Corporate Financing and Conflicts of Interest

The FINRA framework layers on top of the federal registration rules. The federal rules govern whether an offering can happen; the FINRA rules govern whether the underwriting terms and the broker-dealer relationships pass an industry-fairness review.

FINRA Corporate-Financing Rule

The FINRA corporate-financing rule is the substantive review of underwriting terms.

• No member firm may participate in a public offering with unfair or unreasonable underwriting terms
• Compensation guidelines: terms equal to or greater than approximately 9 percent of offering proceeds in an initial public offering (IPO) and 8 percent in other public offerings are considered unreasonable
• 180-day lock-up on securities deemed underwriting compensation, starting on the date of commencement of sales (not the date of effectiveness)
• Filing deadline: documents filed with the SEC must be filed with FINRA within 3 business days after the SEC filing

The "unfair or unreasonable" standard is a totality-of-the-circumstances test. The compensation guidelines are not hard ceilings; they identify the level at which FINRA will scrutinize the deal closely. Actual underwriting fees on most U.S. IPOs are well below the 9 percent threshold (typically around 7 percent for a mid-sized IPO).

Exam Tip: Gotchas

• The 9 percent / 8 percent figures are GUIDELINES, not hard ceilings. The standard is "unfair or unreasonable"; deals at or above the guideline will be scrutinized closely on the facts. Actual underwriting fees are almost always below the guideline.
• The 180-day lock-up clock starts at commencement of SALES, not at effectiveness. A registration that goes effective on day 1 and prices on day 3 starts the lock-up clock on day 3.
• The 3-business-day FINRA filing deadline runs from the SEC filing, not from effectiveness. Missing it can hold up the deal.

FINRA Conflicts Rule and Qualified Independent Underwriter

The FINRA conflicts rule applies when a member firm participates in a public offering with a conflict of interest.

A conflict exists when, among other situations:

• The member is offering its own securities
• The member is an affiliate of the issuer
• The member will receive 5 percent or more of the net offering proceeds (excluding underwriting compensation)
• The issuer is a controlled or controlling person of the member

When a conflict exists, a qualified independent underwriter (QIU) must participate in the offering. The QIU acts as an independent check on pricing and disclosure.

QIU requirements: The QIU must:

• Not have a conflict and not be an affiliate of a conflicted member
• Not beneficially own more than 5 percent of any class of securities of the issuer giving rise to the conflict
• Accept the same civil liability for material misstatements that an underwriter accepts under the registration-statement liability provision (covered in the civil-liabilities section)
• Have acted as lead or co-lead managing underwriter in at least 3 public offerings of similar size and type in the past 3 years
• Have no supervisory principals with disciplinary histories

QIU duties: conduct due diligence on the offering, participate in preparing the offering documents, and recommend the public offering price. "Prominent disclosure" of the conflict of interest and the QIU's role is required in the offering documents.

Exam Tip: Gotchas

• The 5 percent of proceeds test triggers the CONFLICT. The 5 percent ownership cap is what limits who is eligible for the QIU role. Two separate 5 percent tests, two different purposes.
• A QIU must have acted as lead or co-lead in 3 public offerings of similar size and type in the past 3 years. The experience requirement is the hard gating threshold; firms without that track record cannot fill the QIU role.
• The QIU accepts the same civil-liability exposure as a regular underwriter for material misstatements in the registration statement. The QIU is not a back-row participant; it is an underwriter for liability purposes.

Broker-Dealer Disclosure of Control Relationships

Two parallel disclosure regimes (one FINRA, one SEC) require broker-dealers to disclose relationships with the issuer to the customer.

• A member that is controlled by, controlling, or under common control with the issuer must disclose that relationship to the customer before entering into a transaction
• Oral disclosure must be supplemented by written disclosure at or before transaction completion
• The SEC's parallel control-disclosure requirement under the Exchange Act covers the same ground

The rules are designed to surface conflicts that customers might not otherwise see. A broker-dealer whose parent company also controls the issuer has an obvious incentive to push the issuer's securities to customers; the disclosure makes that conflict visible at the point of trade.

Exam Tip: Gotchas

• Control relationships require BOTH oral and written disclosure. Oral disclosure at the time of solicitation is supplemented by written disclosure at or before completion of the transaction.
• The FINRA and SEC rules are parallel, not redundant. A control relationship triggers both; compliance with one does not satisfy the other automatically, though firms typically handle them together.

Broker-Dealer Disclosure of Distribution Participation

A separate FINRA / SEC disclosure regime covers broker-dealer participation in primary or secondary distributions.

• A member acting as broker (or as dealer receiving a customer advisory fee) participating in a primary or secondary distribution must give the customer written notice of that participation at or before transaction completion
• The SEC's parallel distribution-disclosure requirement under the Exchange Act covers the same ground

The distribution disclosure tells the customer that the broker-dealer is not a neutral counterparty for this transaction; the broker-dealer is helping to place the issuer's securities and has an incentive to do so.

Exam Tip: Gotchas

• Distribution-participation disclosure must be in WRITING. Oral disclosure alone is not sufficient.
• The disclosure is required at or before transaction completion. Disclosing the participation after the trade has settled does not satisfy the rule.

Think of it this way: the FINRA framework treats every public offering as a fairness exam with three core questions. Are the underwriting terms fair? (Corporate-financing rule.) Is there an undisclosed conflict between the underwriter and the issuer? (Conflicts rule and QIU.) Is the customer being told about the broker-dealer's relationship with the issuer and with the deal? (Control-disclosure and distribution-disclosure rules.) Each question has a specific rule attached to it, and the deal team has to satisfy all three before the offering can close.