FINRA Relaxes Restrictions on Related Performance in Institutional Communications

On May 12, 2015, the Financial Industry Regulatory Authority (“FINRA”) issued an interpretive letter (the “Letter”) [1] permitting the use of Related Performance Information (as defined below) in communications distributed solely to institutional investors regarding registered funds.  Related Performance Information is defined as the actual performance of all separate or private accounts or funds that have (i) substantially similar investment policies, objectives, and strategies, and (ii) are currently managed or were previously managed by the same adviser or sub-adviser that manages the registered fund that is the subject of the communication. 

The distribution of Related Performance Information to institutional investors in connection with “due diligence” reviews of registered and private funds has long been a common industry practice, as noted in several comment letters (including K&L Gates’ comment letter) provided to FINRA in connection with its retrospective review of Rule 2210 last spring.[2]  However, member firms now have additional clarity that the distribution of Related Performance Information in the manner described below is not inconsistent with Rule 2210.

Background
On its face, Rule 2210 applies to all written (including electronic) communications “distributed or made available” to retail investors and institutional investors by member firms.  Although the filing and pre-use approval requirements vary depending on the recipient of a written communication, the content standards contained in Rule 2210(d) apply broadly to all written communications by member firms regardless of the nature of the recipients or the circumstances in which the communications are distributed.  In particular, pursuant to Rule 2210(d) and FINRA interpretations thereof, communications by member firms: must provide balanced treatment of risks and potential benefits;[3] may not predict or project performance;[4] and may not include any hypothetical or backtested performance information.[5]  Further, FINRA has historically interpreted Rule 2210(d) to restrict members from distributing sales material that includes Related Performance Information, with the exception of sales material for Section 3(c)(7) funds presented solely to “qualified purchasers” as defined under Section 2(a)(51) of the Investment Company Act of 1940, as amended.[6]

As noted in the Letter, institutional investors often request Related Performance Information from member firms in connection with their review and “due diligence” analysis of a mutual fund.  Such information often forms a critical part of the institutional investor’s due diligence of the fund and its investment adviser, particularly where the fund has limited operating history, and assists the institutional investor in determining whether the fund is a suitable investment for its customers.  Accordingly, to avoid impeding an institutional investor’s analysis of a fund, an industry practice has developed over time whereby member firms provide Related Performance Information upon an institutional investor’s request, notwithstanding the restrictions of Rule 2210(d).

Interpretive Relief
In recognition of the overbroad application of Rule 2210(d) and the fact that communications provided solely to institutional investors do not raise the same investor protection concerns as materials provided to retail investors, FINRA has relaxed its historic position and will now allow the use of Related Performance Information in institutional communications.  In addition to complying with all other applicable FINRA rules and federal securities laws, communications containing Related Performance Information are subject to the following conditions:

• The materials must be provided only to “institutional investors” as defined in FINRA Rule 2219(a)(4);[7]
• The Related Performance Information must: (i) include all accounts that are within the definition of Related Performance Information (“Related Accounts”); (ii) be for a period of at least one year and since the inception of the investment strategy; (iii) be current as of the most recently ended calendar quarter; and (iv) be clearly labeled as such and contain clear disclosure of the applicable dates for the performance;
• If there are multiple Related Accounts, they must be presented: (i) in a composite; or (ii) with equal prominence in a list;
• Any communication with Related Performance Information must be clearly labeled “for use with institutions only, not for use with retail investors,” and recipients must be instructed not to provide the communication to noninstitutional investors;
• The Related Performance Information must be shown net of fees and expenses of the Related Accounts, or net of a model fee that is the highest fee charged to any account managed in the strategy.  Gross performance may also be shown, along with required disclosures;
• The fees and expenses of the registered fund that is the subject of the communication must be disclosed, and the registered fund’s actual performance must be shown net of fees and more prominently than the Related Performance Information; and
• The communication must disclose any material differences between the funds or accounts for which Related Performance Information is provided and the registered fund that is the subject of the communication.

FINRA’s position that the presentation of Related Performance Information to retail investors does not comply with Rule 2210 remains unchanged by this interpretive relief.

Analysis and Interpretive Issues
The relief granted by FINRA in the Letter provides much needed clarity to member firms regarding their compliance with Rule 2210 when faced with requests by institutional investors for Related Performance Information.  However, the relief also leaves a number of interpretive questions unanswered.  For example:

• The Letter primarily addresses the provision of Related Performance Information in response to requests from institutional investors that are intermediaries in connection with their due diligence reviews of registered funds.  It is unclear whether member firms may provide Related Performance Information in registered fund marketing materials that have not been specifically requested by an institutional investor.  However, because FINRA adopts the rationale used in the Kawata Letter (concerning “sales materials” for Section 3(c)(7) funds) in granting this interpretive relief, we can infer that the use of Related Performance Information in registered fund “sales materials” provided solely to institutional investors is also permitted.[8]
• Pursuant to the Letter and the Kawata Letter, Related Performance Information may now be presented in communications relating to: (1) Section 3(c)(7) funds, provided the recipients are “qualified purchasers”; and (2) registered funds, provided the recipients are “institutional investors.”  However, FINRA has not addressed the use of Related Performance Information in communications regarding other types of securities products, such as Section 3(c)(1) funds, Section 3(c)(11) funds, or Rule 144A offerings, which require investors to meet standards other than “qualified purchaser” or “institutional investor.”  Further, if a registered fund has both retail and institutional investors, providing Related Performance Information only to “institutional investors” creates a potential selective disclosure issue similar to that illustrated by FINRA in its interpretive letter to Budge Collins, Collins/Bay Island Securities.[9]  This concern can be ameliorated by ensuring that any Related Performance Information that is provided to institutional investors is also included in the registered fund’s offering documents.
• The Letter represents a step toward harmonizing FINRA and U.S. Securities and Exchange Commission (“SEC”) advertising standards.  For example, registered investment advisers and funds are explicitly permitted to provide Related Performance Information to prospective investors under SEC rules and staff guidance.[10]  However, FINRA’s guidance applies only to institutional investors.  Accordingly, registered representatives of member firms who are also associated persons of a fund’s investment adviser (“Dual Employees”) must continue to attempt to delineate when they are communicating on behalf of the investment adviser, particularly when communicating with noninstitutional investors.

While the Letter will not result in a fundamental shift in the industry’s approach to providing Related Performance Information, it does provide welcome clarity for member firms that providing Related Performance Information to institutional investors does not violate Rule 2210.  Perhaps more importantly, it also represents an important step in FINRA’s ongoing efforts to interpret its rules in a way that better aligns their investor protection benefits with their impact on member firms and other market participants.