September 2011—Legislative Intelligence Update | FINRA Proposes Overhaul of Advertising Rules and Issues Guidance on Social Media; GAO Issues Report on Mutual Fund Advertising; and SEC Proposes Rule to Disqualify Bad Actors from Private Placements

Welcome to this edition of IMCA's Legislative Intelligence update. This month's update discusses: (i) a FINRA proposal to overhaul its advertising rules; (ii) FINRA guidance regarding social media websites and the use of personal devices for business communications; (iii) the GAO Report on Mutual Fund Advertising; and (iv) an SEC proposal to deny certain private placements from qualifying for registration exemption if they involve certain “felons and other bad actors.”

The purpose of this update, prepared by Morgan Lewis, is to give members legislative and public affairs intelligence and analysis and is strictly informational and educational. IMCA, as an education and credentialing organization, does not lobby legislators or regulators nor advocate for any particular legislative or regulatory position either on its own or through its relationship with Morgan Lewis.

If, after reading this update, you have additional questions please contact IMCA using the "Questions? E-mail IMCA" button at the bottom of this e-mail. We will either respond personally to your inquiry or include a response in an upcoming issue.
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FINRA Proposes Overhaul of Advertising Rules

The Financial Industry Regulatory Authority (FINRA) recently proposed an overhaul to its advertising rules governing financial analyst communications with the public. The new rules would replace current NASD Rules 2210 and 2211 and certain related materials.1 The proposal would reduce the types of “communications” specified by the rule from six to the following three: (i) “institutional communication,” which would include communications that fall under the current definition of “institutional sales material;” (ii) “retail communication,” which would include any written (including electronic) communication that is distributed or made available to more than 25 retail investors within any 30 calendar-day period; and (iii) “correspondence,” which would include any written (including electronic) communication that is distributed or made available to 25 or fewer retail investors within any 30 calendar-day period, regardless of whether they are existing or prospective customers. A “retail investor” would include any person other than an institutional investor, regardless of whether the person is an existing or prospective customer. The proposal also would modify certain of the approval, review, and recordkeeping requirements applicable to “communications.” It also would, among other things, codify guidance previously given by FINRA on the supervision of communications made on social media sites.2

The proposal retains all of the existing content standards, but rather than distributing them in a series of interpretive material (of which the existing rule has eight), they have been codified in the rule itself and in several adjacent proposed rules. The proposal does, however, make substantive changes to the existing category of content standards.

Of particular note to IMCA members, the proposal:

  • Establishes a ban on promissory statements.
  • Retains the prohibition on the use of performance predictions and projections, but to the current rule’s exception for a “hypothetical illustration of mathematical principles,” the proposed rule expressly allows “projections of performance in reports produced by investment analysis tools.” The proposed rule also expressly allows firms to provide price targets in research reports, as long as there is a reasonable basis for the price target, the valuation method used is disclosed, and the risks that may “impede achievement of the price target” are explained.
  • Expands substantially the language of the existing interpretive material governing the comparison of taxable versus tax-deferred accounts, providing express requirements regarding the use of illustrations that compare tax-deferral to taxable investing.

FINRA Guidance on Social Media

FINRA also recently released new guidance addressing social networking websites, business communications, and application to new technologies.3 By way of background, FINRA reminded brokerage firms that social media implicates recordkeeping requirements and supervisory obligations. It also noted that potential issues are raised by brokerage firm website links to third-party sites and the management of data feeds into brokerage firm websites. FINRA then offered guidance in these areas in a Q&A format. Of particular interest to IMCA members, FINRA offered the following counsel:

  • When a financial analyst posts autobiographical information, such as employment or job responsibilities, the communication will be viewed as a business communication and thus subject to brokerage firm recordkeeping requirements, only in certain contexts (e.g., when the posting lists services or products offered by the firm). However, sending a resume to a potential employer likely would not be viewed as relevant to the business of the brokerage firm.
  • A brokerage firm or financial analyst may not sponsor a social media site or use a communications device that includes technology that automatically erases or deletes content.
  • Financial analysts may use personal communication devices and other equipment, such as smart phones or tablets, to access firm business applications and perform business activity if the firm employs technology that enables the firm to keep records and supervise the activity. FINRA noted that to ensure that the business communications are readily retrievable without necessitating the capture of personal communications made on the same device, firms should have the ability to separate business and personal communications, such as by requiring that the financial analyst use a separately identifiable application on the device for their business communications. FINRA noted further that, if the firm has the ability to separate business and personal communications, and has adequate electronic communications policies and procedures regarding use, then the firm is not required to supervise the personal e-mails made on these devices.

GAO Report on Mutual Fund Advertising

The Government Accounting Office (GAO) recently issued a report on mutual fund advertising.4 In general, the report made two important observations.

The first, and most important observation, was that FINRA does not always effectively communicate changes in advertising rule interpretations. Because FINRA communicates some new interpretative positions initially by making comments on advertisements submitted for its review, the GAO report said, only those firms that submit new advertisements learn of new interpretations of existing rules. As a result, they may be competitively disadvantaged if other firms attract additional investments by continuing to use previously approved advertisements that do not comply with the new position. In addition, the report continued, this uneven method of communicating changes in rule interpretations can result in investors being exposed to advertising that does meet current standards and may be considered misleading. The GAO concluded that to help ensure investors are better protected from misleading advertisements, the Securities and Exchange Commission (SEC) should take steps to ensure FINRA develops sufficient mechanisms to notify all fund companies about changes in rule interpretations for fund advertising.

The second observation concerned the advertising of past performance. In that regard, the GAO report noted that, while some academic studies and others have suggested that advertisements which emphasize a fund’s past performance can influence investors to make inappropriate investments, the evidence that investors are harmed by these advertisements is mixed. In addition, the extent to which investors rely on performance advertisements is unclear, according to the report. The GAO’s review of a random sample of mutual fund advertisements also revealed that advertising focused on performance is generally not common (although the sample was taken from a time period during which it was less likely funds would advertise performance because the period was marked with financial turmoil and significant market losses). The GAO report also noted that, although performance information is not the focus of most advertisements, investors still can seek it out from required disclosure documents or public websites. The GAO report was an initiative directed by the Dodd-Frank Act.

SEC Proposes Rule to Disqualify Felons and Bad Actors from Private Placements

Like the GAO report on mutual fund advertising, a new SEC proposal to disqualify bad actors from private placements also was proposed pursuant to the Dodd-Frank Act.5 ‘‘Bad actor’’ disqualification requirements, sometimes called ‘‘bad boy’’ provisions, prohibit issuers and others (such as underwriters, placement agents, and the directors, officers, and significant shareholders of the issuer) from participating in exempt securities offerings if they have been convicted of, or are subject to court or administrative sanctions for, securities fraud or other violations of specified laws.

Rule 506 is one of three exemptive rules for limited and private offerings under Regulation D and is by far the most widely used. Rule 506, however, in its current form does not impose any bad actor disqualification requirements. Under the proposed rule, an offering would be unable to rely on the commonly-used Rule 506 exemption if the issuer or any other person covered by the rule had a “disqualifying event.”

To clarify the issuer’s obligations under the new rules, the SEC also proposed a ‘‘reasonable care’’ exception, under which an issuer would not lose the benefit of the Rule 506 safe harbor, despite the existence of a disqualifying event, if it can show that it did not know and, in the exercise of reasonable care, could not have known of the disqualification. To establish reasonable care, the issuer would be expected to conduct a factual inquiry, the nature and extent of which would depend on the facts and circumstances of the situation.
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Endnotes
1 Available at http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p123893.pdf.
2 See “Social Media Web Sites,” FINRA Regulatory Notice 10-06 (January 2010). Available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p120779.pdf.
3 See “Social Media Websites and the Use of Personal Devices for Business Communications,” FINRA Regulatory Notice 11-39 (August 2011). Available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p124186.pdf.
4 See “Mutual Fund Advertising: Improving How Regulators Communicate New Rule Interpretations to Industry Would Further Protect Investors, GAO 11-697 (July 2011). Available at http://www.gao.gov/new.items/d11697.pdf.
5 See “Disqualification of Felons and Other ‘Bad Actors’ from Rule 506 Offerings,” SEC Release No. 33–9211 (May 25, 2011). Available at http://sec.gov/rules/proposed/2011/33-9211.pdf.