Document ID: SEC-2019-0583-0001
Agency: sec
Document Type: Notice
Title: Self-Regulatory Organizations; Proposed Rule Changes: Financial Industry Regulatory Authority, Inc.
Posted Date: 2019-05-01T04:00Z

[Federal Register Volume 84, Number 84 (Wednesday, May 1, 2019)]
[Notices]
[Pages 18592-18618]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-08774]

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SECURITIES AND EXCHANGE COMMISSION

[Release No. 34-85715; File No. SR-FINRA-2019-012]

Self-Regulatory Organizations; Financial Industry Regulatory 
Authority, Inc.; Notice of Filing of a Proposed Rule Change To Amend 
FINRA Rule 5110 (Corporate Financing Rule--Underwriting Terms and 
Arrangements) To Make Substantive, Organizational and Terminology 
Changes

April 25, 2019.
    Pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 
(``Act'') \1\ and Rule 19b-4 thereunder,\2\ notice is hereby given that 
on April 11, 2019, Financial Industry Regulatory Authority, Inc. 
(``FINRA'') filed with the Securities and Exchange Commission (``SEC'' 
or ``Commission'') the proposed rule change as described in Items I, 
II, and III below, which Items have been prepared by FINRA. The 
Commission is publishing this notice to solicit comments on the 
proposed rule change from interested persons.
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    \1\ 15 U.S.C. 78s(b)(1).
    \2\ 17 CFR 240.19b-4.
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I. Self-Regulatory Organization's Statement of the Terms of Substance 
of the Proposed Rule Change

    FINRA is proposing to amend FINRA Rule 5110 (Corporate Financing 
Rule--Underwriting Terms and Arrangements) (the ``Rule'') to make 
substantive, organizational and terminology changes to the Rule. The 
proposed rule change is intended to modernize Rule 5110 and to simplify 
and clarify its provisions while maintaining important protections for 
market participants, including issuers and investors participating in 
offerings. The proposed rule change would also update cross-references 
and make other non-substantive changes within FINRA rules due to the 
proposed amendments to Rule 5110.
    The text of the proposed rule change is available on FINRA's 
website at http://www.finra.org, at the principal office of FINRA and 
at the Commission's Public Reference Room.

II. Self-Regulatory Organization's Statement of the Purpose of, and 
Statutory Basis for, the Proposed Rule Change

    In its filing with the Commission, FINRA included statements 
concerning the purpose of and basis for the proposed rule change and 
discussed any comments it received on the proposed rule change. The 
text of these statements may be examined at the places specified in 
Item IV below. FINRA has prepared summaries, set forth in sections A, 
B, and C below, of the most significant aspects of such statements.

A. Self-Regulatory Organization's Statement of the Purpose of, and the 
Statutory Basis for, the Proposed Rule Change

1. Purpose
    The ability of small and large businesses to raise capital 
efficiently is critical to job creation and economic growth. Since its 
adoption in 1992 in response to persistent problems with underwriters 
dealing unfairly with issuers, Rule 5110 has played an important role 
in the capital raising process by prohibiting unfair underwriting terms 
and arrangements in connection with the public offering of securities. 
Moreover, Rule 5110 continues to be important to ensuring investor 
protection and market integrity through effective and efficient 
regulation that facilitates vibrant capital markets.
    Rule 5110 requires a member that participates in a public offering 
to file documents and information with FINRA about the underwriting 
terms and arrangements.\3\ FINRA's Corporate Financing Department 
(``Department'') reviews this information prior to the commencement of 
the offering to determine whether the underwriting compensation and 
other terms and arrangements meet the requirements of the applicable 
FINRA rules.\4\
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    \3\ The following are examples of public offerings that are 
routinely filed: (1) Initial public offerings (``IPOs''); (2) 
follow-on offerings; (3) shelf offerings; (4) rights offerings; (5) 
offerings by direct participation programs (``DPPs'') as defined in 
FINRA Rule 2310(a)(4) (Direct Participation Programs); (6) offerings 
by real estate investment trusts (``REITs''); (7) offerings by a 
bank or savings and loan association; (8) exchange offerings; (9) 
offerings pursuant to SEC Regulation A; and (10) offerings by 
closed-end funds.
    \4\ FINRA does not approve or disapprove an offering; rather, 
the review relates solely to the FINRA rules governing underwriting 
terms and arrangements and does not purport to express any 
determination of compliance with any federal or state laws, or other 
regulatory or self-regulatory requirements regarding the offering. A 
member may proceed with a public offering only if FINRA has provided 
an opinion that it has no objection to the proposed underwriting 
terms and arrangements. See current Rule 5110(b)(4)(B)(ii). See also 
proposed Rule 5110(a)(1)(C)(ii).
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    Rule 5110 was last revised in 2004 to better reflect the various 
financial activities of multi-service members.\5\ After years of 
experience with those amendments, and subsequent narrower amendments 
that addressed industry practices regarding particular underwriting 
terms and arrangements, FINRA recently conducted the equivalent of a 
retrospective review \6\ to further modernize the Rule by, among other 
things, significantly improving the administration of the Rule and 
simplifying the Rule's provisions while maintaining important 
protections for market participants, including issuers and investors 
participating in offerings.
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    \5\ In recognition of the expansion in the variety of services 
provided by members to their corporate financing clients, such as 
venture capital investment, financial consulting, commercial 
lending, hedging risk through derivative transactions and investment 
banking services, the Rule was revised in 2004 to accommodate the 
expanded corporate financing activities of members, while protecting 
issuers and investors from unreasonable or coercive practices. See 
Securities Exchange Act Release No. 48989 (December 23, 2003), 68 FR 
75684 (December 31, 2003) (Order Approving File No. SR-NASD-2000-
04). See also Notice to Members 04-13 (February 2004).
    \6\ Because the review began before FINRA initiated formal 
retrospective review procedures, it did not follow the specific 
procedures that are now followed.
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    As part of this retrospective review, FINRA engaged in extensive 
consultation with the industry to better understand what aspects of the 
Rule needed to be modernized, simplified and clarified. This 
retrospective review, including its industry consultation component and 
comments FINRA received in response to Regulatory Notice 17-15 (April 
2017) (``Notice 17-15 Proposal'') (as further discussed in Items II.B. 
and II.C. infra), has shaped and informed this proposed rule change. 
The proposed rule change includes a range of amendments to Rule 5110, 
including reorganizing and improving the readability of the Rule. FINRA 
proposes changes to the following areas: (1) Filing requirements; (2) 
filing requirements for shelf offerings; (3) exemptions from filing and 
substantive requirements; (4) underwriting

[[Page 18593]]

compensation; (5) venture capital exceptions; (6) treatment of non-
convertible or non-exchangeable debt securities and derivatives; (7) 
lock-up restrictions; (8) prohibited terms and arrangements; and (9) 
defined terms.\7\ The changes to these areas should lessen the 
regulatory costs and burdens incurred when complying with the Rule.
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    \7\ As discussed below, the proposal retains the current 
approach to itemized disclosure of underwriting compensation, but 
makes explicit the existing practice of disclosing specified 
material terms and arrangements related to underwriting 
compensation, such as exercise terms, in the prospectus. In 
addition, the proposed rule change does not include any changes to 
current Rule 5110(h) (Non-Cash Compensation). These provisions are 
the subject of a separate consolidated approach to non-cash 
compensation. See Regulatory Notice 16-29 (August 2016).
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Filing Requirements
    The proposed rule change would amend Rule 5110's filing 
requirements to create a process that is both more flexible and more 
efficient for members. The proposed rule change would allow members 
more time to make the required filings with FINRA (from one business 
day after filing with the SEC or a state securities commission or 
similar state regulatory authority to three business days).\8\ This 
change is intended to help with logistical issues or inadvertent delays 
in making filings without impeding FINRA's ability to timely review the 
underwriting terms and arrangements.
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    \8\ See proposed Rule 5110(a)(3)(A). The documents and 
information required to be filed under Rule 5110 are filed in 
FINRA's Public Offering System (``FINRA System'') for review and, if 
available, the associated SEC document identification number should 
be provided. See proposed Rule 5110(a)(4).
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    The proposed rule change would clarify and further reduce the types 
of documents and information that must be filed by directing members to 
provide the SEC document identification number if available,\9\ and 
require filing: (1) Industry-standard master forms of agreement only if 
specifically requested to do so by FINRA; \10\ (2) amendments to 
previously filed documents only if there have been changes relating to 
the disclosures that impact the underwriting terms and arrangements for 
the public offering in those documents; \11\ (3) a representation as to 
whether any associated person or affiliate of a participating member is 
a beneficial owner of 5 percent or more of ``equity and equity-linked 
securities''; \12\ and (4) an estimate of the maximum value for each 
item of underwriting compensation.\13\
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    \9\ Depending on the filing type, an SEC document identification 
number could include a document control number, document file number 
or accession number. For purposes of clarity, the lack of an SEC 
document identification number does not obviate the need to submit 
the documents and information set forth in proposed Rule 5110(a)(4).
    \10\ See proposed Rule 5110(a)(4)(A)(ii). A member may use a 
master form of agreement which is a standard form used across like 
offerings and transactions in which the member participates (e.g., a 
master agreement among underwriters).
    \11\ See proposed Rule 5110(a)(4)(A)(iii).
    \12\ See proposed Rule 5110(a)(4)(B)(iii) and proposed Rule 
5110(j)(7). Contrast with current Rule 5110(b)(6)(A)(iii), which 
requires a statement or association related to ``any class of the 
issuer's securities.''
    \13\ See proposed Rule 5110(a)(4)(B)(ii).
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    The proposed rule change would clarify that a member participating 
in an offering is not required to file with FINRA if the filing has 
been made by another member participating in the offering.\14\ In 
addition, rather than providing a non-exhaustive list of types of 
public offerings that are required to be filed, the proposed rule 
change would instead state that a public offering in which a member 
participates must be filed for review unless exempted by the Rule.\15\ 
The proposed rule change would clarify the general standard that no 
member may engage in the distribution or sale of securities unless 
FINRA has provided an opinion that it has no objection to the proposed 
underwriting terms and arrangements.\16\ The proposed rule change also 
would clarify that any member acting as a managing underwriter or in a 
similar capacity must notify the other members participating in the 
public offering if informed of an opinion by FINRA that the 
underwriting terms and arrangements are unfair and unreasonable and the 
proposed terms and arrangements have not been appropriately 
modified.\17\ Providing members with more time to file relevant 
documents and information and reducing the filing of duplicative or 
otherwise unnecessary documents and information would lessen members' 
filing burdens while maintaining the Rule's important protections for 
market participants.
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    \14\ See proposed Rule 5110(a)(3)(B). Participating members are 
responsible for filing public offerings with FINRA. While an issuer 
may file an offering with FINRA if a participating member has not 
yet been engaged, a participating member must assume filing 
responsibilities once it has been engaged. As discussed infra, 
issuer filings continue to be permitted for shelf offerings.
    \15\ See proposed Rule 5110(a)(2). As discussed infra, the 
proposed rule change would add the defined term ``public offering'' 
to Rule 5110.
    \16\ See proposed Rule 5110(a)(1)(C).
    \17\ See proposed Rule 5110(a)(1)(B).
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    The new provision addressing terminated offerings provides that, 
when an offering is not completed according to the terms of an 
agreement entered into by the issuer and a member, but the member has 
received underwriting compensation, the member must give written 
notification to FINRA of all underwriting compensation received or to 
be received, including a copy of any agreement governing the 
arrangement.\18\ Information regarding underwriting compensation 
received or to be received in terminated offerings is relevant to 
FINRA's evaluation of compliance with Rule 5110 and, in particular, 
paragraph (g)(5) of the proposed Rule. This new provision would allow 
FINRA to provide more effective oversight when a member's services have 
been terminated.
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    \18\ See proposed Rule 5110(a)(4)(C) and proposed Rule 
5110(g)(5). In 2014, FINRA amended Rule 5110 to expand and specify 
the circumstances under which underwriting compensation in excess of 
a reimbursement of out-of-pocket expenses, such as termination fees 
and rights of first refusal (``ROFR''), could be received in 
connection with an offering that was not completed or when a member 
was terminated from an offering. See Securities Exchange Act Release 
No. 72114 (May 7, 2014), 79 FR 27355 (May 13, 2014) (Order Approving 
File No. SR-FINRA-2014-004).
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Filing Requirements for Shelf Offerings
    Issuers meeting specified reporting history and other requirements 
are eligible to use shelf registration statements. A shelf-eligible 
issuer can use a shelf takedown to publicly offer securities on a 
continuous or delayed basis to meet funding needs or to take advantage 
of favorable market windows. Public offerings by some shelf-eligible 
issuers have historically been exempt from Rule 5110's filing 
requirement; however, for the reasons discussed below, public offerings 
by other shelf-eligible issuers have historically been subject to Rule 
5110's filing requirement. The proposed rule change would codify the 
historical standards for public offerings that are exempt from the 
filing requirement and would streamline the filing requirements for 
shelf offerings that remain subject to the filing requirement.
Public Offerings Exempt From the Filing Requirement
    Substantively consistent with the current Rule, the proposed rule 
change would exempt from Rule 5110's filing requirement a public 
offering by an ``experienced issuer'' (i.e., an issuer with a 36-month 
reporting history and at least $150 million aggregate market value of 
voting stock held by non-affiliates or, alternatively, the aggregate 
market value of voting stock held by non-affiliates is at least $100 
million and the issuer has an annual trading volume of three million 
shares or more

[[Page 18594]]

in the stock).\19\ Unless subject to another exemption, public 
offerings of issuers that do not meet the reporting history or float 
requirement to be codified in the experienced issuer definition have 
historically been subject to Rule 5110's filing requirement, including 
shelf offerings by these issuers.
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    \19\ The proposed rule change would delete references to the 
pre-1992 standards for Form S-3 and standards approved in 1991 for 
Form F-10 and instead codify the requirement that the issuer have a 
36-month reporting history and at least $150 million aggregate 
market value of voting stock held by non-affiliates or alternatively 
the aggregate market value of voting stock held by non-affiliates is 
at least $100 million and the issuer has an annual trading volume of 
three million shares or more in the stock. See proposed Rule 
5110(j)(6).
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Public Offerings Subject to the Filing Requirement
    There are many benefits for eligible issuers in using a shelf 
registration statement, including the ability of issuers to take 
advantage of favorable market conditions on short notice to quickly 
raise capital through takedown offerings. While shelf offerings have 
historically been less likely to have compliance problems, previously 
filed shelf offerings have given rise to issues under Rule 5110, 
including those related to: (1) Excessive underwriting compensation; 
(2) indeterminate underwriting compensation in the form of convertible 
debt or equity securities that do not have a market value; (3) 
undisclosed underwriting compensation, primarily in the form of 
uncapped expense reimbursements; and (4) termination fees and ROFRs 
that do not satisfy the Rule's requirements.
    Given the issues that have arisen in shelf offerings, the proposed 
rule change would continue to apply Rule 5110's filing requirement to 
shelf offerings by issuers that do not meet the ``experienced issuer'' 
standard. However, to facilitate the ability of issuers to take 
advantage of favorable market conditions on short notice to quickly 
raise capital through takedown offerings, the proposed rule change 
would streamline the filing requirements for shelf offerings. The 
proposed rule change would provide that only the following documents 
and information must be filed: (1) The Securities Act of 1933 
(``Securities Act'') registration statement number; and (2) if 
specifically requested by FINRA, other documents and information set 
forth in Rule 5110(a)(4)(A) and (B).\20\
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    \20\ See proposed Rule 5110(a)(4)(E).
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    FINRA would access the base shelf registration statement, 
amendments and prospectus supplements in the SEC's Electronic Data 
Gathering, Analysis, and Retrieval (``EDGAR'') system and populate the 
information necessary to conduct a review in the FINRA System. Upon 
filing of the required registration statement number and documents and 
information, if any, that FINRA requested pursuant to proposed Rule 
5110(a)(4)(E), FINRA would provide the no objections opinion. To 
further facilitate issuers' ability to timely access capital markets, 
FINRA's review of documents and information related to a shelf takedown 
offering for compliance with Rule 5110 would occur on a post-takedown 
basis.\21\
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    \21\ Issuers would continue to be permitted to file a base shelf 
registration statement in anticipation of retaining a member to 
participate in a takedown offering.
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Exemptions From Filing and Substantive Requirements
    Rule 5110 includes two categories of exempt public offerings--
offerings that are exempt from filing, but remain subject to the 
substantive provisions of Rule 5110, and offerings that are exempt from 
both the filing requirements and substantive provisions of Rule 5110. 
The proposed rule change would expand and clarify the scope of the 
exemptions, which is expected to reduce members' filing and compliance 
costs.
    Consistent with historical practice in interpreting the exemption 
that is currently available to corporate issuers, the proposed rule 
change would clarify that securities of banks that have qualifying 
outstanding debt securities are exempt from the filing requirement.\22\
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    \22\ See proposed Rule 5110(h)(1)(A). The exemption has 
historically been interpreted to apply to qualifying securities 
offered by a bank; however, the lack of a specific reference to bank 
securities in the Rule text has raised questions by members.
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    The proposed rule change would also expand the current list of 
offerings that are exempt from both the filing requirements and 
substantive provisions of Rule 5110 to include public offerings of 
closed-end ``tender offer'' funds (i.e., closed-end funds that 
repurchase shares from shareholders pursuant to tender offers), 
insurance contracts and unit investment trusts.\23\ Exempting these 
public offerings is appropriate because they relate to highly regulated 
entities governed by the Investment Company Act of 1940 (``Investment 
Company Act'') whose offering terms would be subject to FINRA Rule 2341 
(Investment Company Securities). In addition, as discussed infra, in 
response to comments to the Notice 17-15 Proposal, the proposed rule 
change reclassifies three items from the offerings exempt from filing 
and rule compliance to offerings excluded from the definition of public 
offering. The three items are: (1) Offerings exempt from registration 
with the SEC pursuant to Section 4(a)(1), (2) and (6) of the Securities 
Act; (2) offerings exempt from registration under specified SEC 
Regulation D provisions; and (3) offerings of exempted securities as 
defined in Section 3(a)(12) of the Exchange Act. This reclassification 
is consistent with the treatment of such offerings in FINRA Rule 5121 
(Public Offerings of Securities With Conflicts of Interest).\24\
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    \23\ See proposed Rule 5110(h)(2)(E), (K) and (L).
    \24\ See proposed Rule 5110(j)(18).
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Disclosure Requirements
    The SEC's Regulation S-K requires fees and expenses identified by 
FINRA as underwriting compensation to be disclosed in the 
prospectus.\25\ The Notice 17-15 Proposal would have modified Rule 
5110's underwriting compensation disclosure requirements. Although a 
description of each item of underwriting compensation would have been 
required to be disclosed, the Notice 17-15 Proposal would have no 
longer required that the disclosure include the dollar amount ascribed 
to each individual item of compensation. Rather, the Notice 17-15 
Proposal would have permitted a member to disclose the maximum 
aggregate amount of all underwriting compensation, except the discount 
or commission that must be disclosed on the cover page of the 
prospectus.
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    \25\ See 17 CFR 229.508(e).
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    FINRA is no longer proposing to eliminate the itemized disclosure 
that Rule 5110 currently requires. As discussed in Item II.C. infra, 
commenters had conflicting views on the proposed change to allow 
aggregation of underwriting compensation with one commenter stating 
that the itemized disclosure may be beneficial for investors in better 
understanding the underwriting compensation paid and incentives that 
may be present in the public offering. Recognizing commenters' 
conflicting views, the proposed rule change would retain the current 
requirements for itemized disclosure of underwriting compensation and 
disclosing dollar amounts ascribed to each such item.\26\ The proposed 
rule change would incorporate the requirements for disclosure of 
specified material terms and arrangements that are consistent with 
current practice.\27\
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    \26\ See proposed Rule 5110(b)(1) and Supplementary Material .05 
to Rule 5110. See also proposed Rule 5110(e)(1)(B) requiring 
disclosure of lock-ups.
    \27\ See proposed Supplementary Material .05 to Rule 5110.

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[[Page 18595]]

    The Notice 17-15 Proposal also included an explicit requirement to 
disclose specified material terms and arrangements in the prospectus. 
The current proposal includes the same obligation, which makes explicit 
the existing practice of disclosing specified material terms and 
arrangements related to underwriting compensation in the prospectus. 
This explicit provision would require a description for: (1) Any ROFR 
granted to a participating member and its duration; and (2) the 
material terms and arrangements of the securities acquired by the 
participating member (e.g., exercise terms, demand rights, piggyback 
registration rights and lock-up periods).\28\
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    \28\ See proposed Supplementary Material .05 to Rule 5110.
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Underwriting Compensation
    The proposed rule change would clarify what is considered 
underwriting compensation for purposes of Rule 5110. As an initial 
matter, the proposed rule change would consolidate the various 
provisions of the current Rule that address what constitutes 
underwriting compensation into a single, new definition of 
``underwriting compensation.'' Underwriting compensation would be 
defined to mean ``any payment, right, interest, or benefit received or 
to be received by a participating member from any source for 
underwriting, allocation, distribution, advisory and other investment 
banking services in connection with a public offering.'' Underwriting 
compensation would also include ``finder's fees, underwriter's counsel 
fees and securities.'' \29\
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    \29\ See proposed Rule 5110(j)(22).
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    Rule 5110 currently provides that all items of value received or to 
be received from any source are presumed to be underwriting 
compensation when received during the period commencing 180 days before 
the required filing date of the registration statement, and up to 90 
days following the effectiveness or commencement of sales of a public 
offering.\30\ However, this approach may not reflect the various types 
of offerings subject to Rule 5110. For example, a best efforts offering 
may be distributed for months or years and underwriters may receive 
compensation throughout the offering period, or a base shelf 
registration statement may become effective months or years before a 
takedown offering for which an underwriter is compensated.
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    \30\ See current Rule 5110(d)(1). See also current Rule 
5110(b)(6)(A)(vi)b. which provides that details of any new 
arrangement entered into within 90 days following the date of 
effectiveness or commencement of sales of the public offering must 
be filed.
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    To better reflect the different types of offerings subject to Rule 
5110, the proposed rule change would introduce the defined term 
``review period'' and the applicable time period would vary based on 
the type of offering. Specifically, the proposed rule change would 
define the review period to mean: (1) For a firm commitment offering, 
the 180-day period preceding the required filing date through the 60-
day period following the effective date of the offering; (2) for a best 
efforts offering, the 180-day period preceding the required filing date 
through the 60-day period following the final closing of the offering; 
and (3) for a firm commitment or best efforts takedown or any other 
continuous offering made pursuant to Securities Act Rule 415, the 180-
day period preceding the required filing date of the takedown or 
continuous offering through the 60-day period following the final 
closing of the takedown or continuous offering.\31\ Accordingly, 
payments and benefits received during the applicable review period 
would be considered in evaluating underwriting compensation.
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    \31\ See proposed Rule 5110(j)(20).
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    The proposed rule change would continue to provide two non-
exhaustive lists of examples of payments or benefits that would be and 
would not be considered underwriting compensation.\32\ Although the 
Rule would no longer incorporate the concept of ``items of value'' 
(i.e., the non-exhaustive list of payments and benefits that would be 
included in the underwriting compensation calculation), the proposed 
non-exhaustive lists are derived from the examples of payments or 
benefits that currently are considered and not considered items of 
value. The proposed examples of payments or benefits that would be 
underwriting compensation is comparable to the list of items of value 
in the current Rule with some additional clarifying changes. For 
example, the proposed rule change would expand the current item of 
value related to reimbursement of expenses to provide that fees and 
expenses paid or reimbursed to, or paid on behalf of, the participating 
members, including but not limited to road show fees and expenses and 
due diligence expenses, would be underwriting compensation.\33\ 
Consistent with current practice, the proposed rule change would also 
include in underwriting compensation non-cash compensation.\34\
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    \32\ See proposed Supplementary Material .01 to Rule 5110.
    \33\ See proposed Supplementary Material .01(a)(2) to Rule 5110. 
See also proposed Supplementary Material .01(a)(3) and (4) to Rule 
5110 which includes fees and expenses of participating members' 
counsel and finder's fees paid or reimbursed to, or paid on behalf 
of, the participating members (except for reimbursement of ``blue 
sky'' fees) as underwriting compensation.
    \34\ See proposed Supplementary Material .01(a)(14) to Rule 
5110.
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    The proposed examples of payments or benefits that would not be 
underwriting compensation include several new examples to provide 
greater clarity and to address questions raised by members. For 
instance, in response to questions from members, the proposed rule 
change would clarify that payments for records management and advisory 
services received by members in connection with some corporate 
reorganizations would not be considered underwriting compensation.\35\ 
Similarly, the proposed rule change would clarify that the payment or 
reimbursement of legal costs resulting from a contractual breach or 
misrepresentation by the issuer would not be considered underwriting 
compensation.\36\ The proposed rule change also would clarify that 
securities acquired pursuant to a governmental or court approved 
proceeding or plan of reorganization as a result of action by the 
government or court (e.g., bankruptcy or tax court proceeding) would 
not be considered underwriting compensation.\37\ These payments are for 
services beyond the traditional scope of underwriting activities and, 
therefore, are appropriately excluded from the coverage of Rule 5110.
    In addition, to give members reasonable flexibility with respect to 
issuer securities acquired in certain circumstances, the proposed rule 
change would take a principles-based approach in considering whether 
issuer securities acquired from third parties or in directed sales 
programs may be excluded from underwriting compensation. This 
principles-based approach starts with the presumption that the issuer 
securities received during the review period would be underwriting 
compensation. However, FINRA would consider the factors set forth in 
proposed Supplementary Material to Rule 5110 and discussed below in 
determining whether the securities may be excluded from

[[Page 18596]]

underwriting compensation.\38\ A participating member is responsible 
for providing documents and information sufficient for FINRA to 
consider in applying the factors to a particular securities 
acquisition.
    With respect to issuer securities received from third parties, it 
is important to note that the proposed definition of ``underwriting 
compensation'' would include payments, rights, interests, or benefits 
received or to be received by a participating member from any source 
for underwriting, allocation, distribution, advisory and other 
investment banking services in connection with a public offering. 
However, some acquisitions of issuer securities from third parties for 
purposes unconnected to underwriting compensation should not be deemed 
underwriting compensation (e.g., securities acquired in ordinary course 
transactions executed over a participating member's trading desk during 
the review period from third parties).
    To address these situations, the proposed rule change uses a 
principles-based approach to considering whether securities of the 
issuer acquired from third parties may be excluded from underwriting 
compensation. Specifically, under proposed Supplementary Material .03 
to Rule 5110, FINRA would consider the following factors, as well as 
any other relevant factors and circumstances: (1) The nature of the 
relationship between the issuer and the third party, if any; (2) the 
nature of the transactions in which the securities were acquired, 
including, but not limited to, whether the transactions are engaged in 
as part of the participating member's ordinary course of business; and 
(3) any disparity between the price paid and the offering price or 
market price.
    With respect to issuer securities acquired in directed sales 
programs (commonly called friends and family programs), it is important 
to note that the proposed definition of ``participating member'' 
includes any FINRA member that is participating in a public offering, 
any affiliate or associated person of the member, and any immediate 
family of an associated person of the member, but does not include the 
issuer.\39\ However, associated persons and their immediate family 
members may have relationships with issuers that motivate the issuer to 
sell these persons shares in directed sales programs. These 
acquisitions may be unrelated to the investment banking services 
provided by the participating member.
    To address these situations, under the proposed rule change FINRA 
would take a principles-based approach to considering whether an 
acquisition of securities by a participating member pursuant to an 
issuer's directed sales program may be excluded from underwriting 
compensation. Specifically, under proposed Supplementary Material .04 
to Rule 5110, FINRA would consider the following factors, as well as 
any other relevant factors and circumstances: (1) The existence of a 
pre-existing relationship between the issuer and the person acquiring 
the securities; (2) the nature of the relationship; and (3) whether the 
securities were acquired on the same terms and at the same price as 
other similarly-situated persons participating in the directed sales 
program.
Venture Capital Exceptions
    Rule 5110 currently provides exceptions designed to distinguish 
securities acquired in bona fide venture capital transactions from 
those acquired as underwriting compensation (for brevity, referred to 
herein as the ``venture capital exceptions'').\40\ Recognizing that 
bona fide venture capital transactions contribute to capital formation, 
the proposed rule change would modify, clarify and expand the 
exceptions to further facilitate members' participation in bona fide 
venture capital transactions. Importantly, the venture capital 
exceptions would include several restrictions to ensure the protection 
of other market participants and that the exceptions are not misused to 
circumvent the requirements of Rule 5110.
---------------------------------------------------------------------------

    \35\ See proposed Supplementary Material .01(b)(3) to Rule 5110.
    \36\ See proposed Supplementary Material .01(b)(4) to Rule 5110.
    \37\ See proposed Supplementary Material .01(b)(22) to Rule 
5110. See also comments from ABA, Davis Polk and SIFMA discussed in 
Item II.C. infra.
    \38\ See proposed Supplementary Material .03 and .04 to Rule 
5110.
    \39\ See proposed Rule 5110(j)(15).
    \40\ See current Rule 5110(d)(5).
---------------------------------------------------------------------------

    The proposed rule change would no longer treat as underwriting 
compensation securities acquisitions covered by two of the current 
exceptions: (1) Securities acquisitions and conversions to prevent 
dilution; and (2) securities purchases based on a prior investment 
history. This treatment is conditioned on prior investments in the 
issuer occurring before the review period. When subsequent securities 
acquisitions take place (e.g., as a result of a stock split, a right of 
preemption, a securities conversion, or when additional securities are 
acquired to prevent dilution of a long-standing interest in the 
issuer), the acquisition of the additional securities should not be 
treated as underwriting compensation. Accordingly, the proposed rule 
change would add these acquisitions to the list of examples of payments 
that are not underwriting compensation because they are based on a 
prior investment history and are subject to the terms of the original 
securities that were acquired before the review period.\41\
---------------------------------------------------------------------------

    \41\ See proposed Supplementary Material .01(b)(14), (16-18).
---------------------------------------------------------------------------

    The proposed rule change also would broaden two of the current 
venture capital exceptions regarding purchases and loans by certain 
affiliates, and investments in and loans to certain issuers, by 
removing a limitation on acquiring more than 25 percent of the issuer's 
total equity securities.\42\ The 25 percent threshold limits each 
member and its affiliates from acquiring more than 25 percent of the 
issuer's total equity securities, which typically establishes a control 
relationship. The threshold, which was codified in 2004, provided 
protection from overreaching by members at a time when there was a 
concern about limiting the aggregate amount of equity acquired in pre-
offering transactions. Subsequent regulatory changes in other areas, 
such as the 2009 revision of Rule 5121 regarding public offerings with 
a conflict of interest,\43\ have added protections and are more 
appropriate to address acquisitions that create control relationships.
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    \42\ See proposed Rule 5110(d)(1) and (2).
    \43\ Rule 5121 requires prominent disclosure of conflicts and, 
for certain types of conflicts, the participation of a qualified 
independent underwriter (``QIU'') in the preparation of the 
registration statement.
---------------------------------------------------------------------------

    These venture capital exceptions specify that the affiliate must be 
primarily in the business of making investments or loans. The proposed 
rule change expands the scope of these exceptions to include that the 
affiliate, directly or through a subsidiary it controls, must be in 
such business and further permits that the entity may be newly formed 
by such affiliate. Expanding the scope of the exceptions to cover 
direct, indirect or newly formed entities that are in the business of 
making investments and loans acknowledges the different structures that 
may be used to participate in bona fide venture capital 
transactions.\44\
---------------------------------------------------------------------------

    \44\ See proposed Rule 5110(d)(1)(D) and (d)(2)(A)(iv).
---------------------------------------------------------------------------

    Another venture capital exception relates to private placements 
with institutional investors. The exception would be available only 
when the institutional investors participating in the offering are not 
affiliates of a FINRA member. This ensures that such institutional 
investors are independent

[[Page 18597]]

sources of capital. The provision is further clarified to require that 
the institutional investors must purchase at least 51 percent of the 
total number of securities sold in the private placement at the same 
time and on the same terms. In addition, the proposed rule change would 
raise the percent that participating members in the aggregate may 
acquire from 20 to 40 percent of the securities sold in the private 
placement.\45\ These private placements typically occur before the 
syndicate is formed and, therefore, members may not know at the time 
whether their participation in the private placement would impact the 
issuer's future public offering by triggering the threshold. Because 
exceeding the threshold would subject members to the compensation 
limits, disclosure provisions and lock-up provisions of the Rule, the 
current 20 percent threshold reduces the number of members available 
for the syndicate. Increasing the threshold would allow more members to 
participate in the private placement and any subsequent public 
offering. An increase in the threshold is appropriate and raising it to 
40 percent: (1) Would not materially change the operation of the 
exception, as the securities acquired in the private placement would 
remain subject to the other conditions in the exception; and (2) would 
benefit issuers that are in the process of assembling a syndicate.
---------------------------------------------------------------------------

    \45\ See proposed Rule 5110(d)(3)(C).
---------------------------------------------------------------------------

    In response to comments to the Notice 17-15 Proposal, the proposed 
rule change would expand the scope of proposed Rule 5110(d)(3) to 
include providing services for a private placement (rather than just 
acting as a placement agent).\46\ Members' roles in acting as placement 
agents and in providing other services in private placements (e.g., 
acting as a finder or a financial advisor) similarly facilitate 
offerings. As such, expanding the current venture capital exception 
beyond securities received for acting as a placement agent to include 
securities received for providing services for a private placement is 
appropriate.
---------------------------------------------------------------------------

    \46\ See proposed Rule 5110(d)(3) and Item II.C. infra.
---------------------------------------------------------------------------

    Where a highly regulated entity with significant disclosure 
requirements and independent directors who monitor investments is also 
making a significant co-investment in an issuer and is receiving 
securities at the same price and on the same terms as the participating 
member, the securities acquired by the participating member in a 
private placement are less likely to be underwriting compensation. To 
address such co-investments, the proposed rule change would adopt a new 
venture capital exception from underwriting compensation for securities 
acquired in a private placement before the required filing date of the 
public offering by a participating member if at least 15 percent of the 
total number of securities sold in the private placement were acquired, 
at the same time and on the same terms, by one or more entities that is 
an open-end investment company not traded on an exchange, and no such 
entity is an affiliate of a FINRA member participating in the offering. 
These conditions lessen the risk that the co-investment would be made 
for the purpose of providing undervalued securities to a participating 
member in return for acting as an underwriter.
    A public offering may be significantly delayed for legitimate 
reasons (e.g., unfavorable market conditions) and during this delay the 
issuer may require funding. Furthermore, a member may make bona fide 
investments in or loans to the issuer during this delay to satisfy the 
issuer's funding needs and any securities acquired as a result of this 
funding may be unrelated to the anticipated public offering. The 
proposed rule change would provide some additional flexibility in the 
availability of the venture capital exceptions for securities acquired 
where the public offering has been significantly delayed.
    The proposed rule change would take a principles-based approach 
where a public offering has been significantly delayed and the issuer 
needs funding in considering whether it is appropriate to treat as 
underwriting compensation securities acquired by a member after the 
required filing date in a transaction that, except for the timing, 
would otherwise meet the requirements of a venture capital exception. 
This principles-based approach starts with the presumption that the 
venture capital exception would not be available where the securities 
were acquired after the required filing date. However, FINRA would 
consider the factors in proposed Supplementary Material .02 in 
determining whether securities acquired in a transaction that occurs 
after the required filing date, but otherwise meets the requirements of 
a venture capital exception, may be excluded from underwriting 
compensation.
    Specifically, FINRA would consider the following principles, as 
well as any other relevant factors and circumstances: (1) The length of 
time between the date of filing of the registration statement or 
similar document and the date of the transaction in which securities 
were acquired; (2) the length of time between the date of the 
transaction in which the securities were acquired and the anticipated 
commencement of the public offering; and (3) the nature of the funding 
provided, including, but not limited to the issuer's need for funding 
before the public offering. A participating member is responsible for 
providing documents and information sufficient for FINRA to consider in 
applying the principles to a particular securities acquisition.
Treatment of Non-Convertible or Non-Exchangeable Debt Securities and 
Derivatives
    The proposed rule change would clarify the treatment of non-
convertible or non-exchangeable debt securities and derivative 
instruments.\47\ The proposed rule change would expressly provide that 
non-convertible or non-exchangeable debt securities and derivative 
instruments acquired in a transaction unrelated to a public offering 
would not be underwriting compensation.\48\ Accordingly, the non-
convertible or non-exchangeable debt securities and derivative 
instruments acquired in a transaction unrelated to a public offering 
would not be subject to Rule 5110 (i.e., a description of the non-
convertible or non-exchangeable debt securities and derivative 
instruments need not be filed with FINRA,\49\ there are no valuation-
related requirements and the lock-up restriction does not apply).
---------------------------------------------------------------------------

    \47\ Consistent with the current Rule, the proposed rule change 
would define the term ``derivative instrument'' to mean any eligible 
OTC derivative instrument as defined in Exchange Act Rule 3b-
13(a)(1), (2) and (3). See proposed Supplementary Material .06(b) to 
Rule 5110.
    \48\ See proposed Supplementary Material .01(b)(19) to Rule 
5110.
    \49\ See proposed Rule 5110(a)(4)(B)(iv)b.
---------------------------------------------------------------------------

    In contrast, non-convertible or non-exchangeable debt securities 
and derivative instruments acquired in a transaction related to a 
public offering would be underwriting compensation. For any non-
convertible or non-exchangeable debt securities and derivative 
instruments acquired in a transaction related to the public offering, 
the proposed rule change would clarify that: (1) A description of those 
securities and derivative instruments must be filed with FINRA; and (2) 
this description must be accompanied by a representation that a 
registered principal or senior manager of the participating member has 
determined if the transaction was or will be entered into at a fair 
price.\50\
---------------------------------------------------------------------------

    \50\ See proposed Rule 5110(a)(4)(B)(iv)a. Generally consistent 
with current Rule 5110, the proposed rule change would define the 
term ``fair price'' to mean the participating members have priced a 
derivative instrument or non-convertible or non-exchangeable debt 
security in good faith; on an arm's length, commercially reasonable 
basis; and in accordance with pricing methods and models and 
procedures used in the ordinary course of their business for pricing 
similar transactions. The proposed rule change would also clarify 
that a derivative instrument or other security received as 
compensation for providing services for the issuer, for providing or 
arranging a loan, credit facility, merger, acquisition or any other 
service, including underwriting services will not be deemed to be 
entered into or acquired at a fair price. See proposed Supplementary 
Material .06(b) to Rule 5110.

---------------------------------------------------------------------------

[[Page 18598]]

    The proposed rule change would also clarify that the valuation 
depends upon whether the non-convertible or non-exchangeable debt 
securities or derivative instruments acquired in a transaction related 
to a public offering were or were not acquired at a fair price. 
Specifically, the proposed rule change would clarify that non-
convertible or non-exchangeable debt securities and derivative 
instruments acquired at a fair price would be considered underwriting 
compensation but would have no compensation value. In contrast, the 
proposed rule change would provide that non-convertible or non-
exchangeable debt securities and derivative instruments not acquired at 
a fair price would be considered underwriting compensation and subject 
to the normal valuation requirements of Rule 5110.\51\
---------------------------------------------------------------------------

    \51\ See proposed Supplementary Material .06(a) to Rule 5110 and 
proposed Rule 5110(c).
---------------------------------------------------------------------------

    The following charts provide an overview of the treatment of non-
convertible or non-exchangeable debt securities and derivative 
instruments under Rule 5110.
[GRAPHIC] [TIFF OMITTED] TN01MY19.000

Lock-Up Restrictions
    Subject to some exceptions, Rule 5110 requires in any public equity 
offering a 180-day lock-up restriction on securities that are 
considered underwriting compensation. During the lock-up period, 
securities that are underwriting compensation are restricted from sale 
or transfer and may not be pledged as collateral or made subject to any 
derivative contract or other transaction that provides the effective 
economic benefit of sale or other prohibited disposition.\52\ Because a 
prospectus may become effective long before the commencement of sales, 
the proposed rule change would provide that the lock-up period begins 
on the date of commencement of sales of the public equity offering 
(rather than the date of effectiveness of the prospectus).\53\ The 
proposed rule change also would provide that the lock-up restriction 
must be disclosed in the section on distribution arrangements in the 
prospectus or similar document consistent with proposed Supplementary 
Material .05 requiring disclosure of the material terms of any 
securities.\54\
---------------------------------------------------------------------------

    \52\ Consistent with the current Rule, securities acquired by a 
member that are not considered underwriting compensation would not 
be subject to the lock-up restrictions of Rule 5110.
    \53\ See proposed Rule 5110(e)(1)(A).
    \54\ See proposed Rule 5110(e)(1)(B).
---------------------------------------------------------------------------

    The proposed rule change would add exceptions from the lock-up 
restriction for clarity or to except securities where other protections 
or market forces obviate the need for the restriction. Due to the 
existing public market for securities of the issuers, the proposed rule 
change would add an exception from the lock-up restriction for 
securities acquired from an issuer that meets the registration 
requirements of SEC Registration Forms S-3, F-3 or F-10.\55\ The 
proposed rule change would also add an exception from the lock-up 
restriction for securities that were acquired in a transaction meeting 
one of Rule 5110's venture capital exceptions.\56\ While these 
securities would not be considered underwriting compensation and, thus, 
not subject to the lock-up restriction, the exception would provide 
additional clarity with respect to these securities.
---------------------------------------------------------------------------

    \55\ See proposed Rule 5110(e)(2)(A)(iii).
    \56\ See proposed Rule 5110(e)(2)(A)(vi).
---------------------------------------------------------------------------

    The proposed rule change would also add an exception from the lock-
up restriction for securities that were received as underwriting 
compensation and are registered and sold as part of a firm commitment 
offering.\57\ This is intended to give some flexibility to members in 
selling securities received as underwriting compensation, while 
limiting the proposed exception to firm commitment offerings where the 
underwriter has assumed the risk of

[[Page 18599]]

marketing and distributing an offering that includes securities the 
underwriter received as underwriting compensation. In addition, firm 
commitment offers are usually marketed and sold to institutional 
investors, who typically purchase a majority of the shares in such 
offerings.
---------------------------------------------------------------------------

    \57\ See proposed Rule 5110(e)(2)(A)(viii) and Item II.C. 
discussion infra.
---------------------------------------------------------------------------

    The proposed rule change would provide clarity about the treatment 
of non-convertible or non-exchangeable debt securities and derivative 
instruments acquired in transactions related to a public offering.\58\ 
The following charts provide an overview of the application of Rule 
5110's lock-up requirement to non-convertible or non-exchangeable debt 
securities and derivative instruments.
---------------------------------------------------------------------------

    \58\ See proposed Rule 5110(e)(2)(A)(iv).
    [GRAPHIC] [TIFF OMITTED] TN01MY19.001
    
    The proposed rule change also addresses members' acquisition of 
derivative instruments in connection with hedging transactions related 
to a public offering. For example, fixed-for-floating swaps are 
commonly used in hedging transactions in connection with offerings of 
debt securities. These hedging transactions would not be effective if 
the derivative securities were subject to lock-up restrictions. 
Accordingly, the proposed rule change would provide that the lock-up 
restriction does not apply to derivative instruments acquired in 
connection with a hedging transaction related to the public offering 
and at a fair price.\59\ Derivative instruments acquired in 
transactions related to the public offering that do not meet the 
requirements of the exception would continue to be subject to the lock-
up restriction.
---------------------------------------------------------------------------

    \59\ See proposed Rule 5110(e)(2)(A)(v).
---------------------------------------------------------------------------

    In addition, the proposed rule change would add an exception to the 
lock-up restriction to permit the transfer or sale of the security back 
to the issuer in a transaction exempt from registration with the 
SEC.\60\ These transactions do not put selling pressure on the 
secondary market that the lock-up is designed to prevent. The proposed 
rule change would also modify the lock-up exception in current Rule 
5110(g)(2)(A)(ii) to permit the transfer of any security to the 
member's registered persons or affiliates if all transferred securities 
remain subject to the restriction for the remainder of the lock-up 
period.\61\
---------------------------------------------------------------------------

    \60\ See proposed Rule 5110(e)(2)(B)(iii).
    \61\ See proposed Rule 5110(e)(2)(B)(i). The proposed rule 
change would retain the current exception to the lock up for the 
exercise or conversion of any security, if all such securities 
received remain subject to the lock-up restriction for the remainder 
of the 180-day lock-up period. See proposed Rule 5110(e)(2)(B)(ii).
---------------------------------------------------------------------------

    Finally, because proposed Supplementary Material .01(b)(20) would 
provide that securities acquired subsequent to the issuer's IPO in a 
transaction exempt from registration under Securities Act Rule 144A 
would not be underwriting compensation, the proposed rule change would 
correspondingly delete as unnecessary the current exception from the 
lock-up restriction for those securities.\62\
---------------------------------------------------------------------------

    \62\ See current Rule 5110(g)(2)(A)(viii).
---------------------------------------------------------------------------

Prohibited Terms and Arrangements
    Rule 5110 includes a list of prohibited unreasonable terms and 
arrangements in connection with a public offering of securities. The 
proposed rule change would clarify and amend the list, such as 
clarifying the scope of relevant activities that would be deemed 
related to the public offering \63\ and referring to the commencement 
of sales of the public offering (rather than the date of effectiveness) 
in relation to the receipt of underwriting compensation consisting of 
any option, warrant or convertible security with specified terms.\64\
---------------------------------------------------------------------------

    \63\ See proposed Rule 5110(g)(11). Specifically, to clarify the 
scope, the proposed rule change would refer to ``solicitation, 
marketing, distribution or sales of the offering'' rather than the 
current ``distribution or assisting in the distribution of the 
issue, or for the purpose of assisting in any way in connection with 
the underwriting.''
    \64\ See proposed Rule 5110(g)(8).
---------------------------------------------------------------------------

    The proposed rule change would also clarify that it would be 
considered a prohibited arrangement for any underwriting compensation 
to be paid prior to the commencement of sales of public offering, 
except: (1) An advance against accountable expenses actually 
anticipated to be incurred, which must be reimbursed to the issuer to 
the extent not actually incurred; or (2) advisory or consulting fees 
for services provided in connection with the offering that subsequently 
is completed according to the terms of an agreement entered into by an 
issuer and a participating member.\65\ The proposed rule change 
recognizes the practical issue that certain fees and expenses, 
including advisor or consultant fees, may be incurred before the 
offering is sold and allows such fees so long as the services are in 
connection with an offering that is completed in accordance with the 
agreement between the issuer and the participating member.
---------------------------------------------------------------------------

    \65\ See proposed Rule 5110(g)(4).
---------------------------------------------------------------------------

    The proposed rule change would also simplify a provision that 
relates to payments made by an issuer to waive or terminate a ROFR to 
participate in a

[[Page 18600]]

future capital-raising transaction.\66\ The application of this 
provision has been challenging for members, particularly in 
circumstances where the terms of the future offering had not been 
negotiated at the time of the proposed public offering. The proposed 
rule change would, however, retain the prohibition on any non-cash 
payment or fee to waive or terminate a ROFR.\67\
---------------------------------------------------------------------------

    \66\ See current Rule 5110(f)(2)(F)(i).
    \67\ See proposed Rule 5110(g)(7).
---------------------------------------------------------------------------

Defined Terms
    In addition to consolidating the defined terms in one location at 
the end of the Rule, the proposed rule change would simplify and 
clarify Rule 5110's defined terms. Most notably, the proposed rule 
change would make the terminology more consistent throughout the Rule's 
various provisions. For example, the proposed rule change would 
consolidate the various provisions of the current Rule that address 
what constitutes underwriting compensation into a single, new 
definition of ``underwriting compensation.'' \68\
---------------------------------------------------------------------------

    \68\ See proposed Rule 5110(j)(22).
---------------------------------------------------------------------------

    The proposed rule change would also add consistency and clarity to 
the scope of persons covered by the Rule. Rule 5110 currently 
alternates between using the defined term ``underwriter and related 
persons'' (which includes underwriter's counsel, financial consultants 
and advisors, finders, any participating member, and any other persons 
related to any participating member) \69\ and the defined term 
``participating member'' (which includes any FINRA member that is 
participating in a public offering, any affiliate or associated person 
of the member and any immediate family).\70\ The proposed rule change 
would eliminate the term ``underwriter and related persons'' and 
instead use the defined term ``participating member.'' However, the 
proposed definition of underwriting compensation would ensure that the 
Rule continues to address fees and expenses paid to persons previously 
covered by the term ``underwriter and related persons'' (e.g., 
underwriter's counsel fees and expenses, financial consulting and 
advisory fees and finder's fees).\71\
---------------------------------------------------------------------------

    \69\ See current Rule 5110(a)(6).
    \70\ See current Rule 5110(a)(4).
    \71\ Substantively consistent with the current Rule, the 
proposed rule change would define ``participating member'' to 
include any FINRA member that is participating in a public offering, 
any affiliate or associated person of the member, and any 
``immediate family,'' but does not include the issuer. See proposed 
Rule 5110(j)(15). While not included in the ``participating member'' 
definition, the broad definition of underwriting compensation would 
include underwriter's counsel fees and expenses, financial 
consulting and advisory fees and finder's fees. As such, the 
definition of underwriting compensation would ensure that the Rule 
addresses fees and expenses paid to persons previously covered by 
the term ``underwriter and related persons.'' In addition, the term 
``immediate family'' is clarified for readability in proposed Rule 
5110(j)(8) to mean the spouse or child of an associated person of a 
member and any relative who lives with, has a business relationship 
with, or provides to or receives support from an associated person 
of a member.
---------------------------------------------------------------------------

    The proposed rule change would move the definition of ``public 
offering'' from Rule 5121 to Rule 5110.\72\ The term ``public 
offering'' is used frequently in Rule 5110 and moving it into the Rule 
should simplify compliance. The definition would be modified to add 
``made in whole or in part in the United States'' to clarify the 
jurisdictional scope of the definition. The proposed rule change would 
also move, without modification, the definition of ``Net Offering 
Proceeds'' from Rule 5110 to Rule 5121 because the term is used only in 
Rule 5121.\73\
---------------------------------------------------------------------------

    \72\ See proposed Rule 5110(j)(18). Rule 5121 would incorporate 
the definition in Rule 5110 by reference. See Rule 5121(f).
    \73\ See proposed Rule 5121(f)(9).
---------------------------------------------------------------------------

    In addition, the proposed rule change would modernize Rule 5110's 
language (e.g., by replacing references to specific securities 
exchanges to instead reference the definition of ``national securities 
exchange'' in the Exchange Act). Furthermore, the proposed rule change 
would include new defined terms to provide greater predictability for 
members in applying the Rule (e.g., ``associated person,'' 
``experienced issuer,'' \74\ ``equity-linked securities,'' 
``overallotment option'' and ``review period'').
---------------------------------------------------------------------------

    \74\ As discussed supra, the proposed rule change would delete 
references to the pre-1992 standards for Form S-3 and standards 
approved in 1991 for Form F-10 and instead codify the requirement 
that the issuer have a 36-month reporting history and at least $150 
million aggregate market value of voting stock held by non-
affiliates. (Alternatively, $100 million or more aggregate market 
value of voting stock held by non-affiliates and an annual trading 
volume of at least three million shares). Issuers meeting this 
standard would be defined as ``experienced issuers'' and their 
public offerings would be exempt from filing, but subject to the 
substantive provisions of Rule 5110. See proposed Rule 5110(j)(6).
---------------------------------------------------------------------------

    The proposed rule change would incorporate the definition of 
``associated person'' in Article I, Section (rr) of the FINRA By-Laws. 
In response to comments on the Notice 17-15 Proposal, the proposed rule 
change would also harmonize the definition of bank in the proposed 
venture capital exceptions and the exemption in proposed Rule 
5110(h)(1). Specifically, the proposed rule change would state that a 
bank is ``a bank as defined in Exchange Act Section 3(a)(6) or is a 
foreign bank that has been granted an exemption under this Rule and 
shall refer only to the regulated entity, not its subsidiaries or other 
affiliates.'' In addition, in response to comments and to clarify the 
scope of covered persons, the proposed rule change would revise the 
issuer definition to refer to the ``registrant or other person'' 
(rather than ``entity'' as initially proposed in the Notice 17-15 
Proposal).
Valuation of Securities
    Rule 5110 currently prescribes specific calculations for valuing 
convertible and non-convertible securities received as underwriting 
compensation. Rather than the specific calculations in the current 
Rule, the Notice 17-15 Proposal would have instead allowed valuing 
options, warrants and other convertible securities received as 
underwriting compensation based on a securities valuation method that 
is commercially available and appropriate for the type of securities to 
be valued (e.g., the Black-Scholes model for options). As discussed in 
Item II.C. infra, commenters had conflicting views on the proposed 
change to the valuation formula and did not provide any information 
regarding alternative commercially available valuation methods that may 
be used by members. As a result, the proposed rule change would retain 
the current methods for valuing options, warrants and other convertible 
securities received as underwriting compensation in the current 
Rule.\75\
---------------------------------------------------------------------------

    \75\ See proposed Rule 5110(c).
---------------------------------------------------------------------------

    If the Commission approves the proposed rule change, FINRA will 
announce the implementation date of the proposed rule change in a 
Regulatory Notice to be published no later than 60 days following 
Commission approval. The implementation date will be no later than 180 
days following publication of the Regulatory Notice announcing 
Commission approval.
2. Statutory Basis
    The proposed rule change is consistent with the provisions of 
Section 15A(b)(6) of the Act,\76\ which requires, among other things, 
that FINRA rules must 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.
---------------------------------------------------------------------------

    \76\ 15 U.S.C. 78o-3(b)(6).
---------------------------------------------------------------------------

    The proposed rule change would facilitate capital formation by

[[Page 18601]]

modernizing Rule 5110. The proposed rule change would simplify the 
provisions of the Rule, make it more comprehensible, and improve its 
administration.
    For example, the proposed rule change is expected to clarify what 
is considered ``underwriting compensation.'' In addition, the proposed 
rule change would make the venture capital exceptions more available to 
members and not impinge on bona fide investments in, and loans to, 
issuers. In general, the proposed rule change would provide members 
with greater operational and financial flexibility, and reduce 
compliance costs.
    The proposed rule change would maintain important protections for 
issuers and investors participating in offerings. The proposed rule 
change also would not decrease its ability to oversee underwriting 
terms and arrangements.
    In totality, the proposed rule change would reduce the 
administrative and operational burdens for members and FINRA, promote 
regulatory efficiency, and enhance market functioning while maintaining 
issuer and investor protection.

B. Self-Regulatory Organization's Statement on Burden on Competition

    FINRA does not believe that the proposed rule change would result 
in any burden on competition that is not necessary or appropriate in 
furtherance of the purposes of the Act. All members would be subject to 
the proposed amendments.
Economic Impact Assessment
    FINRA considered the economic impacts on members when devising the 
proposed rule change. A discussion of the economic impacts is below.
Regulatory Need
    Rule 5110 was last revised in 2004, and since then the capital 
markets and financial activities of member firms have continued to 
evolve.\77\ The proposed change would modernize Rule 5110 through a 
range of amendments. The proposed change would simplify and clarify the 
Rule, and better align the Rule with current market practices.
---------------------------------------------------------------------------

    \77\ See Securities Exchange Act Release No. 48989 (December 23, 
2003), 68 FR 75684 (December 31, 2003) (Order Approving File No. SR-
NASD-2000-04). See also Notice to Members 04-13 (February 2004).
---------------------------------------------------------------------------

Economic Baseline
    The economic baseline for the proposed rule change is current Rule 
5110 and its interpretation by FINRA. The proposed rule change is 
expected to affect participating members, issuers and investors that 
participate in public offerings.
    Rule 5110 regulates the underwriting terms and arrangements in 
connection with the public offering of securities. The primary function 
of the Rule is to protect issuers (and their investors at the time of 
the offering) from unfair underwriting terms and arrangements. Unfair 
underwriting terms and arrangements increase the costs to issuers of 
raising capital, potentially leading to a less efficient allocation of 
capital and thereby imposing a restriction on issuers that need to 
access capital markets.
    The Rule also provides protections for issuers and investors 
through lock-up restrictions. The restrictions reduce the ability of 
participating members to utilize the information they gather as part of 
the underwriting process to opportunistically sell the securities they 
acquire as compensation in the secondary market (i.e., informed 
selling).\78\ The lock-up restrictions thereby decrease the likelihood 
that participating members use the securities to extract undue 
compensation from issuers, and decrease the likelihood that investors 
in the secondary market purchase securities when the securities are 
overvalued. The exposure of investors to informed selling decreases as 
time elapses and more information about the issuer becomes available.
---------------------------------------------------------------------------

    \78\ Participating members may have greater ability to engage in 
informed selling soon after the commencement of sales when they may 
have additional information than other market participants. As more 
information becomes publicly available, the ability of participating 
members to engage in informed selling decreases.
---------------------------------------------------------------------------

    Member firms that participate in offerings, however, incur costs to 
comply with Rule 5110. The costs to members include filing and 
disclosure requirements, limits to direct and indirect compensation, 
and restrictions on financial and investment activities. These costs 
decrease the return to members when participating in offerings.
    Rule 5110 requires participating members to file documents and 
information with FINRA. FINRA reviews the information to determine 
whether underwriting terms and arrangements meet the requirements of 
the Rule. To the extent possible, this economic impact analysis will 
quantify the economic effects of the proposed rule change using the 
information that FINRA collects through its administration of Rule 
5110. The analysis will otherwise discuss the economic effects 
qualitatively.
    In 2017, FINRA received 1,553 filings related to public offerings 
(covering both equity and debt securities). The filings represent at 
least 274 members and 1,071 issuers. The total amount of offering 
proceeds of the filings were over $151 billion, with a median value of 
approximately $38 million per filing.\79\
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    \79\ The 1,553 filings include shelf offerings. FINRA does not 
require filing, in all cases, the total amount of offering proceeds 
related to these filings.
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    Currently, members that participate in fewer offerings are likely 
to incur higher marginal costs to interpret and comply with Rule 5110. 
In 2017, the median number of filings in which a member participated 
was three. This means that approximately half of the members (148 of 
274 members) participated in three or fewer offerings. In addition, a 
large number of these members (85) participated in only one 
offering.\80\
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    \80\ In addition, approximately one-quarter of members (71) 
participated in ten or more offerings, whereas ten percent of 
members (27) participated in 50 or more offerings. The maximum 
number of offerings that any one member participated in was 155.
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Economic Impact
    The proposed amendments would directly impact member firms that 
regularly engage in underwriting, issuers that engage member firms for 
those services, and the investors that seek to participate in those 
offerings. This economic impact analysis seeks to identify the broad 
impacts associated with modernizing Rule 5110, as well as specific 
amendments related to the acquisition of securities, lock-up 
restrictions, filing requirements, and exemptions for offerings that 
relate to highly regulated entities.
Modernization
    Overall, the proposed change would modernize Rule 5110 by 
simplifying and clarifying its provisions, and by increasing the 
consistency of the Rule with current practice. The simplification and 
clarification of the Rule would decrease the compliance costs of member 
firms that participate in offerings. The decrease in compliance costs 
includes the time and expense of internal employees to interpret the 
Rule, as well as the potential expenses associated with outside legal 
counsel or other outside experts. The simplification and clarification 
would also decrease the opportunity costs to participating members from 
not acquiring securities so as to not violate the permitted 
compensation arrangements under the Rule. Members that participate in 
fewer offerings would experience a greater decrease in marginal costs 
from the proposed rule changes.

[[Page 18602]]

    As a result of the simplification and clarification of Rule 5110, 
the underwriting terms and arrangements members negotiate with issuers 
are more likely to be in compliance with the Rule, and the documents 
and information members file with FINRA are more likely to meet the 
regulatory requirements of the rule. This may decrease the amount of 
time that FINRA needs to evaluate the underwriting terms and 
arrangements and provide an opinion. A decrease in the time needed for 
FINRA to provide an opinion could potentially enhance the ability of 
issuers to access capital markets faster provided the concurrent review 
conducted by the SEC staff has concluded and an offering can be 
declared effective.
Securities Acquisitions Not Considered Underwriting Compensation
    The proposed rule change addresses whether the securities and 
derivative instruments that participating members acquire are 
considered underwriting compensation. The amendments relate to 
securities acquired from third parties for purposes unrelated to 
underwriting compensation, investments or loans to the issuer when a 
public offering has been significantly delayed, and non-convertible or 
non-exchangeable debt securities and derivative instruments unrelated 
to a public offering.\81\ The amendments also broaden two current 
venture capital exceptions, and adopt a new venture capital 
exception.\82\
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    \81\ See proposed Supplementary Material .02, .03, .04, and .06 
to Rule 5110.
    \82\ See proposed Rule 5110(d)(1), (2), and (4). Among the 1,553 
filings FINRA received relating to public offerings in 2017, 17 (one 
percent of 1,553) relate to the current venture capital exceptions 
under 5110(d)(5).
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    In general, the proposed rule change would provide participating 
members additional flexibility and clarity with respect to whether the 
securities and derivative instruments they acquire would be subject to 
the compensation limits and lock-up restrictions of Rule 5110. The 
proposed rule change would therefore decrease the constraints on 
participating members to engage in transactions in the ordinary course 
of business and obtain the commissions and trading profits therefrom. 
The proposed rule change would also decrease the constraints on 
participating members to engage in hedging transactions and thereby 
manage their risk exposures.
    The venture capital exceptions would increase the total percentage 
of shares that participating members may acquire without being 
considered underwriting compensation under Rule 5110, and as a result 
may increase the number of members that participate in an offering. The 
proposed amendments to the venture capital exceptions, therefore, would 
increase the number of financial options and amount of capital 
available for issuers. The proposed amendments may also improve the 
market for offerings.\83\ The venture capital exceptions would thereby 
promote capital formation.
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    \83\ See Shane A. Corwin & Paul Shultz, The Role of IPO 
Underwriting Syndicates: Pricing, Information Production, and 
Underwriter Competition, 60(1) Journal of Fin. 443-486 (2005). The 
authors find that larger syndicates increase information production, 
analyst coverage, and the number of market makers following the 
offering.
---------------------------------------------------------------------------

    Conversely, the proposed amendments to the venture capital 
exceptions allowing underwriters to acquire additional securities not 
considered underwriting compensation may increase potential conflicts 
of interest. These acquisitions may create a control relationship, 
potentially resulting in a participating member having a conflict of 
interest and increasing the costs to issuers and investors.\84\
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    \84\ One commenter expressed concern that removing the 
restriction in current Rule 5110(d)(5)(A) and (B) may increase the 
potential for conflicts of interest to arise. See NASAA.
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    Two requirements, however, serve to mitigate against these 
potential costs to issuers. FINRA Rule 5121 specifically addresses the 
conflicts of interest of participating members and requires disclosure 
of the conflicts. Further, the proposed amendments also include a 
requirement that the securities participating members acquire is at the 
same price and with the same terms as the securities purchased by all 
other investors. This is intended to ensure that the securities 
participating members acquire are not for providing undervalued 
securities as a form of underwriting compensation.
    An increase in the percentage of shares that participating members 
acquire that is not subject to Rule 5110 may also impose costs on 
investors. The securities and derivative instruments that participating 
members acquire would not be subject to lock-up restrictions, and may 
increase the exposure of investors in the secondary market to informed 
selling. As described in further detail below and subject to some 
exceptions, the proposed rule change would decrease investor exposure 
to informed selling by amending the lock-up restrictions under the 
Rule.
Lock-up Restrictions
    The proposed rule change would specify that, consistent with 
current practice, the lock-up period begins on the date of commencement 
of sales instead of the date of effectiveness of the prospectus.\85\ 
This would ensure that at least 180 days must pass after the 
commencement of sales before participating members may sell the 
securities that they receive as underwriting compensation. This 
amendment would only impose economic effects on offerings that 
otherwise would have begun the lock-up period on the date of the 
effectiveness of the prospectus. For these offerings, investors would 
have a longer exposure to informed selling from the date of the 
commencement of sales, and participating members would have a longer 
exposure to fluctuations in security values from the date of the 
commencement of sales. In the experience of FINRA staff, however, any 
longer exposure would be minimal.
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    \85\ See proposed Rule 5110(e)(1)(A).
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    The proposed rule change would provide exceptions to the lock-up 
restrictions.\86\ Although the exceptions to the lock-up restrictions 
would provide flexibility and reduce the investment risk of 
participating members, the exceptions may also increase the exposure of 
investors to informed selling. The scope of the proposed exceptions, 
however, reduce the likelihood that investors purchasing the securities 
would be at an informational disadvantage. One exception is for 
securities acquired from an issuer that meet the registration 
requirements of SEC Registration Forms S-3, F-3 or F-10. These 
registration requirements relate to issuers with existing public 
markets for their securities. Other proposed exceptions to the lock-up 
provisions are for sales as part of a firm commitment offering (which 
are usually marketed and sold to institutional investors) and sales 
back to the issuer.\87\
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    \86\ See proposed Rule 5110(e)(2)(A)(iii) and (viii), and 
(B)(iii).
    \87\ Among the 1,553 filings FINRA received relating to public 
offerings in 2017, 778 relate to firm commitment offerings. The 
proceeds of the offerings were over $110 billion, or approximately 
three-quarters of the total proceeds relating to all filings. The 
median proceeds were $60 million. The largest maximum proposed 
offering proceeds registered was $2.7 billion. Information 
describing issuers that meet the registration requirements of SEC 
Registration Forms S-3, F-3 or F-10 or sales back to the issuer is 
not available.
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Filing Requirements
    In general, the proposed rule change would decrease or streamline 
the filing requirements of participating members. For example, unless 
otherwise required by FINRA, participating members would not be 
required to provide documents relevant to the underwriting terms and

[[Page 18603]]

arrangements if industry-standard master forms of agreement are used. 
In addition, participating members would not be required to submit 
amendments to previously filed documents unless the changes impact the 
underwriting terms and arrangements.\88\ The decrease in filing 
requirements would decrease the compliance costs of participating 
members. The costs for members include the time and expense of legal 
counsel and other internal staff to prepare and submit the filings.
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    \88\ See proposed Rule 5110(a)(4)(A) and (E).
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    The proposed changes in filing requirements would decrease the 
documents and information that participating members file with FINRA. 
FINRA does not believe, however, that the decrease in the documents and 
information it receives would reduce its ability to evaluate 
underwriting terms and arrangements and provide protections to issuers 
and investors. The documents and information are often duplicative or 
otherwise unnecessary, or can be accessed through other means.\89\
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    \89\ For example, proposed Rule 5110(a)(4)(E) would streamline 
the filing requirements for shelf offerings. A participating member 
would file the Securities Act registration number, and the documents 
and information set forth in proposed Rule 5110(a)(4)(A) and (B) 
only if specifically requested by FINRA. Otherwise, FINRA would 
access the base shelf registration statement, amendments, and 
prospectus supplements through the SEC's EDGAR system to conduct the 
review.
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    In some instances, however, the proposed rule change would increase 
the filing requirements of participating members. For example, a new 
provision would require participating members of terminated offerings 
to provide written notification of all underwriting compensation 
received or to be received.\90\ The new requirements would increase the 
costs to participating members to file documents and information with 
FINRA. The new requirements, however, would increase the ability of 
FINRA to oversee underwriting terms and arrangements, and provide 
protections to issuers and investors.
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    \90\ See proposed Rule 5110(a)(4)(C) and proposed Rule 
5110(g)(5).
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Exemptions for Highly Regulated Entities
    Lastly, the proposed rule change would expand the current list of 
offerings that are exempt from its filing requirements and its 
substantive provisions.\91\ The offerings relate to highly regulated 
entities whose offering terms would continue to be subject to FINRA 
Rule 2341. The regulatory protections for issuers and investors would 
therefore remain, but participating members would no longer incur the 
costs to comply with Rule 5110.
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    \91\ See proposed Rule 5110(h)(2)(E), (K), and (L). The proposed 
Rule would also clarify that securities of banks that have 
qualifying outstanding debt securities are exempt from the filing 
requirement. See proposed Rule 5110(h)(1)(A).
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    Offerings that are subject only to FINRA Rule 2341 are not required 
to be filed with FINRA. In the experience of FINRA staff, however, few 
filings currently made pursuant to Rule 5110 are also subject to Rule 
2341. FINRA therefore does not expect that the costs and benefits of 
the proposed amendments relating to these offerings would be material.
Alternatives Considered
    FINRA considered several alternatives in developing the proposed 
rule change. FINRA explored how to modernize the Rule and how to 
simplify and clarify its provisions, while maintaining the protections 
for issuers and investors.
    One alternative to the proposed rule change would be to modify or 
eliminate the filing requirement for shelf-offerings by issuers that do 
not meet the ``experienced issuer'' standard.\92\ Although a 
modification or elimination of the filing requirement would decrease 
the compliance costs of participating members, it could increase the 
exposure of these issuers to unfair and unreasonable underwriting terms 
and arrangements. FINRA believes that the decrease in compliance costs 
under this alternative would not justify the increased risk of harm to 
issuers.
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    \92\ See, e.g., ABA and Sullivan.
---------------------------------------------------------------------------

    A second alternative would allow participating members to value 
options, warrants, and other convertible securities they receive as 
underwriting compensation with common or commercially available 
valuation methods. The alternative methods could increase the accuracy 
of the valuations but also their variability across offerings and 
members. The alternative valuation methods could reduce the ability of 
issuers and participating members to agree to terms and the ability of 
FINRA staff to evaluate the underwriting terms and arrangements, and 
thereby increase the amount of time for issuers to access capital 
markets.\93\ FINRA will therefore retain the current valuation methods.
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    \93\ Commenters to the Notice 17-15 Proposal also had 
conflicting views on the proposed change to the valuation formula, 
and did not provide any information regarding commercially available 
valuation methods. See, e.g., NASAA and SIFMA.
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    A third alternative, which was proposed in the Notice 17-15 
Proposal, would no longer require the disclosure of the dollar amount 
ascribed to each individual item of underwriter compensation in the 
prospectus. Instead, participating members could aggregate the 
underwriting expenses for all items, except for the discount or 
commission. This alternative would have decreased the compliance costs 
of participating members. It could have also decreased the ability of 
investors to understand the underwriting terms and arrangements, 
however, and to decide whether to participate in the offerings.\94\
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    \94\ Commenters to the Notice 17-15 Proposal had conflicting 
views on the proposed change to the disclosure of each individual 
item of underwriter compensation. See, e.g., ADISA and NASAA.
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    Other alternatives include different thresholds relating to the 
proposed amendments to the venture capital exceptions.\95\ An increase 
in the amount of securities that participating members may acquire 
before triggering the provisions of the Rule would benefit issuers by 
increasing the number of members available to participate in private 
placements and subsequent public offerings. However, broader exceptions 
may reduce issuer and investor protections if more activities that are 
potentially not underwriting compensation are not governed by these 
provisions of Rule 5110. The proposed rule change maintains several 
restrictions to ensure the protection of other market participants, 
including issuers and investors, and is justified by its benefits 
including the further promotion of capital formation.
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    \95\ See proposed Rule 5110(d).
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C. Self-Regulatory Organization's Statement on Comments on the Proposed 
Rule Change Received From Members, Participants, or Others

    The proposed rule change was published for comment in the Notice 
17-15 Proposal. FINRA received 11 comment letters in response to the 
Notice 17-15 Proposal. A copy of the Notice 17-15 Proposal is attached 
as Exhibit 2a. Copies of the comment letters received in response to 
the Notice 17-15 Proposal are attached as Exhibit 2c.\96\
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    \96\ See Exhibit 2b for a list of abbreviations assigned to 
commenters.
---------------------------------------------------------------------------

    FINRA has considered the concerns raised by commenters and, as 
discussed in detail below, has addressed many of the concerns noted by 
commenters in response to the Notice 17-15 Proposal. The comments and 
FINRA's responses are set forth in detail below.
General Support and Opposition to the Notice 17-15 Proposal
    Four commenters supported FINRA's efforts to simplify, clarify and 
modernize Rule 5110 but did not support all aspects of the Notice 17-15

[[Page 18604]]

Proposal.\97\ SIFMA supported some aspects of the Notice 17-15 Proposal 
but suggested retooling Rule 5110 to a more disclosure-focused and 
principles-based approach. Callcott supported amending Rule 5110 to 
require only disclosure of financial relationships between a broker-
dealer and its client in a securities underwriting. The remaining 
commenters expressed comments to several specific aspects of the Notice 
17-15 Proposal as discussed below.
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    \97\ See ABA, NASAA, Rothwell and Sullivan.
---------------------------------------------------------------------------

    The ability of small and large businesses to raise capital 
efficiently is critical to job creation and economic growth. Since 
1992, Rule 5110 has played an important role in the capital raising 
process by prohibiting unfair underwriting terms and arrangements in 
public offerings of securities. Rule 5110 continues to play an 
important role in ensuring investor protection and market integrity 
through effective and efficient regulation that facilitates vibrant 
capital markets.
    The proposed rule change strikes an appropriate balance in 
modernizing Rule 5110 to allow for some flexibility where appropriate, 
while maintaining important protections. For instance, one area where 
FINRA is proposing to add some flexibility is to incorporate a limited 
principles-based approach to be used by FINRA in determining whether 
some securities acquisitions may be excluded from underwriting 
compensation. Specifically, the proposed rule change would incorporate 
a principles-based approach for acquisitions of securities in venture 
capital transactions where there has been a significantly delayed 
offering, acquisitions of issuer securities from third parties and 
acquisitions of securities pursuant to an issuer's directed sales 
program. The proposed rule change would retain Rule 5110's current 
objective approach for other securities acquisitions.
    Callcott stated that Rule 5110's complexity imposes costs on all 
public underwritings and serves as an incentive to instead conduct 
private placements or other transactions. Moreover, Callcott stated 
that because ``troubled'' public companies present the highest 
liability risks for underwriters, underwriters are unwilling to assist 
those companies unless they are adequately compensated for the risk. 
Callcott suggests that Rule 5110 does not solve the problem of ``small 
troubled'' companies in need of financing; rather, Callcott states the 
Rule simply moves the problem to a largely non-transparent and 
unregulated alternative financial environment, to the significant 
detriment of companies and their investors.
    The application of Rule 5110 to the receipt of underwriting 
compensation does not represent a material detriment to small firms or 
a disincentive to small firm IPOs. Rather, the decrease in small firm 
IPOs is a multi-faceted issue that may be caused by several factors 
(e.g., the availability of alternative financing or industry 
consolidation). Moreover, the availability of different sources of 
financing may be beneficial to some small firms. It is unclear how 
removing Rule 5110's restrictions on underwriting terms and 
arrangements, and corresponding restrictions on underwriting 
compensation, would be a net positive for ``small troubled'' companies 
in need of financing.
Filing Requirements
    Three commenters supported allowing members more time to make the 
required filings with FINRA (from one business day after filing with 
the SEC or a state securities commission or similar state regulatory 
authority to three business days) and agreed that the change would help 
with logistical issues or inadvertent delays without impeding FINRA's 
ability to review the underwriting terms and arrangements.\98\ ABA 
supported proposed Rule 5110(a)(4)(A)(ii) to expressly provide that 
standard industry forms are not required to be filed in connection with 
an offering, unless otherwise specifically requested by FINRA.
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    \98\ See ABA, ADISA and SIFMA.
---------------------------------------------------------------------------

    SIFMA suggested FINRA clarify that the requirement in proposed Rule 
5110(a)(1)(B) that the managing underwriter notify the other members if 
the underwriting terms and arrangements are unfair and unreasonable and 
not appropriately modified be limited to situations where FINRA has 
made such determination with respect to the terms and arrangements and 
has so notified the managing underwriter. FINRA agrees and made the 
suggested change as discussed above in proposed Rule 5110(a)(1)(B).
    ABA suggested that the Rule should permit reliance on filings made 
by issuers in proposed Rule 5110(a)(3)(B) or, alternatively, if not 
retained, the availability of such reliance should be clarified in 
Supplementary Material to Rule 5110. Participating members are 
responsible for filing the required documents and information with 
FINRA. An issuer may file a base shelf registration statement in 
anticipation of retaining a member to participate in a takedown, but a 
participating member must file any documents and information as set 
forth in proposed Rule 5110(a)(4)(A) and (B) if specifically requested 
by FINRA regarding the takedown once the participating member has been 
engaged.
    Commenters requested clarifying or deleting the Notice 17-15 
Proposal's requirement to file amendments to any documents that contain 
``changes to the offering'' in proposed Rule 5110(a)(4)(A)(iii) to 
narrow the filing requirement to changes relating to the disclosures 
made or to be made in any filing that impact the underwriting terms and 
arrangements for the offering.\99\ The commenters suggested that 
narrowing the scope of proposed Rule 5110(a)(4)(A)(iii) would 
appropriately capture the documents relevant to FINRA's review and 
would reduce the burdens on members (and the associated time and cost) 
to make unnecessary administrative filings.
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    \99\ See ABA, ADISA, Davis Polk, Rothwell and SIFMA.
---------------------------------------------------------------------------

    FINRA agrees with the commenters and proposes to narrow the filing 
requirement to changes that ``impact the underwriting terms and 
arrangements for the public offering.'' Examples of changes impacting 
the underwriting terms and arrangements include, but are not limited 
to, changes to the size of the offering, the method of distribution 
(i.e., firm commitment or best efforts), the amount of underwriting 
compensation, the type of underwriting compensation, and any new 
termination fee or ROFR that survives termination of the offering.
    Two commenters supported the change in proposed Rule 
5110(a)(4)(B)(iii) relating to the representation as to the association 
or affiliation between participating members and beneficial owners of 5 
percent or more of ``any class of the issuer's securities'' to instead 
refer to beneficially owning 5 percent or more of any class of the 
issuer's ``equity or equity-linked securities.'' \100\ SIFMA also 
supported the proposed elimination of the requirement currently in Rule 
5110 to provide a representation as to the association or affiliation 
between participating members and ``any beneficial owner of the 
issuer's unregistered equity securities that were acquired during the 
180-day period immediately preceding the required filing date of the 
public offering.'' SIFMA suggested that the narrower focus is 
appropriately designed to elicit the most useful information for 
reviewing relationships that may affect

[[Page 18605]]

the underwriting terms and arrangements.
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    \100\ See ABA and SIFMA.
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    ABA requested guidance with respect to the representation 
requirement in proposed Rule 5110(a)(4)(B)(iii) where beneficial owners 
of 5 percent or more of any class of the issuer's equity securities are 
funds or other types of investment vehicles, which are usually in the 
form of limited partnerships or limited liability companies. ABA also 
requested that the representation be limited to a statement of 
association or affiliation only with respect to the general partner or 
investment manager of such fund or investment vehicle, and any limited 
partner beneficially owning more than 25 percent of the limited 
partnership or limited liability company membership interests of the 
fund or investment vehicle.
    Although application of Rule 5110's requirements to beneficial 
ownership by funds or other types of investment vehicles historically 
has not been problematic, there have been some instances where 
conflicts have been identified. When questions have arisen related to 
beneficial ownership by funds or other types of investment vehicles, 
FINRA has been willing to work with members to address the questions 
raised by particular structures and arrangements. Rather than amending 
the Rule, FINRA proposes to retain the flexibility afforded by this 
established approach because beneficial ownership of 5 percent or more 
of an issuer's securities may result in conflicts of interest.
    SIFMA suggested that proposed Rule 5110(a)(4)(B)(iv)--requiring the 
filing of a ``description of any securities of the issuer acquired and 
beneficially owned by any participating member during the review 
period''--should be limited to a description of any securities-based 
underwriting compensation acquired during the review period by the 
participating member (i.e., no description for securities that do not 
constitute underwriting compensation). Limiting the description to 
securities that the participating member has determined would be 
underwriting compensation could result in an incomplete picture of the 
underwriting terms and arrangements. A description of any issuer 
securities acquired and beneficially owned by the participating member 
during the review period is needed to fully evaluate the underwriting 
terms and arrangements of the public offering and to ensure that there 
is no circumvention of the Rule.
    While a complete description would be required, the proposed rule 
change provides flexibility with respect to whether some securities 
would be treated as underwriting compensation under Rule 5110. For 
example, because FINRA recognizes that some acquisitions of issuer 
securities from third parties are for purposes unconnected to 
underwriting compensation, the proposed rule change would incorporate a 
principles-based approach in considering whether securities of the 
issuer acquired from third parties may be excluded from underwriting 
compensation.
    Given the strict limitations on the receipt of underwriting 
compensation in terminated offerings imposed by proposed Rule 
5110(g)(5), SIFMA suggested deleting the requirement in proposed Rule 
5110(a)(4)(C) for a member to file a written notification to FINRA of 
all underwriting compensation received or to be received pursuant to 
proposed Rule 5110(g)(5), including a copy of any agreement governing 
the arrangement if an offering is terminated. SIFMA suggested that at 
the very least, if the requirement is retained, the requirement should 
be limited to notice to FINRA with respect to the receipt of 
termination fees. ABA also did not support the requirement in proposed 
Rule 5110(a)(4)(C) and suggested that the lack of an end date for the 
requirement would lead to confusion. ABA suggested that, if the 
requirement is retained, FINRA should clarify the purpose of the 
obligation, confirm that any such payments are tied to the original 
failed offering and not a successful subsequent offering, and provide a 
sunset provision for the requirement.
    FINRA believes that information regarding underwriting compensation 
received or to be received in terminated offerings is relevant to its 
evaluation of compliance with Rule 5110 and, in particular, paragraph 
(g)(5). Moreover, incorporating a sunset provision into proposed Rule 
5110(a)(4)(C) could result in intentionally delaying payment of 
underwriting compensation until after the sunset date to circumvent the 
requirements of Rule 5110. Accordingly, the proposed rule change would 
retain the approach in the Notice 17-15 Proposal.
    Davis Polk requested clarification regarding whether information 
relating to unvested securities acquired by participating members 
during the review period must be filed under Rule 5110. Davis Polk 
suggested that these securities should not constitute underwriting 
compensation, as it is unclear whether the conditions precedent to 
vesting will ever be satisfied. As noted above, it is important that 
FINRA have information on all securities received during the review 
period in order to more accurately evaluate the levels of underwriting 
compensation. When considering whether vested or unvested securities 
acquired by participating members and their associated persons are 
underwriting compensation FINRA evaluates why the securities were 
granted. For example, unvested directors' options granted to associated 
persons of participating members in excess of what other directors 
receive would be deemed underwriting compensation, but grants that are 
comparable to what other directors receive would not be underwriting 
compensation.
Filing Requirements for Shelf Offerings
    SIFMA suggested modifying the exemption in proposed Rule 
5110(h)(1)(C) to eliminate the requirement that issuers filing 
offerings on Form S-3 need to satisfy the pre-1992 Form S-3 standards 
or, alternatively, to provide a filing exemption for offerings by well-
known seasoned issuers (``WKSIs'') that meet current Form S-3 
standards. Sullivan suggested exempting all offerings of securities 
registered on Forms S-3 and F-3 from both the Rule's substantive and 
filing requirements and, at a minimum, exempting WKSIs from Rule 5110. 
In light of established market practices, Sullivan believes that these 
issuers do not need FINRA's protection in the negotiation of 
underwriting terms and arrangements and that FINRA's oversight is an 
unnecessary speed bump to these issuers accessing the capital markets. 
Davis Polk questioned whether FINRA's goal of investor protection is 
furthered by the requirement to file WKSI offerings and suggested that 
FINRA's goal should be to make access to capital less expensive.
    Given the availability of documents on the SEC's EDGAR system, 
Davis Polk suggested eliminating the requirement to file with FINRA 
prospectus supplements and underlying documents for shelf offerings 
subject to Rule 5110's filing requirements. Davis Polk suggested that 
member's counsel should instead be required, at the time of filing of 
the registration statement, to obtain representations from members 
that: (1) Underwriting compensation will not exceed 8 percent of the 
gross offering proceeds; and (2) members will not engage in any 
prohibited arrangements in connection with any takedown from the base 
shelf registration statement.
    As discussed in Item II.A., given the regulatory issues that have 
previously arisen in shelf offerings, the proposed rule change would 
continue to apply Rule 5110's filing requirement to shelf

[[Page 18606]]

offerings by issuers that do not meet the ``experienced issuer'' 
standard. However, to facilitate the ability of issuers to take 
advantage of favorable market conditions on short notice and to quickly 
raise capital through takedown offerings, the proposed rule change 
would streamline the filing requirements for shelf offerings by issuers 
that do not meet the ``experienced issuer'' standard. Specifically, 
with respect to these shelf offerings, the proposed rule change would 
provide that only the following documents and information must be 
filed: (1) The registration statement number; and (2) if specifically 
requested by FINRA, other documents and information set forth in 
proposed Rule 5110 (a)(4)(A) and (B).
    FINRA would access the base shelf registration statement, 
amendments and prospectus supplements in the SEC's EDGAR system and 
populate the information necessary to conduct a review in the FINRA 
System. Upon filing of the required registration statement number and 
documents and information, if any, that FINRA requested pursuant to 
proposed Rule 5110(a)(4)(E), FINRA would provide the no objections 
opinion. To further facilitate issuers' ability to have quicker access 
to capital markets, FINRA's review of documents and information related 
to a shelf takedown offering for compliance with Rule 5110 would occur 
on a post-takedown basis.
    Davis Polk suggested adding an exemption to the filing requirement 
for any offering on Forms S-3 and F-3 or any IPO: (1) Of an issuer 
controlled by a venture capital or private equity fund with $100 
million in assets under management; or (2) with proceeds of $75 million 
or more. Davis Polk stated that the filing requirement is not needed as 
these issuers are sophisticated professional negotiators and investors 
have immediate access to company disclosures through EDGAR, issuer 
websites and third party analysis. Alternatively, Davis Polk 
recommended that the proposed exemption for shelf offerings be revised 
to reflect, at a minimum, the Oct. 21, 1992 Form S-3 and F-3 
eligibility requirement of a public float of $75 million or, 
preferably, to eliminate the public float requirement entirely, in 
accordance with current Form S-3 and F-3 standards. Davis Polk 
suggested that the requirement in the exemption that the issuer have 
reported under the Exchange Act for three years be modified to one 
year, as is the case with current Forms S-3 and F-3, on the grounds 
that a three year reporting history does not provide any benefit 
because technology provides investors with immediate access to 
information.
    As discussed above, the proposed rule change would significantly 
reduce the filing obligations for shelf offerings. The underwriting 
terms and arrangements in IPOs of issuers controlled by venture capital 
or private equity funds or IPOs with proceeds of $75 million or more 
are not significantly different from those in other IPOs and FINRA's 
filing and review program is necessary for investor protection.
Exemptions From Filing and Substantive Requirements
    Commenters suggested several changes to the proposed exemptions 
from Rule 5110's filing requirement or substantive provisions to 
expand, modify or clarify the exemptions. Three commenters recommended 
not subjecting to Rule 5110's filing requirement public offerings that 
otherwise meet a filing exemption but for participation by a QIU 
pursuant to Rule 5121.\101\ The commenters suggested that subjecting 
these offerings to Rule 5110's filing requirement is unjustified and 
unwarranted, increases the issuer's transaction costs, and alters the 
composition of underwriting syndicates in ways that do not further 
investor or market protection.
---------------------------------------------------------------------------

    \101\ See ABA, Davis Polk and SIFMA.
---------------------------------------------------------------------------

    Consistent with the approach in the current Rule, proposed Rule 
5110(h)(1) would require filing these offerings only if there is 
participation by a QIU. Rule 5121 was amended in 2009 to focus on 
offerings with significant conflicts of interest that require the 
participation of a QIU.\102\ FINRA has a regulatory interest in 
reviewing offerings in which a member has a significant conflict of 
interest requiring the participation of a QIU. Accordingly, filing and 
review of these offerings under Rule 5110 continues to be appropriate.
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    \102\ See Securities Exchange Act Release No. 60113 (June 15, 
2009), 74 FR 29255 (June 19, 2009) (Order Approving File No. SR-
FINRA-2007-009). See also Regulatory Notice 09-49 (August 2009).
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    ABA requested revising the exemption from the filing requirement in 
proposed Rule 5110(h)(1)(E)(i) for exchange offers to include 
situations in which the securities to be acquired in the exchange are 
convertible into securities that are listed on a national securities 
exchange as defined in Section 6 of the Exchange Act. FINRA believes 
extension of the exemption to these convertible securities is unlikely 
to be problematic for market participants. Accordingly, the proposed 
rule change would expand proposed Rule 5110(h)(1)(E)(i) to exempt from 
the filing requirement exchange offers where the securities to be 
issued or the securities of the company being acquired are listed, or 
convertible into securities that are listed, on a national securities 
exchange as defined in Section 6 of the Exchange Act.
    ABA suggested that in many cases the role played by a member acting 
as a distribution manager in connection with an exchange offer is 
limited to contacting investors and recording their intention to tender 
and that the member receives nominal compensation for these services. 
Accordingly, ABA requested exempting from Rule 5110's filing 
requirement exchange offers in which the compensation to be received by 
the distribution manager does not exceed 2 percent of the registered 
aggregate dollar amount of the offering and no member acts as an 
underwriter for the securities. Distribution managers may provide and 
receive compensation for a range of different services related to a 
public offering. Given this broad range of services, FINRA does not 
agree that providing an exemption from Rule 5110's provisions is 
appropriate based on the compensation for distribution manager-related 
services being less than the suggested threshold.
    Davis Polk requested that an express exemption from Rule 5110's 
filing requirement be added for offerings of convertible debt of an 
issuer that has outstanding investment grade rated debt of the same 
class as that being offered if there is a bona fide public market in 
the common stock underlying the debt (i.e., the debt meets the 
exemption in proposed Rule 5110(h)(1)(B) and the underlying common 
stock generally meets the exemption in proposed Rule 5110(h)(1)(A)). 
FINRA has not received requests for an exemption for this type of 
convertible debt and, as such, the potential consequences of an express 
exemption in the current market environment are unclear. Exemptive 
relief from the filing requirement for this type of convertible debt 
may be available on a case-by-case basis as necessary and appropriate. 
To the extent that FINRA begins receiving numerous such requests, FINRA 
will evaluate whether an express exemption is warranted.
    Davis Polk suggested that filing has not been previously required 
for shelf offerings registered for the benefit of selling shareholders 
that are intended to be sold in ordinary market transactions by members 
acting as agents (commonly called ``dribble out offerings'') and 
requested that an express exemption from the filing requirement be 
added to Rule 5110. Davis Polk also suggested an express exemption from 
the filing requirement for block trades in light of

[[Page 18607]]

the highly competitive nature of negotiations between issuers and 
underwriters in connection with these offerings. Dribble out offerings 
and block trades are typically handled through shelf takedown 
offerings. As previously discussed, the proposed rule change would 
modify the requirements for shelf offerings to no longer require the 
filing of each takedown offering.
    ABA stated that the proposed exemption in the Notice 17-15 Proposal 
from the filing requirement for follow-on offerings by qualifying 
tender offer funds should be extended to also cover IPOs by these 
entities. ABA requested that, if continued filing of IPOs by these 
issuers is required, Rule 5110 should be amended to provide that the 
underwriting terms and arrangements for these offerings, while subject 
to the filing requirements of Rule 5110, will be reviewed for 
compliance with the requirements of Rule 2341. As discussed in Item 
II.A. supra, FINRA believes that it is appropriate to consider 
compensation for distribution of both IPOs and follow-on offerings of 
tender offer funds under the compensation limitations in Rule 2341. 
Accordingly, the proposed rule change would exempt both IPOs and 
follow-on offerings of tender offer funds from Rule 5110.\103\
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    \103\ See proposed Rule 5110(h)(2)(L).
---------------------------------------------------------------------------

    As offerings of open-end funds and continuously offered interval 
funds and tender offer funds are exempted from Rule 5110, JLL suggested 
exempting offerings of continuously offered perpetual-life, publicly 
offered non-listed REITS (``PLRs'') from the filing requirement. Open-
end funds and continuously offered interval funds and tender offer 
funds are investment companies whose offerings can be appropriately 
regulated under the Investment Company Act; however, PLRs are generally 
exempt from the Investment Company Act. Because the protections of the 
Investment Company Act would not apply, the proposed rule change would 
not exempt PLRs from the filing requirement.
    ABA suggested that the exemption from Rule 5110's filing 
requirement for securities offered by issuers with qualifying debt 
securities be expanded to include offerings by issuers that are 
organized limited liability companies, limited partnerships, business 
trusts or other legal persons.\104\ The Notice 17-15 Proposal would 
have replaced ``corporate issuer'' with ``corporation'' in this 
exemption. Rather than including a lengthy list of different types of 
legal persons, the proposed rule change would revert to the use of 
``corporate issuer.'' This approach, which is consistent with Rule 5110 
currently, covers a broad range of legal entities that have qualifying 
debt securities and has not been problematic in practice.
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    \104\ See proposed Rule 5110(h)(1)(A).
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    CAI supported the proposed exemption in Rule 5110(h)(2)(E) from the 
filing and substantive requirements of Rule 5110 for ``any insurance 
contracts not otherwise included'' as appropriately resolving members' 
questions about the status of insurance contracts under FINRA rules. 
SIFMA also supported the addition of proposed exemptions from the 
filing and substantive requirements of Rule 5110 for insurance 
contracts \105\ and unit investment trust securities.\106\
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    \105\ See proposed Rule 5110(h)(2)(E).
    \106\ See proposed Rule 5110(h)(2)(K).
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    ABA requested clarification as to whether the exemption from the 
filing and substantive provisions of Rule 5110 for securities issued 
pursuant to a competitively bid underwriting arrangement meeting the 
requirements of the Public Company Utility Holding Company Act 
(``PUHCA'') remains tied to that Act. The Energy Policy Act of 2005 
repealed the PUHCA Act of 1935 and adopted the PUHCA of 2005.\107\ The 
exemption for any securities issued pursuant to any competitively bid 
underwriting arrangement meeting the requirements of the PUHCA 
continues to be appropriate. Accordingly, consistent with the current 
Rule, the proposed rule change would exempt from the filing and 
substantive requirements of Rule 5110 securities issued pursuant to a 
competitively bid underwriting arrangement meeting the requirements of 
the PUHCA.\108\
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    \107\ See Energy Policy Act of 2005, Public Law 109-58, 119 
Stat. 594 (2005).
    \108\ See proposed Rule 5110(h)(2)(H).
---------------------------------------------------------------------------

    Sullivan stated that all offerings of investment grade debt, 
preferred stock and other fixed-income securities should be exempt from 
Rule 5110's filing and substantive requirements. Sullivan stated that 
these offerings involve the tightest underwriting spreads and are 
intensely negotiated by issuers and, accordingly, the protections of 
Rule 5110 are not necessary for these offerings. Although some 
offerings of investment grade debt, preferred stock and other fixed-
income securities are intensely negotiated by issuers, offerings of 
these securities have previously involved unreasonable and unfair 
underwriting terms and arrangements. Because Rule 5110 prohibits 
unreasonable and unfair underwriting terms and arrangements, it is 
appropriate for the Rule's protections to continue to apply to these 
offerings.
Disclosure of Underwriting Compensation
    The Notice 17-15 Proposal would have no longer required that the 
disclosure include the dollar amount ascribed to each individual item 
of compensation. Instead the Notice 17-15 Proposal would have permitted 
a member to disclose the maximum aggregate amount of all underwriting 
compensation, except the discount or commission that must be disclosed 
on the cover page of the prospectus. The Notice 17-15 Proposal also 
included a requirement to disclose specified material terms and 
arrangements in the prospectus, which is consistent with current 
practice. A description would be required for: (1) Any ROFR granted to 
a participating member and its duration; and (2) the material terms and 
arrangements of the securities acquired by the participating member 
(e.g., exercise terms, demand rights, piggyback registration rights and 
lock-up periods).\109\
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    \109\ See proposed Supplementary Material .05 to Rule 5110.
---------------------------------------------------------------------------

    Commenters expressed differing viewpoints on the proposed 
prospectus disclosure requirement changes in the Notice 17-15 Proposal. 
ADISA supported changing the disclosure requirements to require 
disclosure only of the aggregate amount of all compensation, other than 
discounts and commissions, in the prospectus. On the other hand, NASAA 
supported retaining the requirement in Rule 5110 for itemized 
underwriter compensation disclosure in the prospectus and did not 
support the proposed disclosure requirement changes in the Notice 17-15 
Proposal. NASAA stated that itemized compensation: (1) Allows investors 
to understand how money is being disbursed to underwriters; (2) 
provides investors with a better understanding of incentives underlying 
an underwritten public offering; and (3) provides investors additional 
liability protections for any misstatements in the disclosure. Davis 
Polk requested clarification as to the specific disclosure requirements 
for securities acquired by participating members that are deemed 
underwriting compensation.
    As noted in Item II.A. above, recognizing commenters' conflicting 
views, the proposed rule change would retain the current requirements 
for itemized disclosure of underwriting compensation.\110\ The proposed 
rule

[[Page 18608]]

change would make explicit the existing practice of disclosing 
specified material terms and arrangements related to underwriting 
compensation, such as exercise terms, in the prospectus.\111\
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    \110\ See proposed Rule 5110(b)(1) and Supplementary Material 
.05 to Rule 5110. See also proposed Rule 5110(e)(1)(B) requiring 
disclosure of lock-ups.
    \111\ See proposed Supplementary Material .05 to Rule 5110.
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Underwriting Compensation
    While removal of Rule 5110's references to ``items of value'' was 
supported,\112\ commenters requested several clarifications or changes 
to the proposed definition of underwriting compensation. Two commenters 
suggested that the reference to compensation received from ``any 
source'' in the proposed underwriting compensation definition was 
overly broad and should be deleted to instead focus on benefits 
received from or at the direction of the issuer.\113\ Alternatively, if 
the phrase ``any source'' is not deleted, the commenters suggested that 
the definition should, at a minimum, be more narrowly tailored to 
address any specific concerns. Underwriting compensation typically is 
paid by the issuer, but FINRA has charged violations of its Corporate 
Financing Rules in connection with quid pro quo arrangements between 
underwriters and institutional investors for the allocation of hot 
issues that would make narrowing the source of compensation to issuers 
in all cases problematic.\114\
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    \112\ See SIFMA.
    \113\ See Davis Polk and SIFMA.
    \114\ See News Release, NASD, NASD Regulation Charges Credit 
Suisse First Boston with Siphoning Tens of Millions of Dollars of 
Customers' Profits in Exchange for ``Hot'' IPO Shares (January 22, 
2002), http://www.finra.org/newsroom/2002/nasd-regulation-charges-credit-suisse-first-boston-siphoning-tens-millions-dollars. See also 
News Release, SEC, SEC Charges CSFB with Abusive IPO Allocation 
Practices CSFB Will Pay $100 Million to Settle SEC and NASD Actions; 
Millions in IPO Profits Extracted from Customers in Exchange for 
Allocations in ``Hot'' Deals (January 22, 2002), https://www.sec.gov/news/headlines/csfbipo.htm.
---------------------------------------------------------------------------

    Two commenters suggested revising the proposed underwriting 
compensation definition to provide that only payments made or 
securities received during the ``review period'' would be included in 
underwriting compensation.\115\ In its reviews, FINRA typically only 
considers payments and benefits received during the applicable review 
period in evaluating underwriting compensation. However, if there is an 
arrangement, in fact, to pay compensation related to the underwriting 
outside the review period, the payment must be included under Rule 
5110. Accordingly, the proposed rule change does not limit the proposed 
underwriting compensation definition to payments and benefits received 
during the review period.
---------------------------------------------------------------------------

    \115\ See Davis Polk and Rothwell.
---------------------------------------------------------------------------

    SIFMA suggested deleting the last sentence of the proposed 
underwriting compensation definition, as that sentence would imply that 
finder's fees and underwriter's counsel fees are counted as 
compensation even if not reimbursed to the participating member. The 
approach in the proposed underwriting compensation definition is 
consistent with the treatment in the current Rule, which includes both 
finder's fees and underwriter's counsel fees as items of value.\116\ 
The proposed rule change provides among the examples of payments that 
would be underwriting compensation: (1) Fees and expenses of 
participating members' counsel paid or reimbursed to, or paid on behalf 
of, the participating members (except for reimbursement of ``blue sky'' 
fees); and (2) finder's fees paid or reimbursed to, or paid on behalf 
of, the participating members.\117\
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    \116\ See current Rule 5110(c)(3)(A)(iii)-(iv).
    \117\ See proposed Supplementary Material .01(a)(3) and (4).
---------------------------------------------------------------------------

    Davis Polk suggested revising the proposed underwriting 
compensation definition to exclude securities of foreign (non-U.S.) 
issuers acquired by participating members in the issuer's domestic 
market if such market meets certain volume and float requirements. In 
determining whether the securities are underwriting compensation, Davis 
Polk suggested that considering whether the securities are traded on a 
``designated offshore securities market'' (as defined in Rule 902(b) of 
SEC Regulation S) is overly restrictive and not meaningful; rather, the 
focus should be on whether the securities are freely trading so that 
the price paid is the fair market price. For this reason, Davis Polk 
also suggested that proposed Rule 5110(a)(4)(B)(iv) be modified so that 
participating members need not provide information regarding issuer 
securities they acquire during the review period in the issuer's 
domestic market.
    The approach in the proposed rule change to provide that ``listed 
securities'' purchased in public market transactions would not be 
considered underwriting compensation is consistent with the treatment 
of these securities in the current Rule.\118\ This treatment has not 
been historically problematic, with any issues related to securities of 
foreign (non-U.S.) issuers acquired by participating members in the 
issuer's domestic market arising infrequently. However, the integrity 
of foreign markets may vary significantly and information regarding 
shares obtained in those markets may be important to FINRA's review. 
While the proposed rule change does not propose to alter the treatment 
for these securities, exemptive relief may be available on a case-by-
case basis as necessary and appropriate.
---------------------------------------------------------------------------

    \118\ See proposed Supplementary Material .01(b)(11) to Rule 
5110. Substantively consistent with the current Rule, proposed 
Supplementary Material .01(c)(1) to Rule 5110 would define listed 
securities to mean ``securities that are traded on the national 
securities exchanges identified in Securities Act Rule 146, on 
markets registered with the SEC under Section 6 of the Exchange Act, 
and on any ``designated offshore securities market'' as defined in 
Rule 902(b) of SEC Regulation S.''
---------------------------------------------------------------------------

    Davis Polk requested clarification as to whether fees and other 
compensation paid to foreign broker-dealers in connection with the 
foreign (non-U.S.) distribution of the offering should be deemed 
underwriting compensation. Rule 5110 does not apply to fees and other 
compensation paid to underwriters for securities distributions made 
exclusively in foreign markets. Notwithstanding that some shares may be 
sold in foreign markets global offerings typically register shares in 
the U.S. to accommodate the potential for flow back in the U.S. At the 
time of FINRA's review, the exact amount of shares that will be sold in 
the U.S. is not available. Therefore, FINRA's initial review is based 
on the entire amount registered.
    Two commenters suggested that the lack of an express public 
standard for determining when the aggregate amount of proposed 
underwriting compensation is unfair and unreasonable under Rule 5110 
has caused confusion on the part of issuers, underwriters and 
counsel.\119\ In considering whether the aggregate underwriting 
compensation that participating members receive in connection with a 
public offering is fair and reasonable, FINRA takes into account the 
following factors, as well as all other relevant facts and 
circumstances: (1) The anticipated maximum amount of offering proceeds; 
(2) whether the offering is being distributed on a firm commitment or 
best efforts basis; and (3) whether the offering is an initial or 
follow-on offering.\120\
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    \119\ See EGS and Rothwell.
    \120\ These factors are set forth in current Rule 5110(c)(2)(D). 
Because this guidance is more appropriate for a Regulatory Notice 
than rule text, the proposed rule change would eliminate the factors 
in the current Rule. However, FINRA will consider whether additional 
discussion of this topic in a Regulatory Notice or frequently asked 
questions would be helpful.
---------------------------------------------------------------------------

    The amount of permissible underwriting compensation for an offering 
is typically expressed as a percentage of the proposed maximum

[[Page 18609]]

offering proceeds, and this percentage generally increases as the 
offering size decreases. The maximum permissible compensation 
percentage is typically higher for a firm commitment offering than a 
best efforts offering of the same size, which recognizes the risks and 
expenses of committing capital to an offering. The maximum permissible 
compensation also is typically higher for an IPO than a follow-on 
offering of the same size, which recognizes the higher cost of 
underwriting an offering for an issuer without an established market 
for its securities.
Examples of Payments or Benefits That Are or Are Not Considered 
Underwriting Compensation
    Commenters requested clarification or expansion of the proposed 
non-exhaustive lists of examples of payments or benefits that would be 
and would not be considered underwriting compensation. SIFMA suggested 
that the prefatory language to proposed Supplementary Material .01(a) 
should state ``[t]he following are examples of payments or benefits 
that are considered underwriting compensation `if received during the 
review period for underwriting, allocation, distribution, advisory or 
other investment banking services provided in connection with the 
public offering.' '' The proposed rule change does not include a 
reference to the review period in the prefatory language. As discussed 
above, if there is an arrangement, in fact, to provide payments or 
benefits for underwriting services outside the review period, the 
payments or benefits must be included under Rule 5110. Moreover, 
because the proposed definition of underwriting compensation already 
refers to underwriting, allocation, distribution, advisory or other 
investment banking services provided in connection with a public 
offering, it is unclear how adding the language to the lists of 
examples would be helpful.
    Two commenters suggested that the items in proposed Supplementary 
Material .01(a)(3) and (4) to Rule 5110 be revised to clarify that such 
items (i.e., finder's fees and counsel fees) are counted as 
underwriting compensation solely to the extent they are reimbursed to, 
or paid on behalf of, the participating members.\121\ This is 
consistent with the approach in proposed Supplementary Material 
.01(a)(2) to Rule 5110 for other fees and expenses, including, but not 
limited to, road show fees and expenses and due diligence expenses. 
Accordingly, FINRA made the suggested change.
---------------------------------------------------------------------------

    \121\ See ABA and SIFMA.
---------------------------------------------------------------------------

    SIFMA suggested that proposed Supplementary Material .01(a)(7) to 
Rule 5110 be revised to provide that common stock and other equity 
securities would not be considered underwriting compensation if 
purchased or acquired in a transaction that complies with proposed Rule 
5110(d) or is otherwise excluded as underwriting compensation pursuant 
to other provisions of the proposed Rule (including Supplementary 
Material .01(b) to Rule 5110). The list of examples of underwriting 
compensation in proposed Supplementary Material .01(a) to Rule 5110 is 
intended to be read in combination with the venture capital exceptions 
and list of examples of what would not be considered underwriting 
compensation. The proposed rule change does not incorporate the 
suggested change because it is unclear how adding cross-references to 
Supplementary Material .01(a)(7) to Rule 5110 would be beneficial. 
Rather, adding the cross-reference to one example of underwriting 
compensation as suggested would seem to add confusion, not clarity, to 
the Rule's requirements.
    SIFMA suggested that proposed Supplementary Material .01(a)(9) to 
Rule 5110 be revised to eliminate the one percent valuation assigned to 
ROFRs. SIFMA suggested that ROFRs be deemed underwriting compensation 
but be assigned zero compensation value (unless the agreement in which 
the ROFR is granted contains a dollar amount contractually agreed to by 
the parties to waive the ROFR, in which case that amount should be 
included). ROFRs have historically been assigned a one percent 
valuation for purposes of Rule 5110. FINRA continues to believe that 
ROFRs are a valuable benefit that traditionally have been used in 
combination with other forms of compensation to reward underwriters and 
that this historical approach to valuing ROFRs is reasonable.
    SIFMA acknowledged that proposed Supplementary Material .01(a)(13) 
to Rule 5110--which provides that any compensation paid to any 
participating member in connection with a prior proposed public 
offering that was not completed is considered underwriting 
compensation, if the member participated in the revised public 
offering--is consistent with the current Rule. However, SIFMA 
questioned the rationale for the treatment of this compensation if it 
was received in accordance with proposed Rule 5110(g)(5)--which sets 
forth the requirements for termination fees. SIFMA suggested that 
proposed Supplementary Material .01(a)(13) to Rule 5110 should make it 
clear that the prior compensation would be treated as underwriting 
compensation only if it is received within the review period for the 
new public offering.
    Rule 5110's termination provisions were revised in 2014 to provide 
members with greater flexibility in negotiating the terms of their 
agreements for terminated offerings, while also providing protection 
for issuers if a member fails materially to perform the underwriting 
services contemplated in the written agreement.\122\ The proposed 
Supplementary Material, which is consistent with the current Rule, 
continues to fulfill this purpose. Furthermore, the compensation 
received in a prior terminated offering would be considered 
underwriting compensation under Rule 5110 only if the member 
participates in the revised public offering.
---------------------------------------------------------------------------

    \122\ See Securities Exchange Act Release No. 72114 (May 7, 
2014), 79 FR 27355 (May 13, 2014) (Order Approving File No. SR-
FINRA-2014-004).
---------------------------------------------------------------------------

    With respect to proposed Supplementary Material .01(a)(14) to Rule 
5110, SIFMA stated that gifts and business entertainment provided in 
compliance with the limits set forth in proposed Rule 5110(f)(2)(A) and 
(B) (which allow for nominal gifts and occasional meals, sporting 
events or comparable entertainment) should not be counted as 
underwriting compensation as there is no rationale and investor 
protection goal served by the imposition of this requirement. Non-cash 
compensation, including gifts and business entertainment, in connection 
with a public offering may be reasonably considered underwriting 
compensation. To the extent that any gifts and business entertainment 
are provided in compliance with the limits set forth in proposed Rule 
5110(f)(2)(A) and (B), the amount of underwriting compensation 
attributable to the gifts and business entertainment should not be 
significant in practice. With that said, FINRA is currently reviewing 
all of its non-cash compensation provisions in the context of a 
separate retrospective rule review.\123\
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    \123\ See Regulatory Notice 16-29 (August 2016).
---------------------------------------------------------------------------

    Davis Polk noted that proposed Supplementary Material .01(b)(1) 
provides that fees of ``independent financial advisers'' would not be 
underwriting compensation but questioned the treatment of fees paid to 
members for acting solely as ``financial advisers.'' The proposed rule 
change would define an independent financial

[[Page 18610]]

adviser consistent with the current Rule.\124\ Application of the Rule 
to financial advisers was addressed when the defined term independent 
financial adviser was added to Rule 5110 in 2014.\125\ The application 
of the Rule to fees paid to financial advisers and the carve-out for 
fees of independent financial advisers, as that term is defined, 
continues to be appropriate.
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    \124\ See current Rule 5110(a)(5)(B) and proposed Rule 
5110(j)(9).
    \125\ See Securities Exchange Act Release No. 71372 (January 23, 
2014), 79 FR 4793 (January 29, 2014) (Notice of Filing of File No. 
SR-FINRA-2014-003). See also Letter from Kathryn M. Moore, Associate 
General Counsel, FINRA, to Kevin O'Neill, Deputy Secretary, SEC, 
(regarding File No. SR-FINRA-2014-003), dated April 16, 2014.
---------------------------------------------------------------------------

    SIFMA suggested that proposed Supplementary Material .01(b)(2) to 
Rule 5110 should exclude from underwriting compensation ``cash 
compensation received for providing services in a private placement,'' 
rather than being limited to acting as a placement agent. SIFMA stated 
that limiting the provision to receipt of cash compensation solely for 
acting in a placement agent capacity is unnecessarily narrow and should 
be removed. Rule 5110 currently provides that cash compensation 
received for acting only as a private placement agent would not be an 
item of value. Member's roles in acting as a placement agent and in 
providing services in a private placement similarly facilitate 
offerings. Upon further review, FINRA agrees that this carve-out can be 
expanded to include the provision of other services by a member for a 
private placement without the risk of harm to investors. Accordingly, 
the proposed rule change would expand the scope of proposed 
Supplementary Material .01(b)(2) to Rule 5110 to include cash 
compensation for providing services for a private placement.
    Two commenters suggested that proposed Supplementary Material 
.01(b)(11) to Rule 5110 should be modified to remove the reference to 
``listed'' securities (i.e., all securities purchased in public market 
transactions should be excluded from underwriting compensation, 
regardless of whether they are listed).\126\ The proposed approach is 
consistent with the treatment in Rule 5110 currently, which provides 
that listed securities acquired in public market transactions would not 
be an item of value.\127\ The defined term ``listed securities'' in 
Supplementary Material .01(c)(1) of Rule 5110 provides greater clarity 
on the scope of covered securities than the commenters' suggestion.
---------------------------------------------------------------------------

    \126\ See ABA and SIFMA.
    \127\ See current Rule 5110(c)(3)(B)(iii).
---------------------------------------------------------------------------

    Three commenters suggested amending proposed Supplementary Material 
.01(b)(12) to Rule 5110 to expressly provide that securities received 
by directors or employees under any written compensatory benefit plan 
would not be underwriting compensation.\128\ The commenters stated that 
these types of plans are for the purpose of compensating directors and 
employees and are unrelated to underwriting compensation in connection 
with a public offering. FINRA would interpret the reference to a 
``similar plan'' in proposed Supplementary Material .01(b)(12) to Rule 
5110 to include a written compensatory benefit plan for directors and 
employees that provides comparable grants of securities to similarly 
situated persons (e.g., a written compensatory benefit plan that 
provides comparable grants of securities to all qualifying employees) 
and accordingly does not propose to change the Rule text. A ``similar 
plan'' would not include a compensatory benefit plan that was developed 
or structured to circumvent the requirements of Rule 5110.
---------------------------------------------------------------------------

    \128\ See ABA, Davis Polk and Rothwell.
---------------------------------------------------------------------------

    SIFMA suggested amending proposed Supplementary Material .01(b) to 
Rule 5110 to expressly provide that underwriting compensation would not 
include any cash compensation, securities or other benefit received by 
a person who was not, at the time of the acquisition of the 
compensation, an associated person, immediate family or affiliate of a 
participating FINRA member. Because persons have previously transferred 
from issuers to members around the time of securities acquisitions, the 
proposed rule change would not provide an express carve-out provision 
as suggested. However, exemptive relief may be available for bona fide 
transfers on a case-by-case basis as necessary and appropriate.
    SIFMA suggested amending Supplementary Material .01(b) to Rule 5110 
to expressly provide that underwriting compensation would not include 
any cash compensation, securities or other benefit received by an 
associated person, immediate family or affiliate of a participating 
member if the member or its parent or other affiliate is issuing its 
own securities in the public offering. Because a broad carve-out could 
be used to circumvent the requirements of Rule 5110, the proposed rule 
change would not provide an express provision as suggested. Exemptive 
relief may be available on a case-by-case basis as necessary and 
appropriate where a participating member or its parent or other 
affiliate is issuing its own securities in the public offering.
    Several commenters suggested amending proposed Supplementary 
Material .01(b) to Rule 5110 to expressly provide that underwriting 
compensation would not include securities acquired pursuant to a 
governmental or court-approved proceeding or plan of reorganization. 
Specifically, SIFMA suggested amending proposed Supplementary Material 
.01(b) to Rule 5110 to expressly provide that underwriting compensation 
would not include acquisitions of securities before or after the 
required filing date by participating members pursuant to a U.S. or 
non-U.S. governmental or court-approved proceeding or plan of 
reorganization in which new securities are issued to or are available 
for purchase by existing securities holders (e.g., a bankruptcy or tax 
court proceeding) where such participating members receive or purchase 
such securities on the same terms as other similarly-situated security 
holders. ABA supported amending Supplementary Material .01(b) to Rule 
5110 to expressly provide that underwriting compensation would not 
include securities acquired by a participating member in connection 
with a court-approved bankruptcy process. In addition, Davis Polk 
supported amending Supplementary Material .01(b) to Rule 5110 to 
expressly provide that underwriting compensation would not include 
securities issued pursuant to court order.
    Because these securities acquisitions would be overseen by the 
government or court, the risk of intentional circumvention of Rule 5110 
or investor harm is minimized. Accordingly, the proposed rule change 
would provide that underwriting compensation would not include 
securities acquired pursuant to a governmental or court-approved 
proceeding or plan of reorganization as a result of action by the 
government or court (e.g., bankruptcy or tax court proceeding).\129\
---------------------------------------------------------------------------

    \129\ See proposed Supplementary Material .01(b)(22) to Rule 
5110.
---------------------------------------------------------------------------

Venture Capital Exceptions From Underwriting Compensation
    SIFMA requested that FINRA state affirmatively that Rule 5110's 
venture capital exceptions are non-exclusive safe harbors and that 
other securities acquisitions that do not meet one of the express safe 
harbors (or fall within other exceptions provided elsewhere in Rule 
5110) would also be excluded from

[[Page 18611]]

characterization as underwriting compensation (and the accompanying 
lock-up restrictions) if the acquisition of the securities by the 
participating member is not compensation for providing underwriting, 
allocation, distribution, advisory or other investment banking services 
in connection with the public offering. FINRA proposes to retain an 
objective standard for distinguishing securities acquired in bona fide 
venture capital transactions from those acquired as underwriting 
compensation. While retaining this objective standard, the proposed 
rule change provides additional flexibility for members via the 
principles-based approach for significantly delayed offerings or the 
examples in proposed Supplementary Material .01(b) in some securities 
acquisitions not being underwriting compensation.
    ABA generally supported the proposed changes to the venture capital 
exceptions but suggested that some additional changes be considered. 
Specifically, ABA suggested that the requirement that the participating 
member must acquire the issuer's securities ``at the same price and 
with the same terms as securities purchased by all other investors'' be 
revised such that the participating member may acquire its securities 
``on no better terms'' than the other investors. ABA noted that members 
may choose to forego voting rights or other indicia of control when 
purchasing an issuer's securities and this detrimental variation in the 
purchase terms should not deny a participating member the ability to 
rely on the exceptions.
    Introducing the concept of securities acquisitions ``on no better 
terms'' would introduce considerable uncertainty into the evaluation of 
whether any of the venture capital exceptions would be available. The 
``on no better terms'' concept would require a weighing and 
consideration of all of the various terms of a securities acquisition, 
which could be time consuming for members, counsel and FINRA staff. 
Retaining the concept of ``at the same price and with the same terms,'' 
which is in the current Rule, provides objectivity and clarity.
    ABA also requested revising proposed Rule 5110(d)(1)(B) to read 
``investment or loan'' rather than ``investment and loan'' to make 
clear that the provision does not require a participating member or its 
affiliate to make both an investment in and a loan to the issuer in 
order to rely on the exception. To clarify that both an investment in 
and a loan to the issuer are not required, the proposed rule change 
would revert to the current use of ``or'' in current Rule 
5110(d)(5)(A)(i)c.\130\
---------------------------------------------------------------------------

    \130\ See proposed Rule 5110(d)(1)(B).
---------------------------------------------------------------------------

    Two commenters supported amending the timing requirement for the 
venture capital exceptions to allow for application to situations in 
which the participating member or its affiliate has made its investment 
in the issuer after the required filing date.\131\ If not so amended, 
SIFMA suggested either: (1) Eliminating the pre-filing timing 
restriction in proposed (d)(1) and (2), which address securities 
acquired by certain affiliates of a participating member; or (2) 
establishing for all of these exceptions a formal mechanism to reset 
the required filing date for significantly delayed offerings.
---------------------------------------------------------------------------

    \131\ See ABA and SIFMA.
---------------------------------------------------------------------------

    When an offering has been significantly delayed, FINRA would 
consider the factors in proposed Supplementary Material .02 to Rule 
5110 discussed above to analyze whether securities acquired in a 
transaction that occurs after the required filing date, but otherwise 
meets the requirements of a venture capital exception, may be excluded 
from underwriting compensation.
    SIFMA suggested that the venture capital exceptions be amended to 
provide that the determination as to the availability of an exception 
is to be made by the participating member at the time of the 
acquisition of the securities and on the basis of the information then 
known to the participating member. Except for the principles-based 
approach for significantly delayed offerings, the venture capital 
exceptions apply to the acquisition of securities before the required 
filing date. Accordingly, whether an acquisition of the securities 
meets an exception must be determined before the required filing date.
    NASAA expressed concern about removing the restriction in current 
Rule 5110(d)(5)(A) and (B) that the exception from underwriting 
compensation is available only to underwriters and their affiliates who 
own less than 25 percent of the issuer's total equity, as the removal 
of the restriction may increase the potential for conflicts of interest 
to arise. NASAA questioned whether the proposed changes further 
investor protection and whether the protections of Rule 5121 are 
adequate. FINRA believes, however, the proposed rule change would 
eliminate an unnecessary restriction in the relevant venture capital 
exceptions. Post-2004 regulatory changes in other areas, such as the 
2009 revision of Rule 5121 regarding public offerings with a conflict 
of interest, have added protections to address acquisitions that create 
control relationships. Moreover, in FINRA's experience control 
transactions that result in ownership of more than 25 percent of an 
issuer involve significant investment risks and are not designed to be 
a means to obtain additional underwriting compensation.
    SIFMA stated that the addition of ``through a subsidiary it 
controls'' in the venture capital exceptions in proposed Rule 
5110(d)(1) and (2) is a useful clarification, but suggested that 
provision be modified to require that ``the affiliate is `or will be' 
primarily engaged in the business of making investments in or loans to 
other companies, `or has been formed for the purpose of making this 
investment or loan by a parent that is directly or indirectly engaged 
in such activities.' '' SIFMA suggested that this modification would 
address situations in which the investing entity is a newly formed 
vehicle and does not, outside the present investment, have a history of 
making such investments in other companies.
    Expanding the scope of the exceptions to cover direct, indirect or 
newly formed entities that are in the business of making investments 
and loans acknowledges the different structures that may be used to 
participate in bona fide venture capital transactions. Expanding these 
exceptions to cover entities that may be formed in the future could 
undermine the protection that results from requiring an entity to be in 
the business of making such acquisitions, rather than one simply formed 
to participate in a compensation transaction.
    SIFMA supported increasing the participating members' aggregate 
acquisition threshold from 20 percent to 40 percent of the total 
offering in the venture capital exception in proposed Rule 5110(d)(3). 
SIFMA suggested, however, that limiting this venture capital exception 
to receipt of the securities for placement agent activities is too 
narrow and should be removed (e.g., securities-related compensation 
could be offered by an issuer in return for advisory or other services 
provided by a participating member in connection with the private 
placement, rather than for services as a placement agent).
    FINRA believes that the venture capital exception in proposed Rule 
5110(d)(3) can be expanded to include the provision of other services 
for a private placement without the risk of harm to investors. 
Accordingly, the proposed rule change would expand the scope of 
proposed Rule 5110(d)(3) to include providing services for a private

[[Page 18612]]

placement (rather than just acting as a placement agent). Proposed Rule 
5110(d)(3) would also be clarified to refer to 51 percent of the 
``total number of securities sold in the private placement.'' The 
current rule text states ``at least 51 percent of the `total offering' 
(comprised of the total number of securities sold in the private 
placement and received or to be received as placement agent 
compensation by any member).''
    SIFMA also suggested adding another venture capital exception from 
underwriting compensation for securities acquired before or after the 
required filing date by a participating member in connection with a 
loan or a private placement in which securities (at the same price and 
with the same terms) were also acquired by certain types of special 
investors, including: (1) Registered investment companies; (2) a fund 
or insurance company that meets the qualifications in proposed 
paragraph (d)(1), (2) or (3); (3) a publicly traded company that is 
listed on a national securities exchange or a non-U.S. issuer that 
meets the quantitative designation criteria for listing on a national 
securities exchange; (4) a benefit plan qualified under Section 401(a) 
of the Internal Revenue Code (provided that such plan is not sponsored 
by the participating member); (5) a state or municipality, or a state 
or municipal government benefits plan that is subject to state and/or 
municipal registration; (6) a sovereign wealth fund or similar 
investment vehicle; (7) a bank as defined in Section 3(a)(6) of the 
Exchange Act; or (8) an organization described in Rule 15a-6(a)(4)(ii), 
provided no participating member manages such entity's investments or 
otherwise controls of directs the management or policies of such entity 
and such entity or entities acquire in the aggregate at least 10 
percent of the total offering.
    Providing the suggested venture capital exception could result in a 
significant expansion of the historical scope of Rule 5110's venture 
capital exceptions, as the identified special investors represent much 
of the traditional pool of pre-IPO investors. Providing such a broad 
exception, without requirements comparable to those imposed by the 
other exceptions, could result in most securities acquisitions by 
participating members before the required filing date being excepted 
from underwriting compensation. However, a participating member may 
make a co-investment in an issuer in circumstances that do not fit the 
conditions for the current venture capital exceptions. Where a highly 
regulated entity with significant disclosure requirements and 
independent directors who monitor investments is also making a 
significant co-investment in the issuer and is receiving securities at 
the same price and on the same terms as the participating member, the 
securities acquired by the participating member in a private placement 
are less likely to be underwriting compensation.
    To address such co-investments, the proposed rule change would 
adopt a new venture capital exception from underwriting compensation 
for securities acquired in a private placement before the required 
filing date of the public offering by a participating member if at 
least 15 percent of the total number of securities sold in the private 
placement were acquired, at the same time and on the same terms, by one 
or more entities that are open-end investment companies not traded on 
an exchange, and no such entity is an affiliate of a FINRA member 
participating in the offering. These conditions lessen the risk that 
the co-investment would be made for the purpose of the participating 
member avoiding the requirements of Rule 5110.
Treatment of Non-Convertible or Non-Exchangeable Debt Securities and 
Derivatives
    Commenters requested clarifications and modifications to the 
treatment of non-convertible or non-exchangeable debt securities and 
derivatives. Rothwell stated that non-convertible or non-exchangeable 
debt securities should not be underwriting compensation, regardless of 
whether the securities were acquired in a transaction related to the 
offering, as they are unlikely to be used as a payment for investment 
banking services. If these debt securities continue to be treated as 
underwriting compensation, Rothwell recommended adopting a narrower 
exception from underwriting compensation for these debt securities 
issued at par (if the purchaser is the sole purchaser) or purchased at 
least at the same price as other purchasers at or about the same time 
for the same issue of debt. Rothwell stated there would be no investor 
protection benefit to including such securities in underwriting 
compensation. Rothwell suggested that this valuation method would 
provide an objective methodology that is appropriate to these debt 
securities and is consistent with investor protection.
    SIFMA stated that non-convertible or non-exchangeable debt 
securities and derivative instruments that are acquired or entered into 
at a fair price in a transaction related to a public offering should 
not be considered underwriting compensation. However, SIFMA suggested 
that such arrangements should continue to be disclosed in the 
prospectus because they are entered into in transactions related to the 
public offering. As a secondary option, SIFMA suggested that proposed 
Supplementary Material .06 to Rule 5110 be modified to provide that: 
(1) ``non-convertible or non-exchangeable debt securities and 
derivative instruments acquired `from or entered into with the issuer' 
in a transaction related to the public offering and at a fair price 
will be considered underwriting compensation but will have no 
compensation value''; and (2) any securities or other payment received 
by a participating member during the review period in connection with 
the settlement or termination of a derivative instrument that was 
entered into at a fair price in a transaction related to the public 
offering will, like the derivative instrument itself, have no 
compensation value. SIFMA further commented that if the suggested 
change is not made, proposed Rule 5110(g)(8), which prohibits certain 
terms in connection with ``the receipt of underwriting compensation 
consisting of any option, warrant or convertible security,'' should be 
modified to exclude fair price derivatives.
    Because ``related to the offering'' is not defined, Davis Polk 
suggested that the test of whether the non-convertible or non-
exchangeable debt and derivative instruments were acquired at a fair 
price provides a more meaningful standard. Rothwell stated that the 
terms ``related to the public offering'' and ``unrelated to the public 
offering'' as used in the Rule are confusing and that it would be more 
appropriate to treat securities as underwriting compensation if not 
acquired at a fair price or to apply the standards in the definition of 
``underwriting compensation.''
    Rule 5110 distinguishes between whether the non-convertible or non-
exchangeable debt securities and derivative instruments were acquired 
in a transaction related or unrelated to a public offering. The 
proposed rule change would clarify that non-convertible or non-
exchangeable debt securities and derivative instruments acquired in a 
transaction unrelated to a public offering would not be underwriting 
compensation. Consistent with the current Rule, these debt securities 
and derivative instruments would not be subject to Rule 5110 (i.e., a 
description of the debt securities and derivative instruments need not 
be filed with FINRA, there are no valuation-related requirements and 
the lock-up restriction does not apply).

[[Page 18613]]

    In contrast, non-convertible or non-exchangeable debt securities 
and derivative instruments acquired in a transaction related to a 
public offering would be underwriting compensation and a description of 
these debt securities or derivative instruments must be filed with 
FINRA. The proposed rule change would clarify that these debt 
securities and derivative instruments acquired at a fair price would be 
considered underwriting compensation but would have no compensation 
value, while these debt securities and derivative instruments acquired 
not at a fair price would be considered underwriting compensation and 
subject to the normal valuation requirements of Rule 5110.
    SIFMA also suggested the definition of fair price be revised to 
clarify that securities or instruments that are intended to be 
compensatory in nature for acting as a private placement agent for the 
issuer, for providing a loan, credit facility, merger, acquisition or 
any other service, including underwriting services, would not be viewed 
as having been acquired or entered into at a fair price, otherwise the 
reference to ``any other service'' could be read broadly as to render 
the definition meaningless. To clarify the scope of the definition, the 
proposed rule change would provide that a ``derivative instrument or 
other security received as compensation for providing services for the 
issuer, for providing or arranging a loan, credit facility, merger, 
acquisition or any other service, including underwriting services will 
not be deemed to be entered into or acquired at a fair price.'' \132\
---------------------------------------------------------------------------

    \132\ See proposed Supplementary Material .06(b) to Rule 5110.
---------------------------------------------------------------------------

Lock-Up Restrictions
    Commenters requested several changes to the lock-up restriction, 
including the length of and securities subject to the restriction. Some 
commenters agreed that a 180-day lock-up period would be appropriate 
for IPOs but recommended a shorter (e.g., 30- to 45-day) lock-up period 
for follow-on offerings.\133\ SIFMA also suggested that the lock-up 
requirement not apply in connection with offerings of securities that 
have a bona fide public market (as that term is defined in Rule 5121).
---------------------------------------------------------------------------

    \133\ See ADISA, Rothwell and SIFMA.
---------------------------------------------------------------------------

    In contrast, NASAA noted that the NASAA Promotional Shares 
Statement of Policy requires a lock-up period that is much longer than 
180 days (i.e., that promotional shares that are not fully paid will be 
subject to a lock-up agreement for at least one or two years following 
the completion of the offering) to ensure that investors and promoters 
assume similar risks in the offering. Consequently, NASAA urged 
requiring a longer lock-up period under Rule 5110 to more closely align 
the interests of the underwriters with those of the investors in the 
offering.
    The proposed rule change continues the historical approach of a 
180-day lock-up period for both initial and follow-on public offerings. 
While the insider lock-up period could be less than 180 days in a 
follow-on offering, the insider lock-up period is commonly 180 days in 
IPOs. Keeping the same lock-up period for underwriters and the issuer's 
insiders provides equivalent protections for the secondary market. 
While the insider lock-period may vary among follow-on offerings, a 
consistent 180-day lock-up period for underwriters ensures that they do 
not accept less investment risk than insiders subject to a 180-day 
lock-up period.
    ABA commended FINRA for revising the lock-up restrictions under 
proposed Rule 5110(e)(1) to clarify that the 180-day restricted period 
begins with the date of commencement of sales in the public offering 
and to minimize the impact of the lock-up restriction by including some 
important additional exemptions. NASAA supported the lock-up 
restriction being determined by the date of commencement of sales in 
the public offering (rather than from the date of effectiveness) and 
suggested that this change would provide increased protection for 
investors. However, ADISA suggested that the lock-up restriction should 
be determined using the date of effectiveness to provide clarity to all 
participants as the term ``commencement of sales'' can be vaguer and 
harder to determine rather than the definitive date of effectiveness.
    Because the approach in the Notice 17-15 Proposal provides clarity 
in measuring the lock-up period, particularly with respect to 
securities sold pursuant to a registration statement or amendment 
thereto that does not have to be declared effective by the SEC, the 
proposed rule change retains the approach that the lock-up restriction 
is determined by the date of commencement of sales in the public 
offering (rather than from the date of effectiveness).
    ABA stated that the lock-up restriction should apply only to equity 
securities received in transactions that are not registered with the 
SEC and that the lock-up restriction in the Notice 17-15 Proposal would 
potentially expand the scope of the lock-up restriction to include all 
public offerings. Rothwell stated that the lock-up restriction should 
apply only to securities deemed underwriting compensation in the case 
of public offerings of equity securities. Rothwell suggested revising 
the lock-up restriction to state that the restriction applies only in 
the case of a public equity offering of common or preferred stock, 
options, warrants, and other equity securities, including debt 
securities convertible to or exchangeable for equity securities of the 
issuer, that are unregistered.
    The Notice 17-15 Proposal provided a broad lock-up requirement with 
several delineated exceptions. FINRA agrees that the scope of the lock-
up requirement should be ``public equity offering'' as is used in the 
current Rule. The proposed rule change simplifies, clarifies and 
reduces the securities considered underwriting compensation and thus 
subject to the lock-up restriction. To the extent that securities are 
underwriting compensation and subject to lock-up restriction, exemptive 
relief may be available on a case-by-case basis as necessary and 
appropriate.
    ABA requested guidance with respect to whether it is intended that 
the lock-up restriction would prevent participating members from 
selling securities acquired as underwriting compensation in the public 
offering itself. The proposed rule change would add an exception from 
the lock-up restriction for securities that were received as 
underwriting compensation, and are registered and sold as part of a 
firm commitment offering.\134\ This is intended to give some 
flexibility to members in selling securities received as underwriting 
compensation, while limiting the proposed exception to firm commitment 
offerings where the underwriter has assumed the risk of marketing and 
distributing an offering that includes securities the underwriter 
received as underwriting compensation. In addition, firm commitment 
offerings are usually marketed and sold to institutional investors, who 
typically purchase a majority of the shares in such offerings.
---------------------------------------------------------------------------

    \134\ See proposed Rule 5110(e)(2)(A)(viii).
---------------------------------------------------------------------------

    SIFMA stated that the Notice 17-15 Proposal appeared to subject 
non-convertible or non-exchangeable debt securities and derivative 
instruments acquired at a fair price in a transaction related to the 
offering and non-listed securities of an issuer acquired in a public 
market transaction to Rule 5110's lock-up restriction, unless the 
security is of an issuer that meets the registration requirements of 
current Forms S-3, F-3, F-10 (for brevity, referred to herein as 
``current eligible issuers''). SIFMA supported the exception for 
current

[[Page 18614]]

eligible issuers, but stated that the lock-up restriction should apply 
only to public offerings of equity and equity-linked securities, should 
cover only equity and equity-linked securities received as underwriting 
compensation by participating members in offerings not registered under 
the Securities Act and should provide an express exception for fair 
price derivatives. Moreover, SIFMA suggested that the proposed 
exception for current eligible issuers should be clarified to expressly 
provide that the exclusion also applies to derivative instruments 
entered into with such issuers.
    Davis Polk stated that application of the lock-up restriction to 
non-convertible or non-exchangeable debt securities and derivative 
instruments is not justified and may interfere with some derivative 
transactions. Rothwell suggested that non-convertible or non-
exchangeable debt securities deemed to be underwriting compensation 
should be excluded from the lock-up restriction as there is no investor 
protection benefit to be received. Rothwell stated that these 
securities that are included in the calculation of underwriting 
compensation: (1) Are likely a different issue or series than those 
sold to the public and will not have a public market; and (2) even if 
the securities are from the same issue, the public secondary market 
trading price of such debt securities is primarily determined by 
fluctuating interest rates rather than the types of market forces that 
affect the equity markets.
    The proposed rule change would provide clarity about the treatment 
of non-convertible or non-exchangeable debt securities and derivative 
instruments acquired in transactions related to a public offering. The 
proposed rule change would retain the current approach for non-
convertible or non-exchangeable debt securities acquired in a 
transaction related to the public offering and would provide an express 
exception from the lock-up restriction for clarity (i.e., the exception 
would provide that the lock-up restriction does not apply).\135\
---------------------------------------------------------------------------

    \135\ See proposed Rule 5110(e)(2)(A)(iv).
---------------------------------------------------------------------------

    However, derivative instruments are currently subject to Rule 
5110's lock-up restriction. FINRA recognizes that members may acquire 
derivative instruments in connection with a hedging transaction related 
to the public offering and that, given the nature of these hedging 
transactions, the lock-up restriction should not apply. Accordingly, 
the proposed rule change would provide that the lock-up restriction 
does not apply to derivative instruments acquired in connection with a 
hedging transaction related to the public offering and at a fair 
price.\136\ Derivative instruments acquired in transactions related to 
the public offering that do not meet the requirements of the exception 
would be subject to the lock-up restriction.
---------------------------------------------------------------------------

    \136\ See proposed Rule 5110(e)(2)(A)(v).
---------------------------------------------------------------------------

    SIFMA suggested expressly excluding from the lock-up restriction 
any securities received in connection with the settlement or 
termination of a derivative instrument received outside the review 
period or during the review period in a transaction unrelated to the 
public offering, such as by revising proposed Supplementary Material 
.01(b)(14) to Rule 5110 to read ``securities acquired as the result of 
a conversion `or exchange' of securities originally acquired prior to 
the review period and securities acquired at termination or in 
settlement of a derivative instrument entered into prior to the review 
period or during the review period in a transaction unrelated to the 
public offering.'' The lock-up restriction would not apply to 
securities that were acquired in a transaction unrelated to the public 
offering. However, because an ``exchange'' could relate to a wholly 
different transaction, the suggested revision to proposed Supplementary 
Material may be overly broad.
    SIFMA suggested that the one percent threshold in proposed Rule 
5110(e)(2)(A)(ii)--which provides that the lock-up restrictions will 
not apply if the aggregate amount of securities of the issuer 
beneficially owned by a participating member does not exceed one 
percent of the securities being offered--should be tied to the amount 
of securities received as underwriting compensation during the review 
period rather than more broadly to all securities held by the 
participating member. Accordingly, SIFMA suggested that the lock-up 
restriction should not apply to securities received during the review 
period as underwriting compensation if the amount of such securities 
does not exceed one percent of the securities being offered in the 
public offering. FINRA believes that the aggregate amount of securities 
beneficially owned by a participating member is a better measure of the 
potential impact of sales by the participating member into the 
secondary market.
    SIFMA suggested that the exception in proposed Rule 
5110(e)(2)(A)(vii) should be modified to allow for the sale or other 
disposition of the securities by registered investment advisers, even 
if such advisers are affiliated with a participating FINRA member. To 
accomplish this change, SIFMA suggested revising proposed Rule 
5110(e)(2)(A)(vii) to state ``the security is beneficially owned on a 
pro-rata basis by all equity owners of an investment fund, provided 
that (a) no participating member `(other than a participating member 
that is registered as an investment adviser under the U.S. Investment 
Advisers Act of 1940 and is acting in accordance with its 
responsibilities thereunder)' manages or otherwise directs investments 
by the fund, and (b) participating members in the aggregate do not own 
more than 10 percent of the equity of the fund.'' SIFMA stated that 
participating members registered as investment advisers are separately 
regulated and have a fiduciary duty to act in the best interests of 
their clients, and the lock-up restriction may interfere with that 
regulatory responsibility. FINRA believes that this lock-up exception 
continues to be appropriate to securities received as underwriting 
compensation by a fund controlled by a participating member.
Defined Terms
    The Notice 17-15 Proposal definition of ``public offering'' was 
based on the definition in Rule 5121, but included the delineated 
carve-outs in the Rule 5121 definition (which relate to certain types 
of securities offerings that are commonly understood not to constitute 
offerings to the public) separately in the list of securities offerings 
exempted from Rule 5110's filing and substantive requirements. The 
practical effect of this approach was that the carve-outs in Rule 5121 
(e.g., securities exempt from registration under Securities Act Rule 
144A or Regulation S) would not be subject to the filing or substantive 
provisions of Rule 5110.
    Two commenters stated that the definition of public offering 
proposed in Notice 17-15 eliminated the carve-outs currently in the 
Rule 5121 definition of public offering, thus substantially broadening 
the definition.\137\ The commenters requested a definition of public 
offering be adopted that retains the carve-outs with the definition, as 
such offerings would already be exempt from the Rule's coverage by 
virtue of the definition of public offering itself. Because the 
approach in the Notice 17-15 Proposal raised questions regarding the 
intended scope of the public offering definition, the proposed rule 
change incorporates the public offering definition from Rule 5121, 
accompanied

[[Page 18615]]

by the delineated carve-outs, and correspondingly deletes those carve-
outs from the proposed list of exemptions from the filing and 
substantive provisions of Rule 5110.\138\
---------------------------------------------------------------------------

    \137\ See ABA and SIFMA.
    \138\ See proposed Rule 5110(j)(18).
---------------------------------------------------------------------------

    ABA recommended revising the public offering definition to state 
``any primary or secondary distribution of securities `made in whole or 
in part in the United States' `to the public.' '' ABA suggested that 
this approach would avoid circularity and more accurately reflect the 
types of offerings intended to be covered by the Rule. To clarify the 
jurisdictional scope, the proposed rule change would include ``in whole 
or in part in the United States'' in the public offering definition. 
However, because the addition of ``to the public'' may raise new 
questions on the scope of covered offerings, the proposed definition 
does not include that language.
    SIFMA suggested that because the defined term ``experienced 
issuer'' differs from the terminology used by the SEC for purposes of 
Form S-3, the term is likely to lead to confusion. Beyond the name, 
commenters suggested modifying the definition substantively. 
Specifically, SIFMA suggested that the definition mean: ``an issuer 
that (i) meets the registrant requirements specified in paragraph I.A 
of SEC Form S-3, except that for purposes of paragraph I.A.3 thereof, 
the reference to twelve calendar months shall be deemed to refer 
instead to 36 calendar months; and (ii) has an aggregate market value 
of outstanding voting and non-voting common equity held by non-
affiliates (as calculated pursuant to General Instruction I.B.1 of Form 
S-3) of (a) at least U.S. $150 million or (b) at least U.S. $100 
million and the issuer has had an annual trading volume of its common 
equity of at least three million shares (or share equivalent).'' 
Sullivan suggested that, at a minimum, the experienced issuer 
definition should be revised to conform to existing Forms S-3 and F-3 
because requiring an additional 24 months of reporting history does not 
enhance the ability of these issuers to fend for themselves.
    ABA appreciated FINRA's attempt to streamline Rule 5110 by using 
the defined term experienced issuer but suggested that the criteria is 
outdated and the exemption should be available to any issuer who is 
eligible to file a registration statement under the SEC's current 
requirements for Forms S-3, F-3 and F-10. If limiting the exemption 
beyond the current requirements for Forms S-3, F-3 and F-10 is 
necessary for the protection of investors, ABA requested that FINRA 
consider revising the definition to also cover issuers with a 12 month 
reporting history if they have: (1) A public float of at least $75 
million; and (2) average daily trading volume (as defined in SEC 
Regulation M) in their common equity securities of at least $1 million 
and also requested exempting issuers that meet these criteria that are 
filing on SEC Form N-2.
    Rather than referring to the pre-1992 standards for Form S-3 and F-
3 and standards approved in 1991 for Form F-10, the proposed definition 
of experienced issuer codifies those standards currently in Rule 5110 
to simplify the analysis for the benefit of members. The continued 
application of the Rule to these issuers continues to be 
justified.\139\ The proposed rule change intentionally uses language 
different from that used in other requirements (e.g., Form S-3's use of 
``seasoned issuer'') to avoid confusion and make clear that the defined 
term covers a different set of issuers.
---------------------------------------------------------------------------

    \139\ See supra discussion of previous problems associated with 
shelf offerings in Item II.A.
---------------------------------------------------------------------------

    Two commenters stated that retaining the current definition of 
``institutional investor'' is problematic and difficult to use, thereby 
rendering the venture capital exceptions in proposed Rule 5110(d)(2) 
and (3) largely unworkable.\140\ SIFMA stated that, given the expansive 
definition of ``participating member,'' it is difficult to ascertain 
whether an entity qualifies as an institutional investor and that the 
focus of the definition should instead be on whether a participating 
member manages the investor's investments or otherwise controls or 
directs the investment decisions of the investor.
---------------------------------------------------------------------------

    \140\ See Davis Polk and SIFMA.
---------------------------------------------------------------------------

    SIFMA suggested defining the term ``institutional investor'' to 
mean a ``person that has an aggregate of at least U.S. $50 million 
invested in securities in its portfolio or under management, including 
investments held by its wholly owned subsidiaries; provided that no 
participating members manage the institutional investor's investments 
or otherwise control or direct the investment decisions of such 
investor.'' Alternatively, if the equity interest element of the 
definition is not deleted, SIFMA proposed that the: (1) Reference to 
``equity interest'' be changed to ``beneficial ownership'' as defined 
in Rule 5121; (2) thresholds for both public and non-public entities be 
raised to 15 percent and the reference to ``entity'' be changed to 
``investor'' (due to the incorporation by reference of the specific 
definition of ``entity'' in Rule 5121 which does not fit well in this 
specific context in Rule 5110); and (3) calculation of the beneficial 
ownership threshold be limited to ownership by the participating FINRA 
member and its affiliates (i.e., the calculation should not include 
associated persons that are not otherwise ``affiliates'' of the member 
or immediate family of such persons).
    Revising the institutional investor definition as suggested to 
focus on controlling or directing investment decisions would insert 
uncertainty and subjectivity into the definition. The proposed rule 
change retains this definition because the current definition is more 
objective. Moreover, because Rule 5110's venture capital exceptions are 
relied upon by members, FINRA does not agree that the institutional 
investor definition makes the venture capital exceptions unworkable.
    Two commenters suggested that the Notice 17-15 Proposal's addition 
of ``other than the issuer'' at the end of the definition of 
``participating member'' does not make it clear that the issuer is 
exempted from all categories of participating member.\141\ To make 
clear that the definition does not include the issuer, the proposed 
rule change would define participating member to mean ``any FINRA 
member that is participating in a public offering, any affiliate or 
associated person of the member, and any immediate family, but does not 
include the issuer.'' \142\
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    \141\ See ABA and Rothwell.
    \142\ See proposed Rule 5110(j)(15).
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    Three commenters stated that the proposed carve-out of the 
``issuer'' from the definition of ``participating member'' is useful 
and would help with inadvertent overlap between the two 
definitions.\143\ These commenters suggested that a comparable carve-
out to include participating members be included in the definition of 
``issuer.'' The proposed rule change does not incorporate the suggested 
change to the definition of ``issuer'' because a participating member 
could also be the issuer of the securities.
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    \143\ See ABA, Rothwell and SIFMA.
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    SIFMA stated that the proposed definition of ``issuer'' referencing 
an ``entity'' offering its securities to the public may be confusing 
given that the defined term ``entity'' in Rule 5121 excludes certain 
types of issuers such as DPPs and REITs. To address this issue, SIFMA 
suggested that ``issuer'' be defined to mean the ``registrant or other 
person offering its securities to the public, any selling security 
holder offering securities to the public, any affiliate of the 
registrant, such other person or selling security holder (other than an 
affiliate that is a participating

[[Page 18616]]

member), and the officers or general partners, and directors thereof.'' 
To clarify the scope of covered persons, the proposed rule change would 
revise the issuer definition to refer to the ``registrant or other 
person'' (rather than ``entity'').\144\
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    \144\ See proposed Rule 5110(j)(12).
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    ABA stated that while proposed Rule 5110(j)(2) would define the 
term ``bank'' for purposes of the Rule's venture capital exceptions, 
the term ``bank'' is not defined for purposes of the exemption for 
qualifying bank securities under proposed Rule 5110(h)(1). As the 
purpose of the proposed Rule 5110(h)(1) exemption is to exempt 
offerings by qualifying issuers, ABA stated that the exemption should 
include non-U.S. bank issuers and should not be limited to banks as 
defined in Exchange Act Section 3(a)(6), which definition is largely 
limited to U.S. domiciled banks and U.S.-based branches of non-U.S. 
banks.
    The proposed rule change would harmonize the definition of bank in 
the proposed venture capital exceptions and the Rule 5110(h)(1) 
exemption. Specifically, the proposed rule change would define bank for 
purposes of Rule 5110 as ``a bank as defined in Exchange Act Section 
3(a)(6) or is a foreign bank that has been granted an exemption under 
this Rule and shall refer only to the regulated entity, not its 
subsidiaries or other affiliates.'' \145\ This harmonized approach 
combines the definition of bank currently in Rule 5110, with the scope 
of banking entities currently covered by the venture capital 
exceptions.
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    \145\ See proposed Rule 5110(j)(2). Because of this expanded 
definition, the proposed rule change would delete as unnecessarily 
duplicative the conditions in the venture capital exceptions.
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    ABA supported clarifying and codifying the relevant ``review 
period'' through a defined term but requested additional guidance 
regarding when the review period would end for offerings with an 
indeterminate time period such as at-the-market offerings. An at-the-
market offering would be a takedown offering and the corresponding 
review period is set forth in proposed Rule 5110(j)(20)(C). Additional 
guidance regarding other offerings with indeterminate time periods may 
be provided as necessary or appropriate.
    ABA questioned why the review period in proposed Rule 
5110(j)(20)(C) would be limited to firm commitment or best efforts 
takedowns or any other continuous offering ``on behalf of security 
holders'' and requested that the definition be revised to include the 
issuer. ABA suggested that as proposed ``on behalf of security 
holders'' appears to qualify ``firm commitment,'' ``best efforts'' and 
``other continuous offering'' for the purpose of the review period 
definition. The reference to ``on behalf of securities holders'' was 
not intended to limit proposed Rule 5110(j)(20)(C) as suggested. To 
clarify the intended scope of the definition, the proposed rule change 
deletes the reference to ``on behalf of security holders.''
    Davis Polk stated that because the review period is defined to 
include the 60-day period following the effective date of a firm 
commitment offering (or following the final closing for other 
offerings), participating members would be required to provide FINRA 
with information regarding any fees or other compensation received by 
them, their affiliates, associated persons, and immediate family of 
associated persons for 60 days following the offering, which represents 
a significant diligence burden. Providing a specific time period gives 
clarity to participating members. Moreover, the inclusion of a short 
period of time following the offering prevents circumvention of the 
Rule 5110 and is consistent with current rule, which has a 90-day 
requirement.
    Davis Polk suggested that the definition of ``required filing 
date'' be modified for offerings that are dormant for a period of six 
months or more. Because the exceptions from underwriting compensation 
are unavailable for securities acquired by participating members after 
the first confidential submission to or public filing of the 
registration statement with the SEC, an issuer may not be able to 
accept financing from a participating member because of potentially 
excessive underwriting compensation. Accordingly, Davis Polk suggested 
either the definition of ``required filing date'' should be modified or 
the exceptions from underwriting compensation should be modified to 
apply to acquisitions by participating members of the issuer's 
securities after the required filing date. If the former, Davis Polk 
suggested that the definition provide that with respect to offerings 
that are dormant for six months or more, the review period begin upon 
the filing of the first amendment to the registration statement, which 
has been confidentially or publicly filed with the SEC, following the 
dormant period.
    Availability of a venture capital exception is contingent upon the 
securities being acquired before the required filing date because after 
that date, in FINRA's experience, securities acquisitions are more 
likely to be underwriting compensation and issuers may be more 
dependent on a particular underwriter or underwriters to raise 
necessary capital. A public offering may be significantly delayed for 
legitimate reasons (e.g., unfavorable market conditions) and during 
this delay the issuer may require funding to operate its business or 
continue as a going concern. Furthermore, a member may make bona fide 
investments in or loans to the issuer during this delay to satisfy the 
issuer's funding needs and any securities acquired as a result of this 
funding may be unrelated to the anticipated public offering. The 
proposed rule change would provide some additional flexibility in the 
availability of the venture capital exceptions for securities acquired 
where the public offering has been significantly delayed as discussed 
above in a principles-based approach in proposed Supplementary Material 
.02 to Rule 5110.
Valuation of Securities
    The Notice 17-15 Proposal removed the valuation formula for 
convertible securities and instead allowed for convertible securities 
to be valued based on a securities valuation method that is 
commercially available and appropriate for the type of securities to be 
valued, such as, for example, the Black-Scholes model for options. 
NASAA stated that the NASAA Underwriting Expenses Statement of Policy 
uses the same formula as current Rule 5110 for the valuation of 
underwriter's warrants in calculating total underwriting expenses. 
NASAA stated that the current valuation formula serves a useful purpose 
by providing an objective valuation method that provides consistency 
across different offerings and suggested that FINRA consider retaining 
the existing formula as a continued optional method of valuation. NASAA 
also urged FINRA to reexamine whether it is appropriate for an issuer 
to grant any options or warrants to underwriters as potential conflicts 
could impact the due diligence process.
    EGS stated that Rule 5110 should continue to have a single 
valuation method to process filings in a consistent, predictable and 
efficient manner. EGS's expressed concerns with the approach in Notice 
17-15 Proposal included: (1) Varying methods will yield inconsistent 
results from dealer to dealer and deal to deal; and (2) assessment of a 
new valuation method during the pendency of a filing would delay 
resolution of that filing and divert FINRA staff's time and attention 
away from other filings.
    Rothwell supported removal of the current Rule 5110 formula for 
valuing options but questioned whether, as a matter of policy, FINRA 
would continue

[[Page 18617]]

to accept the warrant formula as a valuation method for securities that 
have an exercise or conversion price. Rothwell stated that there are 
situations where the warrant formula may continue to be a viable method 
for valuing securities.
    SIFMA supported removal of the current Rule 5110 formula for 
valuing options, warrants and convertible securities to instead allow 
members to use a commercially available valuation method but requested 
additional guidance as to what should be filed with respect to such 
methodology. SIFMA stated that in addition to commercially available 
valuation models, the use of proprietary valuation models should be 
permitted if the member uses such a model in the ordinary course of its 
business to value securities of a similar type and files a description 
of the methodology with FINRA.
    The Notice 17-15 Proposal requested comment on whether the proposed 
change to the valuation method was appropriate and whether the 
valuation method should be limited to one that is commercially 
available. Some commenters supported the proposed change, while others 
did not. Commenters did not provide any information regarding use of 
commercially available valuation methods, such as what methods are 
available and their anticipated benefits. The proposed rule change 
would retain the current Rule 5110 formula for valuing options, 
warrants and convertible securities because of the conflicting views on 
the proposed change to the valuation formula and the lack of 
information regarding what commercially available valuation methods may 
be used by members.
    Two commenters stated that, consistent with the current Rule, 
members should be allowed to value non-convertible securities that are 
currently trading in the secondary market based on the difference 
between the market price at the time of acquisition (rather than the 
public offering price) and the acquisition cost.\146\ The proposed rule 
change would retain the current Rule 5110 formula and, consequently, 
would allow members to value non-convertible securities that are 
currently trading in the secondary market based on the difference 
between the market price at the time of acquisition (rather than the 
public offering price) and the acquisition cost.
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    \146\ See Rothwell and SIFMA.
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    Rothwell stated that the valuation of unit securities is not 
addressed in either the current Rule 5110 or the proposed rule change. 
Rothwell speculated that FINRA looks through the unit to value the 
individual components and ascribe an additional value to the warrant 
within the unit even though the purchaser may have paid the same price 
for the unit as the public offering price. Rothwell stated that the 
unit security should instead be valued as a non-convertible security 
(as the unit is a security that does not itself have an exercise or 
conversion price) and that the unit securities should have a zero value 
and should not be ascribed an additional value when a participating 
member acquires a non-convertible unit at the same price as the public 
offering price of the unit. FINRA has previously provided guidance, 
with accompanying examples, for valuing unit securities.\147\ This 
guidance remains valid and illustrative. FINRA does not agree with the 
commenter's proposed approach to valuing unit securities because a unit 
given to an underwriter may include a warrant with unique terms, which 
should be considered in evaluating underwriting compensation.
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    \147\ See Notice to Members 92-28 (May 1992).
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Numerical Stock Limit
    Prior to 2004, Rule 5110 contained a ``stock numerical limit'' that 
prohibited underwriters and related persons from receiving securities 
that constitute underwriting compensation in an aggregate amount 
greater than 10 percent of the number or dollar amount of securities 
being offered to the public. FINRA eliminated this requirement as 
unnecessary as the convertible securities valuation formula in current 
Rule 5110 results in a de facto stock numerical limit.\148\ Given the 
proposed elimination of the convertible securities valuation formula in 
the Notice 17-15 Proposal, that Proposal requested comment on whether a 
new stock numerical limit should be included in Rule 5110.
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    \148\ See Securities Exchange Act Release No. 48989 (December 
23, 2003), 68 FR 75684 (December 31, 2003) (Order Approving File No. 
SR-NASD-2000-04). See also Notice to Members 04-13 (February 2004).
---------------------------------------------------------------------------

    NASAA suggested reinstating the numerical stock limit if FINRA 
determines to eliminate the convertible securities valuation formula. 
Rothwell stated that FINRA should not now impose a limit in a manner 
that would artificially restrict permissible venture, lending and other 
services that benefit corporate financing clients. Rothwell also stated 
that any numerical restriction on private placement purchases by a 
member or affiliate of the securities of the issuer would be contrary 
to the interest of issuers that look to the FINRA members that will 
participate in its public offering to also purchase a significant 
portion of any pre-IPO private placement. Similarly, Rothwell stated 
that the customers of such members that purchase pre-IPO private 
placement securities generally expect that the member will share the 
risk of the investment by being a co-investor. With respect to 
securities acquired in venture and lending activities where the 
participating member must take a significant financial investment, 
Rothwell stated that the current requirements of Rule 5110 have and 
will continue to effectively limit the amount of securities acquired as 
underwriting compensation.
    Because the proposed rule change would retain the current Rule 5110 
formula for valuing options, warrants and convertible securities, the 
proposed rule change does not incorporate a new stock numerical limit.
Exemptive Relief
    As set forth in the Notice 17-15 Proposal, Rule 5110 would have 
been amended to provide that FINRA may in exceptional and unusual 
circumstances exempt a member from any or all or the provisions in the 
Rule that FINRA deems appropriate in lieu of the current approach that 
appropriate FINRA staff, for good cause shown may grant a conditional 
or unconditional exemption from any of the Rule's provisions. Two 
commenters questioned whether the change from the exemptive relief 
provision in the current Rule is intended to limit the circumstances in 
which an exemption may be sought.\149\
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    \149\ See ABA and SIFMA.
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    The Notice 17-15 Proposal would have amended the exemptive relief 
provision in Rule 5110 to be consistent with the exemptive relief 
provision in the more recently amended Rule 5121. Because the change 
was not intended to alter the circumstances in which exemptive relief 
may be sought, the proposed rule change would revert to the language in 
current Rule 5110 to avoid any confusion regarding the granting of 
exemptive relief.
Non-Cash Compensation
    While acknowledging that the non-cash compensation-related 
provisions in the Notice 17-15 Proposal are also in the current Rule, 
SIFMA recommended clarifying these provisions and eliminating inherent 
inconsistencies between the provisions and the rest of the Rule. To 
this end, SIFMA suggested revising proposed Rule 5110(f)(2) to state 
``in connection with the sale and distribution of a public offering of

[[Page 18618]]

securities, no member or person associated with a member shall directly 
or indirectly accept or make payments or offers of payments of any non-
cash compensation, except as provided in this provision, `or as 
permitted elsewhere in this Rule.' '' Alternatively, SIFMA suggested 
adding guidance in the Supplementary Material providing that the 
receipt of non-cash compensation items (including securities, 
derivatives and ROFRs) that are permitted under other provisions of 
Rule 5110 will not be prohibited by, or deemed inconsistent with, the 
restrictions in Rule 5110(g).
    ABA also suggested addressing Rule 5110's non-cash compensation-
related provisions in this proposed rule change. ABA suggested that if 
applied literally, the non-cash compensation provisions state that 
members may not receive any non-cash compensation other than those 
limited items set forth in the provision itself, and those items do not 
include certain forms of non-cash compensation such as securities, 
derivative instruments or ROFRs that are expressly permitted elsewhere 
in the Rule.
    Consistent with the Notice 17-15 Proposal, because the provisions 
are the subject of a separate consolidated approach to non-cash 
compensation, the proposed rule change would incorporate the Rule's 
current non-cash compensation provisions without modification.
Rule 5121
    ABA suggested some clarifications and amendments to Rule 5121. 
Because any substantive changes to Rule 5121 are more appropriately 
considered as part of FINRA's separate consideration of our rules and 
programs governing the capital raising process and their effects on 
capital formation, this proposed rule change does not include any 
amendments to Rule 5121 beyond the conforming definitional amendments 
discussed above.
Regulation A+
    ADISA stated that FINRA should be more responsive to the review and 
clearance of filings made pursuant to SEC Regulation A+ as extensive 
and long reviews of those offerings have impacted members' ability to 
effectively raise capital through the public markets. FINRA will 
continue to review our internal operations and administrative processes 
to improve the review and clearing of these filings. Separate from this 
proposed rule change, FINRA will consider the appropriateness of 
issuing guidance regarding underwriting and related services and 
financial services provided to issuers in offerings pursuant to 
Regulation A+.
Guidance
    EGS requested that the Public Offering Frequently Asked Questions 
available on FINRA's website be enhanced and that FINRA publish 
informal interpretations more broadly and circulate guidance to members 
and their counsel more frequently. If the proposed rule change is 
approved, FINRA will consider providing additional guidance as 
necessary and appropriate.

III. Date of Effectiveness of the Proposed Rule Change and Timing for 
Commission Action

    Within 45 days of the date of publication of this notice in the 
Federal Register or within such longer period up to 90 days (i) as the 
Commission may designate if it finds such longer period to be 
appropriate and publishes its reasons for so finding or (ii) as to 
which the self-regulatory organization consents, the Commission will:
    A. By order approve or disapprove such proposed rule change, or
    B. institute proceedings to determine whether the proposed rule 
change should be disapproved.

IV. Solicitation of Comments

    Interested persons are invited to submit written data, views, and 
arguments concerning the foregoing, including whether the proposed rule 
change is consistent with the Act. Comments may be submitted by any of 
the following methods:

Electronic Comments

     Use the Commission's internet comment form (http://www.sec.gov/rules/sro.shtml); or
     Send an email to rule-comments@sec.gov. Please include 
File Number SR-FINRA-2019-012 on the subject line.

Paper Comments

     Send paper comments in triplicate to Secretary, Securities 
and Exchange Commission, 100 F Street NE, Washington, DC 20549-1090.

All submissions should refer to File Number SR-FINRA-2019-012. This 
file number should be included on the subject line if email is used. To 
help the Commission process and review your comments more efficiently, 
please use only one method. The Commission will post all comments on 
the Commission's internet website (http://www.sec.gov/rules/sro.shtml). 
Copies of the submission, all subsequent amendments, all written 
statements with respect to the proposed rule change that are filed with 
the Commission, and all written communications relating to the proposed 
rule change between the Commission and any person, other than those 
that may be withheld from the public in accordance with the provisions 
of 5 U.S.C. 552, will be available for website viewing and printing in 
the Commission's Public Reference Room, 100 F Street NE, Washington, DC 
20549, on official business days between the hours of 10:00 a.m. and 
3:00 p.m. Copies of the filing also will be available for inspection 
and copying at the principal office of FINRA. All comments received 
will be posted without change. Persons submitting comments are 
cautioned that we do not redact or edit personal identifying 
information from comment submissions. You should submit only 
information that you wish to make available publicly. All submissions 
should refer to File Number SR-FINRA-2019-012, and should be submitted 
on or before May 22, 2019.

    For the Commission, by the Division of Trading and Markets, 
pursuant to delegated authority.\150\
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    \150\ 17 CFR 200.30-3(a)(12).
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Eduardo A. Aleman,
Deputy Secretary.
[FR Doc. 2019-08774 Filed 4-30-19; 8:45 am]
 BILLING CODE 8011-01-P