Finra in surprise proposal to allow predicted returns in marketing

A 230 page proposal, which Finra has submitted to the Securities and Exchange Commission for review, would allow the use of predicted returns in marketing and would apply to brokers dealing with institutions and investors possessing assets over $5 million.

The Financial Industry Regulatory Authority Inc. believes that “A member’s views regarding the projected performance of an investment strategy or single security may be useful,” according to its proposal documentation.

However, this proposal has raised concerns among investor protection advocates. Stephen Hall, legal director of Better Markets, told the Financial Times that “Using projections is one of the easiest ways to mislead people. It’s easy for people to think the result is guaranteed. [Finra] are really opening a can of worms.”

The proposal will undergo a public comment period before the SEC decides on its approval, a process that may extend beyond eight months. If approved, the change would significantly impact the marketing of private funds, a sector known for higher fees and growing investor interest due to potentially higher returns compared to public markets.

Lance Dial, a partner at K&L Gates law firm, told the FT, “This is a big change. It is good for fund managers who want to use this [information] in marketing through brokers.”

Finra’s 210-page filing notes that the rule change aims to align broker regulations more closely with those for fund managers and registered investment advisers, who are currently permitted to use projections in some marketing materials for sophisticated investors.

However, the proposal has stirred debate over the differing responsibilities of brokers and investment advisers. While advisers have a fiduciary duty to prioritize client interests constantly, brokers are only required to recommend products in the client’s best interest without ongoing responsibilities.

The SEC has traditionally been strict about preventing money managers from making future promises to the general public. This stance was evident in September, when the SEC fined nine asset managers for displaying hypothetical results accessible to the general public, totaling $850,000. The nine companies were Banorte Asset Management, BTS Asset Management, Elm Partners Management, Hansen and Associates Financial Group, Linden Thomas Advisory Services, Macroclimate, McElhenny Sheffield Capital Management, MRA Advisory Group and Trowbridge Capital Partners.

Finra’s proposal does include safeguards for investors, requiring brokers to have a sound basis for their estimates and ensuring investors can independently analyze the information or possess the necessary financial expertise. Yet, critics like Hall remain skeptical, fearing that even sophisticated investors could be misled, describing the proposal as “ill-considered and could open the door to lots of mischief.”

The SEC, Finra, and the Securities Industry and Financial Markets Association, the brokers’ industry lobby group, have declined to comment on the proposal.

Inside the Finra proposal:

1. Scope of the Change: The change permits institutional communications, defined as written communications distributed only to institutional investors, to include projections of performance or targeted returns. These communications exclude internal communications of a member firm.
2. Definition of Institutional Investors: Institutional investors are defined broadly, including entities like governmental subdivisions, employee benefit plans with at least 100 participants, qualified plans under the Exchange Act, and others with significant assets.
3. Inclusion of Qualified Purchasers (QPs): Communications that are directed only to QPs and promote private placements sold solely to QPs can also include projected performance and targeted returns. These investors are known as “QP private placement investors.”
4. Additional Protection Obligations: Despite the relaxation of rules, the proposed change imposes additional obligations for investor protection:
   1. Firms must adopt written policies to ensure communications are relevant to the financial situation and objectives of the investor.
   1. Firms should have a reasonable basis for the criteria and assumptions used in performance projections, and they must maintain records supporting these.
   1. Communications must disclose that projected or targeted performance is hypothetical and there’s no guarantee of achievement.
   1. Sufficient information must be provided to help investors understand the criteria, assumptions, risks, and limitations of using these projections in investment decisions.
5. Applicability to Individual Investors: An individual investor with $5 million or more in investments but less than $50 million in assets is both a qualified purchaser under the Investment Company Act and a retail investor for the purposes of Rule 2210.
6. Exemptions: The rule change creates an exception from the prohibition on performance projections for communications that promote or recommend Member Private Offerings or private placements exempt from certain Finra rules, provided they are sold solely to qualified purchasers.

Related Topics: Financial Industry Regulatory Authority Inc., Marketing rule, Securities and Exchange Commission