchasers and
Knowledgeable Employees
July 19, 2024.
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
[[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\
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\1\ 15 U.S.C. 78s(b)(1).
\2\ 17 CFR 240.19b-4.
\3\ ``Projections of performance reflect an estimate of the
future performance of an investment or investment strategy, which is
often based on historical data and assumptions. Projections of
performance are commonly established through mathematical
modeling.'' See Exchange Act Release No. 98977 (Nov. 17, 2023), 88
FR 82482, 82482 n.3 (Nov. 24, 2023), File No. SR-FINRA-2023-016
(``Notice''), <a href="https://www.govinfo.gov/content/pkg/FR-2023-11-24/pdf/2023-25881.pdf">https://www.govinfo.gov/content/pkg/FR-2023-11-24/pdf/2023-25881.pdf</a>.
\4\ ``Targeted returns reflect the aspirational performance
goals for an investment or investment strategy.'' Notice at 82482
n.3.
\5\ An ``institutional communication'' means ``any written
(including electronic) communication that is distributed or made
available only to institutional investors[ ] but does not include a
member's internal communications.'' FINRA Rule 2210(a)(3). An
``institutional investor'' means any: ``(A) person described in
[FINRA] Rule 4512(c), regardless of whether the person has an
account with a member; (B) governmental entity or subdivision
thereof; (C) employee benefit plan, or multiple employee benefit
plans offered to employees of the same employer, that meet the
requirements of Section 403(b) or Section 457 of the Internal
Revenue Code and in the aggregate have at least 100 participants,
but does not include any participant of such plans; (D) qualified
plan, as defined in Section 3(a)(12)(C) of the Exchange Act, or
multiple qualified plans offered to employees of the same employer,
that in the aggregate have at least 100 participants, but does not
include any participant of such plans; (E) member or registered
person of such a member; and (F) person acting solely on behalf of
any such institutional investor.'' FINRA Rule 2210(a)(4). FINRA Rule
4512(c) states that for purposes of Rule 4512, the term
``institutional account'' shall mean the account of: ``(1) a bank,
savings and loan association, insurance company or registered
investment company; (2) an investment adviser registered either with
the SEC under Section 203 of the Investment Advisers Act or with a
state securities commission (or any agency or office performing like
functions); or (3) any other person (whether a natural person,
corporation, partnership, trust or otherwise) with total assets of
at least $50 million.''
\6\ Section 2(a)(51)(A) of the Investment Company Act defines
the term ``qualified purchaser'' as: (i) any natural person who owns
not less than $5 million in investments (as defined by the SEC);
(ii) a family-owned company that owns not less than $5 million in
investments; (iii) a trust not formed for the purpose of acquiring
the securities offered, as to which each trustee or other person
authorized to make decisions with respect to the trust, and each
settlor or other person who has contributed assets to the trust, is
a person described in clauses (i), (ii), or (iv); and (iv) any other
person, acting for its own account or the account of other QPs, who
in the aggregate owns and invests on a discretionary basis not less
than $25 million in investments. See 15 U.S.C. 80a-2(a)(51)(A).
\7\ A ``member private offering'' means ``a private placement of
unregistered securities issued by a member or a control entity.''
FINRA Rule 5122(a)(1). FINRA Rule 5122 (Private Placements of
Securities Issued by Members) governs, among other things, the
disclosure and filing requirements applicable to member private
offerings. FINRA Rule 5122(c)(1)(B) states that member private
offerings sold solely to QPs, as defined in Section 2(a)(51)(A) of
the Investment Company Act, are exempt from the requirements of
FINRA Rule 5122.
\8\ For purposes of the proposed rule change, a ``knowledgeable
employee'' includes any natural person who is an executive officer,
director, trustee, general partner, advisory board member, or person
serving in similar capacity of the fund excluded from the definition
of ``investment company'' pursuant to Investment Company Act Section
3(c)(7) or certain of its affiliates, and other employees, under
certain conditions, who participate in the investment activities of
the fund or certain of the fund's affiliates. See Exchange Act
Release No. 99588 (Feb. 22, 2024), 89 FR 14728, 14729 n.26 (Feb. 28,
2024), File No. SR-FINRA-2023-016, <a href="https://www.govinfo.gov/content/pkg/FR-2024-02-28/pdf/2024-04072.pdf">https://www.govinfo.gov/content/pkg/FR-2024-02-28/pdf/2024-04072.pdf</a> (citing Investment Company Act
Rule 3c-5 (17 CFR 270.3c-5(a)(2), (4)) (``OIP'').
\9\ See Notice; OIP. FINRA Rule 5123 governs, among other
things, the filing requirements applicable to members that sell a
security in a non-public offering in reliance on an available
exemption from registration under the Securities Act (``private
placement''). FINRA Rule 5123(b)(1)(B) exempts private placements
sold solely to QPs from the requirements of FINRA Rule 5123. FINRA
Rule 5123(b)(1)(H) exempts private placements sold solely to
knowledgeable employees from the requirements of FINRA Rule 5123.
\10\ See Notice; OIP.
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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.
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\11\ See Notice.
\12\ The comment letters received in response to the Notice are
available at <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm</a>.
\13\ See letter from Meredith Cordisco, Associate General
Counsel, Office of General Counsel, FINRA, to Craig Slivka, Division
of Trading and Markets, Commission, dated Jan. 5, 2024, <a href="https://www.finra.org/sites/default/files/2024-01/SR-FINRA-2023-016-extension1.pdf">https://www.finra.org/sites/default/files/2024-01/SR-FINRA-2023-016-extension1.pdf</a>.
\14\ See letter from Meredith Cordisco, Associate General
Counsel, Office of General Counsel, FINRA, to Vanessa Countryman,
Secretary, Commission, dated Feb. 22, 2024, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-433139-1075042.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-433139-1075042.pdf</a>
(``FINRA Response Letter I''); Amendment No. 1.
\15\ See OIP.
\16\ The comment letters received in response to the OIP are
available at <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm</a>.
\17\ See letter from Meredith Cordisco, Associate General
Counsel, Office of General Counsel, FINRA, to Craig Slivka, Division
of Trading and Markets, Commission, dated May 17, 2024, <a href="https://www.finra.org/sites/default/files/2024-05/FINRA-2023-016-Extension-2.pdf">https://www.finra.org/sites/default/files/2024-05/FINRA-2023-016-Extension-2.pdf</a>.
\18\ See letter from Meredith Cordisco, Associate General
Counsel, Office of General Counsel, FINRA, to Vanessa Countryman,
Secretary, Commission, dated July 17, 2024 (``FINRA Response Letter
II''), <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016.htm</a>.
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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.
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\19\ FINRA Rule 2210(d)(1)(F); see Notice at 82482.
\20\ Notice at 82483.
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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\
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\21\ See FINRA Rule 2210.
\22\ FINRA Rule 2210(d)(1).
\23\ FINRA Rule 2210(d)(1)(A).
\24\ Id.
\25\ FINRA Rule 2210(d)(1)(B) (``No member may publish,
circulate or distribute any communication that the member knows or
has reason to know contains any untrue statement of a material fact
or is otherwise false or misleading.'').
\26\ FINRA Rule 2210(d)(1)(E).
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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
[[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\
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\27\ FINRA Rule 2210(d)(1)(F).
\28\ A member firm may communicate a ``hypothetical illustration
of mathematical principles, provided that it does not predict or
project the performance of an investment or investment strategy.''
FINRA Rule 2210(d)(1)(F)(i). This exception ``applies to tools that
serve the function of a calculator that computes the mathematical
outcome of certain assumed variables without predicting the
likelihood of either the assumed variables or the outcome. For
example, this exception applies to a calculator that computes a net
amount of savings that an investor would earn over an assumed period
of time with assumed variables of rates of returns, frequency of
compounding, and tax rates.'' Notice at 82482.
\29\ A member firm may publish ``[a]n investment analysis tool,
or a written report produced by an investment analysis tool, that
includes projections of performance provided it meets the
requirements of FINRA Rule 2214 [(Requirements for the Use of
Investment Analysis Tools)].'' FINRA Rule 2210(d)(1)(F)(ii). An
``investment analysis tool'' is ``an interactive technological tool
that produces simulations and statistical analyses that present the
likelihood of various investment outcomes if certain investments are
made or certain investment strategies or styles are undertaken,
thereby serving as an additional resource to investors in the
evaluation of the potential risks and returns of investment
choices.'' Notice at 82482-83 (citing FINRA Rule 2214(b)).
\30\ A member firm may communicate ``[a] price target contained
in a research report on debt or equity securities, provided that the
price target has a reasonable basis, the report discloses the
valuation methods used to determine the price target, and the price
target is accompanied by disclosure concerning the risks that may
impede achievement of the price target.'' FINRA Rule
2210(d)(1)(F)(iii).
\31\ See FINRA Rule 2210(d)(1)(F).
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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\
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\32\ See Notice at 82483.
\33\ Id.
\34\ Id.
\35\ Id.
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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\
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\36\ Id. at 82488.
\37\ Id.
\38\ See id. at 82489 (``Some of these members may have
Projection-Eligible Investor customers that already have access to
or are receiving projections-related communications from a member
that is dually registered, a member's advisory affiliate, or an
investment adviser owned by an associated person of the member, as
part of the clients' investment advisory relationship. For example,
some dually registered members and dually registered representatives
communicate information regarding projected performance to their
investment advisory clients already.'').
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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\
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\39\ Id. at 82483.
\40\ Id.; OIP at 14729.
\41\ FINRA Response Letter I at 5-6.
\42\ Notice at 82483.
\43\ Id. at 82483 n.18 (citing FINRA Rule 2210(a)(4)).
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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
[[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\
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\44\ See Investment Advisers Act Release No. 5653 (Dec. 22,
2020), 86 FR 13024 (Mar. 5, 2021) (hereinafter; ``IA Marketing Rule
Adopting Release''), <a href="https://www.govinfo.gov/content/pkg/FR-2021-03-05/pdf/2020-28868.pdf">https://www.govinfo.gov/content/pkg/FR-2021-03-05/pdf/2020-28868.pdf</a>; SEC Staff, Investment Adviser Marketing: A
Small Entity Compliance Guide, <a href="https://www.sec.gov/investment/investment-adviser-marketing">https://www.sec.gov/investment/investment-adviser-marketing</a>.
\45\ Notice at 82487, 82490.
\46\ For purposes of the IA Marketing Rule, an ``advertisement''
includes ``[a]ny direct or indirect communication an investment
adviser makes to more than one person, or to one or more persons if
the communication includes hypothetical performance, that offers the
investment adviser's investment advisory services with regard to
securities to prospective clients or investors in a private fund
advised by the investment adviser or offers new investment advisory
services with regard to securities to current clients or investors
in a private fund advised by the investment adviser.'' 17 CFR
275.206(4)-l(e)(1)(i). This general definition is subject to three
exceptions, 17 CFR 275.206(4)-1(e)(i)(A)-(C), and ``advertisement''
also includes certain endorsements and testimonials, 17 CFR
275.206(4)-1(e)(1)(ii).
\47\ 17 CFR 275.206(4)-1.
\48\ 17 CFR 275.206(4)-l(d)(6). For purposes of the IA Marketing
Rule, ``hypothetical performance'' means ``performance results that
were not actually achieved by any portfolio of the investment
adviser.'' 17 CFR 275.206(4)-l(e)(8). It includes, but is not
limited to, performance derived from model portfolios, performance
that is backtested by the application of a strategy to data from
prior time periods when the strategy was not actually used during
those time periods, and targeted or projected performance returns
with respect to any portfolio or to the investment advisory services
with regard to securities offered in the advertisement. 17 CFR
275.206(4)-l(e)(8)(i). However, ``hypothetical performance'' does
not include certain interactive analysis tools or predecessor
performance. 17 CFR 275.206(4)-l(e)(8)(ii).
\49\ IA Marketing Rule Adopting Release at 13083.
\50\ 17 CFR 275.206(4)-l(d)(6). Collectively, these conditions
help to ensure that: (1) advertisements with hypothetical
performance information are distributed only to ``investors who have
access to the resources to independently analyze this information
and who have the financial expertise to understand the risk and
limitations of these types of presentations;'' and (2) the intended
audience receives ``tailored'' information that is sufficient for
the intended audience ``to understand the criteria, assumptions,
risks, and limitations'' of the hypothetical performance
information. IA Marketing Rule Adopting Release at 13078.
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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.
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\51\ Proposed Rule 2210(d)(1)(F)(iv).
\52\ Id.; see Notice at 82483.
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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\
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\53\ Proposed Rule 2210(d)(1)(F)(iv)(a).
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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\
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\54\ See Notice at 82483; see also FINRA Response Letter I at 6.
\55\ Notice at 82483; see Amendment No. 1 at 5 (``FINRA believes
that knowledgeable employees 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.'').
\56\ OIP at 14729.
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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\
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\57\ Proposed Rule 2210(d)(1)(F)(iv)(b).
\58\ Notice at 82484.
\59\ Id.
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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\
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\60\ Id.
\61\ Id. at 82484 n.22.
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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
[[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\
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\62\ Proposed Rule 2210(d)(1)(F)(iv)(c). Because ``targeted
returns are aspirational and may be used as a benchmark or to
describe an investment strategy or objective to measure the success
of a strategy,'' FINRA acknowledged that they ``may not involve all
(or any) of the assumptions and criteria applied to generate a
projection.'' Notice at 82484 n.21. However, FINRA ``does not
believe that the difference between targeted returns and projections
of performance is always readily apparent to the recipient of a
communication,'' so ``the presentation of both projections of
performance and targeted returns would be subject to the same
conditions, including that both must have a reasonable basis.''
Notice at 82484 n.21.
\63\ Id. at 82484.
\64\ Id. (citing FINRA Rules 2210(d)(1)(F)(iii), 2241(c)(1)(B)).
\65\ Id. (citing Securities Act Regulation S-K, 17 CFR
229.10(b)).
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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\
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\66\ Id.
\67\ Proposed Rule 2210.01(a).
\68\ Id.
\69\ Notice at 82485 (citing CFA Institute, Standards of
Practice Handbook, 155-56 (11th ed. 2014)).
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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\
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\70\ Proposed Rule 2210.01(b).
\71\ FINRA Response Letter I at 14.
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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\
---------------------------------------------------------------------------
\72\ Proposed Rule 2210(d)(1)(F)(iv)(d).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\73\ Proposed Rule 2210(d)(1)(F)(iv)(e).
\74\ Notice at 82485.
\75\ Id.
\76\ Id.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\77\ Proposed Rule 2210(d)(1)(F)(iv)(e).
\78\ Notice at 82485.
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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\
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\79\ In approving this rule change, the Commission has
considered the rule's impact on efficiency, competition, and capital
formation. See 15 U.S.C. 78c(f).
\80\ 15 U.S.C. 78o-3(b)(6).
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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
[[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\
---------------------------------------------------------------------------
\81\ Notice at 82483-84; proposed Rule 2210(d)(1)(F)(iv)(a).
\82\ Proposed Rule 2210(d)(1)(F)(iv)(a).
---------------------------------------------------------------------------
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.
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\83\ See, e.g., letters from Bernard Canepa, Managing Director
and Associate General Counsel, Securities Industry and Financial
Markets Association, dated Dec. 15, 2023, at 2-3, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314759-820242.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314759-820242.pdf</a> (``SIFMA Letter''); Dorothy Donohue, Deputy General
Counsel, and Matthew Thornton, Associate General Counsel, Investment
Company Institute, dated Dec. 15, 2023, at 5-7, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314280-819322.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314280-819322.pdf</a> (``ICI
Letter I''); Anya Coverman, President and CEO, Institute for
Portfolio Alternatives, dated Dec. 15, 2023, at 5, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314439-819782.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314439-819782.pdf</a> (``IPA Letter''); Jack O'Brien, Morgan, Lewis & Bockius
LLP, dated Mar. 25, 2024, at 3, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-450559-1152522.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-450559-1152522.pdf</a> (``Morgan Lewis
Letter''); Dechert LLP, dated Dec. 15, 2023, at 2-8, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314499-819902.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-314499-819902.pdf</a> (``Dechert Letter''); Jay Knight, Federal Regulation of
Securities Committee, ABA Business Law Section, dated Jan. 8, 2024,
at 3, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-368259-893862.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-368259-893862.pdf</a> (``ABA Letter''); Molly Diggins, Partner & General
Counsel, Monument Group, Inc., dated Jan. 31, 2024, at 3, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-418839-996922.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-418839-996922.pdf</a> (``Monument Group Letter II '').
\84\ See letter from Joseph Peiffer, President, Public Investors
Advocate Bar Associations, dated Dec. 15, 2023, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-313899-818504.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-313899-818504.pdf</a> (``PIABA
Letter'').
\85\ See letter from the Center for American Progress, dated
Apr. 12, 2024, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-458213-1173034.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-458213-1173034.pdf</a> (``CAP Letter'').
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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\
---------------------------------------------------------------------------
\86\ See SIFMA Letter at 2; ICI Letter I at 5-6.
\87\ See SIFMA Letter at 2-3; IPA Letter at 5; Morgan Lewis
Letter at 3.
\88\ See, e.g., SIFMA Letter at 2-3; Dechert Letter at 8.
\89\ CAP Letter.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\90\ SIFMA Letter at 2.
\91\ See ICI Letter I at 5-6.
\92\ ICI Letter I at 6. Indicating that the IA Marketing Rule
does not restrict the scope of investors eligible to receive
hypothetical performance, a third commenter stated that FINRA should
eliminate any such restrictions from the proposed rule change.
Morgan Lewis Letter at 2-3. This commenter explained that this
asymmetry would result in a lack of ``any meaningful harmonization
between the [IA] Marketing Rule and FINRA Rule 2210 with respect to
hypothetical performance and will only enhance information
asymmetries that already exist in the market.'' Id. at 2.
---------------------------------------------------------------------------
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
[[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\
---------------------------------------------------------------------------
\93\ SIFMA Letter at 2-3; see Morgan Lewis Letter at 3
(asserting that FINRA should expand the scope of Projection-Eligible
Investors to include accredited investors if FINRA insisted on
limiting the scope to certain investors).
\94\ This commenter explained that FINRA's Corporate Financing
Department reviews private placement memoranda and retail
communications under FINRA Rules 5122 and 5123 and considers
``whether the member [firm] appears to have conducted a reasonable
investigation of the issuer.'' IPA Letter at 5-6.
\95\ See IPA Letter at 5-6.
\96\ PIABA Letter at 2. PIABA indicated that the number of
investors who qualified as ``accredited'' rose from approximately
1.8% of U.S. households in 1983 to approximately 9.9% of U.S.
households in 2013. Id. (citing Commissioner Luis Aguilar, Statement
on Revisiting ``Accredited Investor'' Definition to Better Protect
Investors, n.3 (Dec. 17, 2014), <a href="https://www.sec.gov/news/statement/spch121714laa">https://www.sec.gov/news/statement/spch121714laa</a> (figures not adjusted for inflation)).
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\97\ Investment Company Act Rule 3c-5 generally defines a
``knowledgeable employee'' as certain persons associated with
private funds that would be investment companies but for the
exclusions provided in Section 3(c)(1) or (c)(7) funds. See
Investment Company Act Rule 3c-5 (17 CFR 270.3c-5(a)(2), (a)(4)-
(6)). Investment Company Act Section 3(c)(1) generally excludes from
the definition of ``investment company'' ``[a]ny issuer whose
outstanding securities . . . are beneficially owned by not more than
one hundred persons . . . and which is not making and does not
presently propose to make a public offering of its securities,'' and
Section 3(c)(7) generally excludes ``[a]ny issuer, the outstanding
securities of which are owned exclusively by persons who, at the
time of acquisition of such securities, are [QPs], and which is not
making and does not at that time propose to make a public offering
of such securities.'' 15 U.S.C. 80a-3(c)(1) and (c)(7).
\98\ SIFMA Letter at 2-3.
\99\ Dechert Letter at 8.
\100\ Id.
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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\
---------------------------------------------------------------------------
\101\ See CAP Letter; see also PIABA Letter at 2 (urging FINRA
to ``be mindful of the challenges accompanying this proposal and
devote adequate resources to policing all communications,'' keeping
in mind that any weakening of communication standards ``will only
serve to harm individual investors.''). CAP stated that--as a
general matter--FINRA has failed to articulate the basis for the
proposed rule change. See CAP Letter at 3, 6. FINRA disagreed,
explaining that its stakeholder engagement led to repeated requests
for more permissive use of projected performance and targeted
returns and greater regulatory harmonization with the IA Marketing
Rule. FINRA Response Letter II at 11-14. Through this engagement,
FINRA also learned that institutional investors often request this
information from broker-dealers and that ``institutional investors
and QPs often test their own opinions against performance
projections they receive from other sources, including from issuers
and investment advisers.'' Id. at 13-14. As discussed in this order,
FINRA reasonably articulated a basis for approval of the proposed
rule change consistent with the Exchange Act. The proposed rule
change would permit the communication of projected performance or
targeted returns only in narrow circumstances and when certain
conditions reasonably designed to protect investors are met.
\102\ CAP Letter at 3-4 (explaining that investors of any level
may be ``misled by cherry-picked or inaccurate information and
dubious projections or predictions'').
\103\ See id. (citing Tyler Gellasch et al., ``How Exemptions
From Securities Laws Put Investors and the Economy at Risk,'' Center
for American Progress (Mar. 22, 2023), <a href="https://www.americanprogress.org/article/how-exemptions-from-securities-laws-put-investors-and-the-economy-at-risk/">https://www.americanprogress.org/article/how-exemptions-from-securities-laws-put-investors-and-the-economy-at-risk/</a>). CAP also stated that
the proposed rule change would be inconsistent with the Commission's
recently finalized Private Fund Advisers rule's ``express purpose''
to promote the standardization of information disclosures. CAP
Letter at 6 (citing Investment Advisers Act Release No. 6383 (Aug.
23, 2023), 88 FR 63206 (Sep. 14, 2023)). In early June 2024, the
Fifth Circuit issued a ruling that vacated the Private Fund Advisers
rules. See Nat'l Ass'n of Priv. Fund Managers v. SEC, No. 23-60471,
2024 U.S. App. LEXIS 13645 (5th Cir. June 5, 2024). In any event, as
FINRA explained, the proposed rule change serves a different purpose
from and is not inconsistent with the Private Fund Advisers rules.
See FINRA Response Letter II at 16.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\104\ FINRA Response Letter II at 11. FINRA explained that
investors may benefit from projected performance and targeted
returns ``when presented in a context that helps investors to better
understand the information.'' Id. Toward this end, FINRA noted that
the proposed rule change imposes multiple disclosure-related
obligations. Id.
\105\ Id.
\106\ Id. at 15.
\107\ Id. at 14-15.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\108\ Id. at 15-16.
\109\ Id. (citing Andrew N. Vollmer, Evidence of the Use of
Disclosure Documents in Private Securities Offerings to Accredited
Investors, Mercatus Working Paper, Mercatus Center at George Mason
University (Oct. 2020)).
\110\ Id. at 16 (citing CFA Institute, Private Company
Valuation, <a href="https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/private-company-valuation">https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/private-company-valuation</a>).
\111\ Id. (citing CFA Institute, Company Analysis, Forecasting,
<a href="https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/Company-Analysis-Forecasting">https://www.cfainstitute.org/en/membership/professional-development/refresher-readings/Company-Analysis-Forecasting</a>).
\112\ Id. at 15.
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[[Page 60468]]
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\
---------------------------------------------------------------------------
\113\ Id. at 12.
\114\ FINRA Response Letter I at 5-7.
\115\ Id. at 5-6.
\116\ Id. at 5.
\117\ Id. at 7 n.28 (citing SEC Staff, Review of the
``Accredited Investor'' Definition (Dec. 14, 2023), <a href="https://www.sec.gov/files/review-definition-accredited-investor-2023.pdf">https://www.sec.gov/files/review-definition-accredited-investor-2023.pdf</a>).
\118\ Id. at 7.
\119\ Id. at 8.
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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\
---------------------------------------------------------------------------
\120\ Id. at 6; see proposed Rule 2210(d)(1)(F)(iv)(a).
\121\ FINRA Response Letter I at 6.
\122\ See id. Section 3(c)(7) of the Investment Company Act
excludes from the definition of ``investment company'' any issuer
whose outstanding securities ``are owned exclusively by persons who,
at the time of acquisition of such securities, are qualified
purchasers.'' 15 U.S.C. 80a-3(c)(7)(A). For purposes of determining
its eligibility for the exclusion provided by Section 3(c)(7), a
private fund need not consider any securities beneficially owned by
a knowledgeable employee. Investment Company Act Rule 3c-5 (17 CFR
270.3c-5(b)). Notwithstanding this eligibility rule, the proposed
rule change--as originally proposed--would not have permitted
communications of projected performance or targeted returns to QPs
about a Section 3(c)(7) fund if that fund was sold to both QPs and
knowledgeable employees.
\123\ FINRA Response Letter II at 6 n.17 (citing FINRA Response
Letter I at n.30). Section 3(c)(5) of the Investment Company Act
excludes from the definition of investment company ``[a]ny person
who is not engaged in the business of issuing redeemable securities,
face-amount certificates of the installment type or periodic payment
plan certificates, and who is primarily engaged in one or more of
the following businesses: (A) Purchasing or otherwise acquiring
notes, drafts, acceptances, open accounts receivable, and other
obligations representing part or all of the sales price of
merchandise, insurance, and services; (B) making loans to
manufacturers, wholesalers, and retailers of, and to prospective
purchasers of, specified merchandise, insurance, and services; and
(C) purchasing or otherwise acquiring mortgages and other liens on
and interest in real estate.'' 15 U.S.C. 80a-3(c)(5). Unlike
securities offerings made pursuant to Sections 3(c)(1) and 3(c)(7)
which are required to be made privately, offerings pursuant to
Section 3(c)(5) may be made either publicly (either listed on an
exchange or unlisted) or privately.
\124\ FINRA Response Letter II at 6 n.17 (citing FINRA Response
Letter I at n.30).
\125\ Id. at 7.
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One commenter offered ``no objection'' to Partial Amendment No.
1.\126\
---------------------------------------------------------------------------
\126\ Letter from Dorothy Donohue, Deputy General Counsel, and
Matthew Thornton, Associate General Counsel, Investment Company
Institute, dated Mar. 15, 2024, at 2, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-447019-1142723.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-447019-1142723.pdf</a> (``ICI Letter
II'').
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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\
---------------------------------------------------------------------------
\127\ FINRA Response Letter I at 8.
\128\ FINRA Response Letter II at 7, 12.
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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
[[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.
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\129\ 17 CFR 230.501(a).
\130\ 17 CFR 230.501(a)(5).
\131\ 17 CFR 230.501(a)(6); see also FINRA Response Letter I at
7 n.25 (noting these categories of accredited investors).
\132\ Review of the ``Accredited Investor'' Definition at 35,
supra note 117. This is a report by the staff of the U.S. Securities
and Exchange Commission. The Commission has expressed no view
regarding the analysis, findings, or recommendations contained
herein.
---------------------------------------------------------------------------
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\
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\133\ See FINRA Response Letter I at 12 (``FINRA Rule 2210 is
broader and governs any communications that a member distributes or
makes available to investors, regardless of whether the
communications contain a recommendation that would also trigger Rule
2111 or Regulation Best Interest.'' (emphasis in original)).
\134\ See 17 CFR 240.15l-1.
\135\ See Notice at 82488.
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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.
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\136\ FINRA Response Letter I at 5-6.
\137\ See Notice at 82483; FINRA Response Letter I at 7;
Amendment No. 1 at 5 (``FINRA believes that knowledgeable employees
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.'').
\138\ FINRA Response Letter I at 6.
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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\
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\139\ Proposed Rule 2210(d)(1)(F)(iv)(a). As noted above, as
originally proposed, the proposed rule change would have permitted
the communication of projected performance and targeted returns to
QPs so long as the communication promotes or recommends a Member
Private Offering or a private placement that is exempt from the
requirements of FINRA Rule 5123 pursuant to Rule 5123(b)(1)(B) (that
is, a private placement sold solely to QPs). As a result of
Amendment No. 1, the proposed rule change would permit such
communications to QPs so long as the communication promotes or
recommends: (1) a Member Private Offering; or (2) a private
placement that is exempt from the requirements of FINRA Rule 5123
pursuant to FINRA Rules 5123(b)(1)(B) or 5123(b)(1)(H) (as noted,
referred to herein as an ``Exempted Private Placement'').
\140\ Proposed Rule 2210(d)(1)(F)(iv)(a).
\141\ Id. (``that promotes or recommends a Member Private
Offering that is exempt from the requirements of Rule 5122 pursuant
to Rule 5122(c)(1)(B)''); FINRA Rule 5122(c)(1)(B) (exempting
private placements ``sold solely to . . . qualified purchasers'').
\142\ Proposed Rule 2210(d)(1)(F)(iv)(a) (``that promotes or
recommends a private placement that is exempt from the requirements
of Rule 5123 pursuant to Rule 5123(b)(1)(B) or Rule 5123(b)(1)(H),
respectively.''); FINRA Rule 5123(b)(1)(B) (exempting ``offerings
sold by the member or person associated with the member solely to .
. . qualified purchasers''); 5123(b)(1)(H) (exempting ``offerings
sold by the member or person associated with the member solely to .
. . knowledgeable employees'').
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\143\ See SIFMA Letter at 3; ICI Letter I at 6-7; ABA Letter at
3.
\144\ SIFMA Letter at 3.
\145\ Id.
\146\ ICI Letter I at 6-7 (``If QP status is meant to be a proxy
for financial sophistication and resources, it makes no sense to
prohibit QPs from receiving performance projections or targets for
more highly regulated investments available to retail investors
(e.g., mutual funds and ETFs) when they would be permitted for
private placements.''); ABA Letter at 3 (``[T]he Committee believes
that QPs can generally be expected to have the requisite degree of
sophistication and resources available to them to benefit, rather
than be susceptible to harm, from receiving targeted returns and
projections. The Committee believes that this is the case regardless
of whether the relevant broker-dealer communication is in relation
to an offering in which only QPs can invest (e.g., a 3(c)(7) Fund
offering) or an offering in which non-QPs can also invest (e.g., a
fund offering that is exempt from registration pursuant to Section
3(c)(1) of the 1940 Act or a registered offering).'').
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[[Page 60470]]
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\
---------------------------------------------------------------------------
\147\ FINRA Response Letter I at 8.
\148\ FINRA Response Letter II at 7.
---------------------------------------------------------------------------
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\
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\149\ Proposed Rule 2210.01(b). The proposed rule change leaves
undisturbed pre-existing guidance on the use of extracted
performance, which constitutes performance results of a subset of
investments extracted from a portfolio. FINRA, Frequently Asked
Questions About Advertising Regulation, FAQ D.6.2, D.6.3 (Sept. 30,
2021), <a href="https://www.finra.org/rules-guidance/guidance/faqs/advertising-regulation">https://www.finra.org/rules-guidance/guidance/faqs/advertising-regulation</a>. One commenter asked FINRA to rescind and
replace this guidance, asserting that it is inconsistent with the
Commission's IA Marketing Rule. Dechert Letter at 6-7. In response,
FINRA stated that the proposed rule change does not address
extracted performance, and it declined to modify pre-existing
guidance that is peripheral to the proposed rule change. FINRA
Response Letter II at 10. The Commission does not address this
issue, as it agrees that it is outside the scope of the proposed
rule change.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\150\ Dechert Letter at 2-4; Monument Group Letter II at 3.
\151\ Dechert Letter at 4.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\152\ FINRA Response Letter I at 13-14.
\153\ FINRA Response Letter II at 10 (citing Joel M. Dickson,
Sachin Padmawar & Sarah Hammer, Joined at the hip: ETF and index
development, Vanguard Research, at 6 (July 2012); Carl Ackerman &
Tim Loughran, Mutual Fund Incubation and the Role of the Securities
and Exchange Commission, 70 Journal of Business Ethics 33-37
(2007)).
\154\ FINRA Response Letter I at 14.
\155\ Id. at 13 n.48; FINRA, Interpretive Letter to Meredith F.
Henning, Foreside (Jan. 31, 2019), <a href="https://www.finra.org/rules-guidance/guidance/interpretive-letters/interpretive-letter-meredith-f-henning-foreside">https://www.finra.org/rules-guidance/guidance/interpretive-letters/interpretive-letter-meredith-f-henning-foreside</a>; Interpretive Letter to Bradley J. Swenson, ALPS
Distributors, Inc. (Apr. 22, 2013), <a href="https://www.finra.org/rules-guidance/guidance/interpretive-letters/bradley-j-swenson-alps-distributors-inc">https://www.finra.org/rules-guidance/guidance/interpretive-letters/bradley-j-swenson-alps-distributors-inc</a>.
\156\ FINRA Response Letter I at 13.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\157\ Id. at 14.
\158\ FINRA Response Letter II at 13.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\159\ See supra note 153.
\160\ See FINRA Response Letter II at 10.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\161\ Proposed Rule 2210(d)(1)(F)(iv)(b).
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[[Page 60471]]
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\
---------------------------------------------------------------------------
\162\ SIFMA Letter at 3-4.
\163\ Id. at 3.
---------------------------------------------------------------------------
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\
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\164\ See Monument Group Letter II at 5; Dechert Letter at 4-5;
ABA Letter at 4-5. In the alternative, the ABA's Federal Regulation
of Securities Committee requested that FINRA issue guidance ``that
explains what broker-dealers acting as placement agents should do in
circumstances where they determine that projections or targeted
returns are appropriate for some potential investors in the
prescribed nonpublic offerings, but not others, including whether
broker-dealers should limit the use of projection and targeted
return information to prospective fund investors who pass the
independent suitability requirements of FINRA Rule 2111 and
Regulation Best Interest.'' ABA Letter at 4-5.
\165\ Dechert Letter at 4-5 (acknowledging that the separate
requirement ``that FINRA members develop policies and procedures
that are reasonably designed to ensure compliance with [FINRA] Rule
2210 . . . is reasonable''); ABA Letter at 4-5.
\166\ FINRA Rule 2111(b) addresses a member firm's ``customer-
specific suitability obligation for an institutional account.''
\167\ ABA Letter at 4; see Monument Group Letter II at 5.
Monument Group indicated that proposed Rule 2210(d)(1)(F)(iv)(b)
would impose an affirmative obligation upon any member firm
communicating projected performance or targeted returns to a
Projection-Eligible Investor ``to collect information concerning the
financial objectives/financial situation of institutional
investors--solely for the purpose of providing marketing material
containing investment projections and targets.'' Monument Group
Letter II at 5 n.3. In response, FINRA explained that the proposed
rule change would not impose an ``express document or data
collection requirement and would not require firms to assess
individual investors'' under suitability or Regulation Best Interest
standards. FINRA Response Letter II at 9.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\168\ FINRA Response Letter II at 9.
\169\ FINRA Response Letter I at 12.
\170\ Id.
\171\ FINRA Response Letter II at 9.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\172\ See FINRA Response Letter I at 12-13.
\173\ Id. at 13.
\174\ Id.
---------------------------------------------------------------------------
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.
---------------------------------------------------------------------------
\175\ Proposed Rule 2210(d)(1)(F)(iv)(b).
\176\ See Notice at 82484; FINRA Response Letter I at 13.
\177\ See supra Part III(A)(1).
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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
[[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\
---------------------------------------------------------------------------
\178\ Proposed Rule 2210(d)(1)(F)(iv)(c).
\179\ Proposed Rule 2210.01(a).
\180\ Id.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\181\ PIABA Letter at 2 (``PIABA strongly believes the `sound
basis' requirement should be strictly adhered to and not just be
window dressing to further a more liberal standard for
communications.'').
\182\ SIFMA Letter at 2.
---------------------------------------------------------------------------
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\
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\183\ See Monument Group Letter II at 4; ICI Letter I at 7;
SIFMA Letter at 3; Dechert Letter at 7.
\184\ Monument Group Letter II at 4.
\185\ ICI Letter I at 7; SIFMA Letter at 3; Dechert Letter at 7;
Monument Group Letter II at 4.
\186\ Dechert Letter at 7.
---------------------------------------------------------------------------
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\
---------------------------------------------------------------------------
\187\ SIFMA Letter at 3.
\188\ Id.
\189\ ICI Letter I at 7 (``For instance, if registered fund
materials are created by the fund (or its distributor) and a third-
party broker wishes to use them, it could be difficult for the
third-party broker to establish that it ``has 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.'').
---------------------------------------------------------------------------
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\
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\190\ See Dechert Letter at 7-8.
\191\ Id. at 8.
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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\
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\192\ ICI Letter I at 7.
\193\ Monument Group Letter II at 4. In a subsequent letter,
Monument Group stated that FINRA Rule 2210 already has general
content standards, and proposed Rule 2210.01(a)'s guidelines ``would
overlap with those of private fund managers.'' See letter from Molly
Diggins, Partner & General Counsel, Monument Group, Inc., dated Mar.
29, 2024, at 2-3, <a href="https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-452579-1160882.pdf">https://www.sec.gov/comments/sr-finra-2023-016/srfinra2023016-452579-1160882.pdf</a> (``Monument Group Letter III'').
\194\ See SIFMA Letter at 4.
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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\
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\195\ FINRA Response Letter I at 10-11.
\196\ FINRA Response Letter II at 4.
\197\ Id.
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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.''
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\198\ FINRA Response Letter I at 10.
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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
[[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\
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\199\ Id. (indicating that the reasonable-basis requirement
``follows well-established precedents'').
\200\ Id.
\201\ Id. (citing Securities Act Regulation S-K, 17 CFR
229.10(b)). Regulation S-K's ``policy on projections'' provides
guidelines on the factors to be considered in formulating and
disclosing certain projections. It states ``that management must
have the option to present . . . its good faith assessment of a
registrant's future performance'' in documents specified in
Securities Act Rule 175 (17 CFR 230.175) and Exchange Act Rule 3b-6
(17 CFR 240.3b-6)). 17 CFR 229.10(b), (b)(1). Any such projection,
however, must have a reasonable basis. 17 CFR 229.10(b)(1). The
documents specified in this policy include documents filed with the
Commission, Part I of quarterly reports on Form 10-Q, and certain
annual reports to security holders. See 17 CFR 230.175(b)(1); 17 CFR
240.3b-6(b)(1).
\202\ FINRA Response Letter I at 10.
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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\
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\203\ Id. at 11.
\204\ Id.
\205\ Id. at 10-11.
\206\ Id. at 11. FINRA stated that the proposed rule change
would not require member firms to ``obtain trade secrets from third
parties,'' but it would require member firms to consider whether the
information at its disposal is sufficient to form a reasonable basis
for the projected performance or targeted returns. FINRA Response
Letter II at 4; see FINRA Response Letter I at 10-11.
\207\ FINRA Response Letter I at 11.
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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\
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\208\ FINRA Response Letter II at 9.
\209\ FINRA Response Letter I at 16.
\210\ FINRA Response Letter II at 9.
\211\ See FINRA Response Letter I at 16.
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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.
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\212\ SIFMA Letter at 4; FINRA Response Letter I at 16.
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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\
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\213\ FINRA Response Letter II at 4. Moreover, as FINRA notes,
the IA Marketing Rule's general prohibitions would prohibit the
advertisement of hypothetical performance for which the adviser
lacks a reasonable basis, even if that rule lacks a requirement
identical to that of the proposed rule change. FINRA Response Letter
I at 10.
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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.
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\214\ Id. at 10-11.
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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.
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\215\ Proposed Rule 2210(d)(1)(F)(iv)(c); see FINRA Response
Letter II at 4 (``there is no requirement to obtain trade secrets
from third parties'').
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D. Disclosure Requirements
The proposed rule change would impose three disclosure-related
[[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\
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\216\ Proposed Rule 2210(d)(1)(F)(iv)(d).
\217\ Proposed Rule 2210(d)(1)(F)(iv)(e).
\218\ Id.
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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.
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\219\ See Notice at 82485 (absent the disclosure of criteria and
assumptions, ``it is more likely that a projection or targeted
return would mislead a potential investor''; disclosures about risks
and limitations help ensure that investors ``do not unreasonably
rely on a projection or targeted return given its uncertainty and
risks'').
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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\
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\220\ 15 U.S.C. 78o-3(b)(6).
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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.
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\221\ 15 U.S.C. 78s(b)(2).
For the Commission, by the Division of Trading and Markets,
pursuant to delegated authority.\222\
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\222\ 17 CFR 200.30-3(a)(12).
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J. Matthew DeLesDernier,
Deputy Secretary.
[FR Doc. 2024-16304 Filed 7-24-24; 8:45 am]
BILLING CODE 8011-01-P
</pre></body>
</html>Indexed from Federal Register on July 25, 2024.
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