FINRA Proposes Rule Change to Permit Projections of Performance in Private Placement Communications with Qualified Purchasers and in Institutional Communications

The Financial Industry Regulatory Authority, Inc. (“FINRA”) has proposed long-awaited changes to FINRA Rule 2210 (Communications with the Public) that would permit FINRA member broker-dealers to include performance projections and target returns in institutional communications and in communications to qualified purchasers regarding private placements.¹ If approved by the SEC, the proposed changes to FINRA Rule 2210 (the “Proposal”) would resolve a significant difference between FINRA’s Rule 2210, applicable to FINRA member broker-dealers, and the SEC’s marketing rule, applicable to SEC-registered investment advisers (the “Advisers Act Marketing Rule”).² The changes would be a particularly welcome development for private fund sponsors that market their funds through placement agents and other registered broker-dealers and for broker-dealers that market private funds.

Background

Current FINRA Rule 2210 expressly prohibits the use of projections of performance in broker-dealer communications.³ Projections of performance reflect an estimate of the future performance of an investment or investment strategy and are commonly established through mathematical modeling based on historical data and assumptions about future conditions. Although targeted returns are commonly considered to be distinguishable from projections because targets are aspirational and do not necessarily reflect all of the same inputs and assumptions as projections, FINRA has generally viewed targeted returns as a species of projection that is likewise prohibited.⁴

FINRA’s prohibition on the use of projections (and targets) has created challenges for private fund investors, sponsors and broker-dealers. Private fund investors often want to know the targeted return to which a fund will be managed and are also interested in performance projections for the fund or its underlying investments. Such investors – who are often institutional investors such as foundations, endowments and family offices and other sophisticated investors who are “qualified purchasers” (“QPs”) under § 2(a)(51) of the Investment Company Act – may find targets and projections to be important components of their determination whether to invest in a private fund, and generally have professional staff or access to professional advisers who are capable of critically analyzing the targets or projections. Moreover, private fund sponsors that offer their funds through a broker-dealer (and, thus, may not show projections and targets) may be at a competitive disadvantage to private fund sponsors that do not offer their funds through a broker-dealer.

The Proposal

Projection Eligible Investors. The Proposal would permit FINRA member broker-dealers to use targets and projections in certain communications with specified “projection eligible investors.” Targets and projections would be permitted in (i) institutional communications and (ii) communications distributed to QPs that promote or recommend private placements.

“Institutional communications” include any written (including electronic) communication of a broker-dealer that is distributed or made available only to “institutional investors” as defined in FINRA Rule 2210, which includes investors with total assets of at least $50 million.⁵ Under the Proposal, projections and targets would no longer be prohibited in institutional communications regarding any type of investment. In addition, projections and targets would no longer be prohibited in communications with non-institutional investors who are QPs if the communication relates to a private placement that is sold exclusively to QPs.⁶ The Proposal otherwise would not alter existing prohibitions on including targets or projections in most types of retail communications. In other words, the Proposal would continue to prohibit the use of targets with investors who are not QPs, including in connection with private placements (e.g., many private funds that rely on Section 3(c)(1) of the Investment Company Act).

Conditions. To be eligible to include targets or projections in communications with projection eligible investors, the Proposal provides that FINRA member broker-dealers would be required to meet all of the following conditions:

1. Written Policies and Procedures. The broker-dealer would be required to adopt and implement written policies and procedures reasonably designed to ensure, among other things, that the communication is relevant to the likely financial situation and investment objectives of the intended audience. The Proposal specifies that the broker-dealer should have a reasonable belief that investors either have (i) the financial expertise to digest targets and projections and understand the associated risks and limitations or (ii) resources to access financial professionals that have such expertise.

2. Reasonable Basis Standard. The broker-dealer would be required to have a reasonable basis for the criteria used and assumptions made in calculating the target or projection, and to retain written records supporting the basis for such criteria and assumptions.

   In furtherance of this requirement, the Proposal would add Proposed Supplementary Material .01 to FINRA Rule 2210, which would list various factors that broker-dealers might appropriately consider when forming a reasonable basis for the criteria used and assumptions made in calculating targets or projections. Several of the factors include:

   • global, regional, and country macroeconomic conditions, as well as the industry’s and sector’s current market conditions and the state of the business cycle;
   • documented fact-based assumptions concerning the future performance of capital markets;
   • the historical performance and performance volatility of the same or similar asset classes and the appropriateness of selected peer-group comparisons;
   • 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;
   • for funds or managed accounts, the actual past performance of other funds or accounts managed by the same investment adviser or sub-adviser, provided such funds or accounts had substantially similar investment objectives, policies and strategies as the fund or account for which the projected performance or targeted returns are shown;⁷
   • in the case of a single security issued by an operating company, the issuing company’s operating and financial history;
   • the impact of fees, costs, and taxes; and
   • expected contribution and withdrawal rates by investors.⁸

   This condition may prove difficult to meet for a broker-dealer selling a product sponsored by a third party that is not affiliated with the broker-dealer. For example, many private fund sponsors sell their funds through unaffiliated placement agents. In this case, the fund sponsor typically creates the marketing materials, including any projections or targets contained therein, and provides those materials for use by the broker-dealer. Under those circumstances, it is unclear whether the broker-dealer would be required to form its own independent reasonable basis for projections and targets provided by the fund sponsor or whether the broker-dealer could delegate that responsibility to the fund sponsor.

3. Investor Information. The broker-dealer would be required to provide sufficient information to enable the investor to understand:
   • the criteria used and assumptions made in calculating the target or projection, including whether the target or projection is net of anticipated fees and expenses;⁹ and
   • the risks and limitations of using the target or projection in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.
4. Required Disclosure. The communication would be required to prominently disclose that the target or projection is hypothetical in nature and that there is no guarantee that the target or projection will be achieved.

Comparison to Marketing Rule’s Hypothetical Performance Standards

The Advisers Act Marketing Rule permits investment advisers to present hypothetical performance, which includes “targeted or projected performance returns with respect to any portfolio or to the investment advisory services with regard to the securities offered,” under certain conditions.¹⁰ The Proposal is in many respects consistent with the Advisers Act Marketing Rule, with a few key differences. The Proposal notes that FINRA anticipates it would interpret overlapping requirements consistently with how the SEC has interpreted the Advisers Act Marketing Rule’s requirements.

The key similarities and differences between the Proposal and the Advisers Act Marketing Rule include the following:

	FINRA Proposal	Advisers Act Marketing Rule
Scope	Addresses performance projections and target returns (and not other types of hypothetical performance).	Addresses hypothetical performance, including projections and targets as well as back tested and model portfolio performance.
Eligible Investors	Expressly limits use of targets and projections to institutional communications and communications distributed to QPs that promote or recommend private placements.	Does not expressly limit universe of eligible investors but does impose conditions based on the “intended audience” of an advertisement.
Basis for Criteria and Assumptions	Express requirement that broker-dealers have a “reasonable basis” for the criteria and assumptions used to calculate targets or projections.	No express “reasonable basis” requirement.
Policies and Procedures	Broker-dealer must adopt and implement written policies and procedures reasonably designed to ensure, among other things, that the communication is relevant to the likely financial situation and investment objectives of the investor.	Adviser must adopt and implement policies and procedures reasonably designed to ensure that the hypothetical performance is relevant to the likely financial situation and investment objectives of the intended audience.
Required Information – Criteria & Assumptions	Provide sufficient information to enable the investor to understand the criteria used and assumptions made in calculating the target or projection, including whether the target or projection is net of anticipated fees and expenses.	Provide sufficient information to enable the intended audience to understand the criteria used and assumptions made in calculating such hypothetical performance.
Required Information – Risks & Limitations	Provide sufficient information to enable the investor to understand the risks and limitations of using the target or projection in making investment decisions, including reasons why the projected performance or targeted return might differ from actual performance.	Provide (or, if the intended audience is an investor in a private fund, provide or offer 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.

Observations

If approved as proposed, the Proposal would narrow the gap between FINRA Rule 2210 and the Advisers Act Marketing Rule by permitting FINRA member broker-dealers to provide target returns and performance projections under the circumstances described above. Harmonization would be a positive development for investors who desire such information as well as for broker-dealers (and fund sponsors who sell through broker-dealers) that otherwise have lacked a clear path to providing this critical information.

The initial public comment period on the Proposal expires on December 15, 2023. While the SEC is permitted to act on the Proposal as early as December 24, 2023, there is likely to be a robust volume of comments for the SEC and FINRA to consider, and interim amendments to the Proposal are possible. The exercise of statutory extensions could push the final deadline out as far as July 21, 2024.¹¹

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