Proposed FINRA Rule 5123: Enhanced Investor Protection or Unnecessary Regulatory Burden?

Originally proposed on October 5, 2011, FINRA Rule 5123 (the “Rule”) would, if adopted, significantly increase the regulatory burden on certain issuers, such as private funds, and FINRA members involved in the private placement of securities such as third party marketers, placement agents, solicitors and finders and may encourage issuers to rely on the services of unregistered intermediaries to facilitate introductions to accredited investors. Additional, the Rule has been criticized on the basis that it departs from established practice in the realm of private placements by mandating the disclosure of specific information to investors. In particular, the Rule would require FINRA members who offer and sell private securities through the dissemination of a disclosure document, such as a private placement memoranda (“PPM”) or term sheet, to provide each solicited investor who is an accredited investor the following information prior to sale of such securities: (i) the anticipated use of the offering proceeds, (iii) the amount and type of offering expenses, and (iii) the amount and type of compensation provided to sponsors, finders, consultants and members and their associated persons in connection with the offering.  And within 15 calendar days of the date of first sale, each member would be required to file such PPM or term sheet with FINRA along with any material amendment to these documents within 15 days of such occurrence.

In response to comments submitted by various industry participants, on January 20, 2012, the SEC proposed a variety of amendments and clarifications to the draft Rule including: (i) removal of any reference implying that FINRA would review or sign-off on the offering documents before they are sold, (ii)  exemption of “institutional accounts”, “qualified purchasers”  and “investment companies”, among others, and (iii) exemption of certain offerings including those made under 4(1), 4(3) and 4(4) of the Securities Act of ‘33.

Despite the SEC’s attempt to address certain of these initial comments, the Rule continues to generate significant opposition from industry players on a number of grounds. Some of the most salient of these concerns are outlined below:   

a.       The Rule conflicts with the statutory framework for private placements long-established under Section 4(2) of the Securities Act of 1933 which, under SEC interpretation, does not proscribe any particular type of information an issuer must disclosure in the course of a Reg. D private offering. The Rule departs from the this long standing practice by requiring issuers to disclose specific information to investors regarding the offering, information akin to certain disclosures required in a registered offering.

b.      Since much, if not all, information required to be filed under the proposed Rule is already required to be provided under an issuer’s SEC filed and publically available Form D, which must also be filed within 15 days of the first private sale, it is unclear what additional transparency the Rule would provide the market post-sale.

c.       The Rule is likely to significantly inhibit the capital formation process especially for smaller funds and issuers, the placement agents that serve them and the retail accredited investors they solicit. The heightened regulatory oversight, administrative burden and compliance costs will disproportionately affect smaller market players and inhibit their ability to reach the accredited investor who make of the bulk of their investors. Additionally, the past several years have seen the introduction of a variety of new regulatory obligations on FINRA members including registration as "municipal advisers" with the MSRB and compliance with certain "pay to play" rules. Taking the cumulative increase of these compliance requirements into consideration, many smaller FINRA registered broker-dealer may be squeezed out of business.

d.      The Rule is also likely to have the unintended effect of encouraging issuers to pursue relationships with unlicensed agents not subject to the regulatory scrutiny and compliance costs imposed on registered FINRA members. Required to comply with these additional compliance obligations and costs, FINRA members will be placed at a further competitive disadvantage in to unlicensed brokers conducting business illicitly.  As FINRA and the SEC has acknowledged, since there are few resources available to pursue the hundreds, or even thousands, of finders and solicitors doing business on an unregistered basis, these entities operate with virtual impunity, and for all practical purposes, there is unlikely to be penalties for the private funds and issuers using their services.

e.      The Rule also does not specify the penalties a member firm would be subject to in the event of an unintentional late or incomplete filing or non-compliance with filing requirements. If such oversight were not part of a pattern of non-compliance, would it be considered administrative in nature or subject to more serious sanctions as a consequence of being an 'investment related' instance of non-compliance?

f.        Lastly, the Rule is likely to shift a degree of liability from issuers to placement agents in so far as member firms are required to provide "best practices" level disclosure and due diligence prior to accepting subscriptions from private placement investors. The Rule could potentially impose strict liability on member firms for information supplied by issuers over which they have little, if any, ability to verify accuracy.

Given these concerns, it remains unclear whether the SEC will ultimately approve Rule 5123. Perhaps as an indication that the agency is taking a particularly close look at the ramifications of the Rule, the SEC has requested additional comments on its potential impact on investors purchasing private securities through broker-dealers, the potential burden on members resulting from compliance requirements, and the potential impact on the capital formation process and on competition.  

The blog entry above was written by Simon Riveles from the Riveles Law Group in NYC.  The website for Riveles Law Group is   If you are looking for legal counsel regarding hedge funds, their establishment, or securities laws generally, then I certainly recommend contacting either myself or Simon directly.  Be sure to tell him you read his article on

If you have an opinion on current hedge fund marketing/capital introduction rules or regulation, or tips on how hedge funds can further their own marketing efforts, please submit your article to


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