FINRA Settlement Highlights Issues Under Corporate Financing Rule

In December 2024, FINRA entered into a settlement agreement with a U.S. broker-dealer arising from failures to comply with FINRA's Corporate Financing Rule (FINRA Rule 5110). The related consent agreement imposed a fine on the broker-dealer relating to these issues, which mainly occurred in connection with an initial public offering of a special purpose acquisition company ("SPAC"). The consent agreement is a useful reminder of several key compliance issues that underwriters face when working on a variety of types of public offerings, including, but not limited to, SPACs.

Key Allegations

According to the agreement, in 2020 and 2021, while participating in the initial public offering for the SPAC, the broker-dealer (or its affiliate, which was the SPAC's sponsor) received underwriting compensation from the issuer that was (a) unreasonable and (b) inaccurately described in the offering documents and to FINRA. In addition, the broker-dealer failed to make, or failed to make on a timely basis, required filings with FINRA in connection with a number of public offerings.

Many of the allegations relate to securities received by the broker-dealer or its affiliate in connection with the SPAC offering. In a sense, a SPAC offering can be a situation in which the application of the Corporate Financing Rule is tested most fully – in these transactions, the common practice of offering equity-linked compensation to the SPAC sponsor and/or underwriter must be evaluated very carefully against the considerable amount of regulation that applies under the Corporate Financing Rule.

Incorrect Descriptions of Underwriting Compensation

The broker's incorrect descriptions of its compensation sets the tone for many of the issues identified in the agreement. Rule 5110(b) requires each item of underwriting compensation received by a participating member to be disclosed in the prospectus or similar offering document. Rule 5110 Supplementary Material (.05) requires a description of the compensation that contains all of the material terms and arrangements relating to any securities to be acquired, including the exercise terms for warrants and any applicable lock-up periods. On a related point, a violation of FINRA Rule 5110 is also a violation of FINRA Rule 2010, which requires member firms to observe high standards of commercial honor and just and equitable principles of trade in the conduct of their business. Providing untrue or misleading information to FINRA is inconsistent with just and equitable principles of trade and therefore, in FINRA's view, violates FINRA Rule 2010.

The following table compares the compensation that the broker represented that it or its sponsor affiliate was receiving, vs. what it actually received.

Exercisability of Warrants. The prospectus describing the underwriting terms, which FINRA approved, stated that the warrants would expire five years after the IPO date. However, the actual warrant agreement provided for a longer exercise period. This difference is problematic, as FINRA Rule 5110(g)(8)(A) provides that one form of unreasonable compensation for an underwriter would be warrants or other convertible securities that are exercisable more than five years after the commencement of the applicable public offering.

Lock-up. The prospectus for the IPO stated that the securities received as underwriting compensation were subject to a 360-day lock-up period. However, these terms were not included in the agreements governing the warrants. Current FINRA Rule 5110(e)(1)(A) provides that, in general, any underwriting compensation consisting of securities must be subject to a lock-up period of at least 180 days after the commencement of the related equity offering.

Unfair Underwriting Arrangements

FINRA Rule 5110 prohibits unfair underwriting arrangements in connection with the public offering of securities. Specifically, Rule 5110(a)(1)(A) provides that “no member or person associated with a member shall participate in a public offering in which the terms and conditions relating thereto, including the aggregate amount of underwriting compensation, are unfair or unreasonable pursuant to this Rule or inconsistent with any By-Law or any rule or regulation of FINRA.” Under FINRA Rule 5110(j)(4), non-cash compensation, including securities, received by the participating members constitutes compensation under the rule, and the Corporate Financing Rule contains provisions for valuing these securities. In fact, valuing these securities for compliance with the Rule is an important task for an underwriter and its counsel in connection with the FINRA filing process.

In 2021, the SPAC entered into a business combination. The SPAC and its sponsor agreed to convert all of the private warrants held by the sponsor into a right to receive shares of the SPAC immediately prior to the effective date of the merger. The merger became effective in October 2021, and due to the warrant exchange and the exercise of an overallotment option, the sponsor received a total of 3,146,454 shares in the merged company at no additional cost. These securities constitute underwriting compensation under FINRA Rules 5110(c)(2) and (4), and their value alone represented more than 30% of the total public offering proceeds from the IPO; FINRA deemed this amount to be unreasonable. Of course, without the full correct information at the time of the IPO, FINRA's Corporate Financing Department could not have properly valued the securities in connection with its review of the underwriting arrangements.

Untimely Filings with FINRA

FINRA Rule 5110(a)(1)(C) requires member firms that participate in public offerings to file specified information with FINRA about the underwriting terms and arrangements; these filings enable FINRA to determine whether the underwriting terms and arrangements satisfy its rules. Rule 5110(a)(4) provides that the documents required to be filed include, among others, the registration statement and any other document used to offer the securities, all documents that relate to the underwriting terms and arrangements, including any proposed underwriting agreement or warrant agreement, and the final registration statement declared effective by the SEC and the notice of effectiveness. Rule 5110(a)(3) requires the documents to be filed no later than three business days after these documents are filed with or submitted to the SEC, or at least 15 days prior to the commencement of sales if they are not filed with the SEC. Rule 5110(a)(4) also requires amendments to any documents reflecting changes to the underwriting terms and arrangements to be filed with FINRA.

FINRA determined that the broker violated these rules. FINRA indicated that on 13 occasions between July 2020 and April 2023, both in connection with the SPAC IPO at issue and two other public offerings, the broker did not file with FINRA the required documents, and did not file any documents relating to changes to the underwriting terms. FINRA also determined that in connection with the SPAC offering and one other public offering, the broker failed to timely file documents six times. The late filings ranged from less than one month to more than seven months late.

Supervisory Systems and WSPs

Current FINRA Rule 3110 require FINRA members to establish and maintain a system to supervise the activities of associated persons that is reasonably designed to achieve compliance with applicable securities laws and regulations, and FINRA rules. The rule also requires member firms to establish, maintain, and enforce written supervisory procedures ("WSPs") to supervise its businesses and the activities of its associated persons.

FINRA concluded that the broker failed to establish and maintain a supervisory system reasonably designed to achieve compliance with FINRA Rule 5110. The broker did not have procedures to determine the fairness of underwriting compensation or discuss the filing requirements imposed by the rule. The broker did not implement any supervisory review to monitor its underwriting compensation (both contemplated and received) or its filings with FINRA, or assign supervisory responsibility for compliance with FINRA Rule 5110 to any individual or supervisor.

Sanctions

As a result of these findings, the broker dealer was subjected to:

• a censure;
• a fine of $900,000;
• an undertaking that it would remediate the issues identified in the agreement and implement an appropriate supervisory system.

Conclusion

The extent of the compliance issues described in the agreement are unusual. However, they are a useful reminder for lead underwriters:

• to ensure that they have systems in place to ensure the timely and accurate filing with FINRA of required public offering materials, including amendments; and
• to ensure that all compensation arrangements, and especially the receipt of any securities, are designed to be in compliance with relevant FINRA rules, and to evaluate the individual elements of compensation and the total amount of compensation for compliance with the rules.