Deferred Underwriting Compensation in Public Offerings

The following post comes to us from Robert Buckholz, partner and co-coordinator of the Corporate and Finance Group at Sullivan & Cromwell LLP, and is based on a Sullivan & Cromwell publication.

FINRA proposes to amend Rule 5110, the Corporate Financing Rule, to permit a broader range of deferred compensation arrangements between member firms and issuers regarding future public offerings, provided the arrangements meet two significant new requirements. [1] Under the proposal, engagement letters for underwriting and financial advisory services will be permitted to include termination fees and rights of first refusal, but must specify that any future underwriting fees be reasonable or customary and must permit the issuer to terminate these arrangements for cause. As is currently the case, the arrangements also must be limited to two or three years in duration as described below. While the proposal will provide member firms more flexibility to negotiate deferred compensation arrangements with their issuer clients, they should consider the potential impact of the proposed new requirements on their engagement letter practices. Separately, FINRA also proposes to amend Rule 5110 to exempt a broader range of exchange-traded fund (“ETF”) offerings from the filing requirement of the Rule. FINRA has asked for comments on the proposals by July 23, 2012.


FINRA Rule 5110 generally prohibits member firms participating in a public offering from entering into underwriting terms and arrangements with the issuer that are unfair or unreasonable, and requires the members to submit documents and information about the terms and arrangements to FINRA’s Corporate Financing Department for review. Rule 5110 currently prohibits a number of arrangements as unreasonable per se, including termination fees and rights of first refusal in certain circumstances. These two types of arrangements are often set forth in engagement letters in which a member agrees with an issuer to provide financial advisory and underwriting services in connection with a future public offering. FINRA notes that, in these circumstances, the issuer may have important business reasons for wanting to defer payment of compensation to the member for its financial advisory services until the transaction occurs, while the member may be concerned that, if payment is deferred until that time, the issuer could unreasonably terminate the engagement without compensating the member for the advisory services already rendered. To address these points, an engagement letter may defer payment of such compensation until after the transaction is completed, but provide for termination fees or rights of first refusal to protect the member’s interests. A termination fee (also known as a “tail fee”) provides for the member to receive compensation for services performed if the issuer terminates the engagement before a transaction is completed and subsequently consummates a similar transaction with another underwriter. A right of first refusal grants the member the right to act as an underwriter (or in some other agreed-upon capacity) in a subsequent financing transaction in the event the transaction initially contemplated is not consummated.

FINRA states that, under Rule 5110 as currently in effect, termination fees are permitted only in connection with exchange offers or similar transactions in which a member has provided substantial structuring and advisory services beyond traditional underwriting and distribution services. [2] With regard to rights of first refusal, the Rule currently permits such rights on certain conditions [3] but FINRA has interpreted the Rule to prohibit these rights when a member’s participation in the original transaction is terminated.

In its proposal, FINRA expresses concern that the current restrictions on termination fees and rights of first refusal may “unnecessarily interfere with the ability of issuers and underwriters to negotiate deferred or other appropriate compensation arrangements that may be better suited to the issuer’s business interests.” For this reason, FINRA states, it has proposed to amend the Rule to permit these fees and rights in a wider set of circumstances.

Proposed Amendments

FINRA proposes to amend the Rule to allow termination fees and rights of first refusal when the written agreement between the issuer and the member specifies that:

  • the amount of the termination fee must be reasonable in relation to the services contemplated in the agreement and the fees arising from the services provided under a right of first refusal must be customary for those types of services;
  • the issuer has a right of “termination for cause,” which shall include the member’s material failure to provide the services contemplated in the agreement; and
  • an issuer’s termination for cause eliminates any obligations with respect to any termination fee or right of first refusal.

The proposed amendments would not change the time frame in which termination fees may be paid and for which rights of first refusal may be granted. As proposed to be amended, the Rule would continue to prohibit a termination fee unless the future offering (or other specified transaction) is consummated within two years after the engagement is terminated, and would continue to prohibit a right of first refusal with a duration beyond three years after commencement of sales in the public offering or the termination of the engagement. [4] FINRA believes that these time limits will help ensure that the issuer is not subject to a termination fee or right of first refusal even after its business and operations may have changed significantly.

Members should review their underwriting engagement letter practices in light of the proposed changes, assuming they take effect. In particular, engagement letters that provide for a termination fee or right of first refusal must permit the issuer to terminate its obligations relating to any such fee or right “for cause.” FINRA does not define this term in the proposal, but the amended Rule would state that it shall include material failure of the member to provide the contemplated services. Thus, the scope of the issuer’s required termination right is not clear. In addition, it would appear that the engagement letter must specify that any termination fee will be “reasonable” and any fee arising from a right of first refusal will be “customary.” It is not clear how this requirement would affect the inclusion of other provisions setting forth the amount of the fee or how it is to be determined.

Exemption from Filing for Certain Exchange-Traded Funds

The proposal would also expand the filing exemption for public offerings of securities issued by ETFs. FINRA states that most ETFs are structured as open-end investment companies or unit investment trusts (“UITs”) that offer redeemable securities, and that investment companies and UITs are exempt from regulation under the Corporate Financing Rule. [5] FINRA notes, however, that some ETFs are structured as statutory trusts or grantor trusts and the portfolio assets in these trusts typically are commodities, currencies or other assets that are not securities. Currently, there is no exemption for public offerings of ETFs structured in this manner and, as a result, these offerings are required to comply with the filing and other requirements of Rule 5110. FINRA states that ETFs should be treated consistently, without regard to their formal legal structures, which it believes are dictated by the nature of the assets in the portfolio rather than differences in distribution methods or underwriting arrangements. Accordingly, the proposal would exempt from the Rule’s filing requirement offerings of securities issued by ETFs formed as grantor or statutory trusts in which the portfolio assets include commodities, currencies or other assets that are not securities. [6] FINRA does not say why these ETFs would be exempt only from the filing requirement and not all the requirements of the Rule.

Request for Comments

The comment period for the proposed amendments ends on July 23, 2012. Before becoming effective, the proposal must be authorized by FINRA’s Board of Governors and must be filed with the SEC for its approval.


[1] See Regulatory Notice 12-27, available at
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[2] As written, the Rule generally prohibits compensation for a member in connection with an offering of securities that is not completed according to the terms of the agreement with the issuer, and further prohibits tail fees with a duration of more than two years after termination of the member’s services. See paragraphs (f)(2)(D) and (E) of Rule 5110. FINRA proposes to modify the general prohibition to permit termination fees on specified conditions and to delete the paragraph on tail fees.
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[3] As written, the Rule permits rights of first refusal as long as their duration is limited to three years after commencement or effectiveness of the public offering and they cannot be waived or terminated for a fee on more than one occasion. The Rule also prohibits payments to waive or terminate such rights relating to a future offering in excess of 1% of the offering proceeds, if granted in connection with an initial offering, or 5% of the underwriting discount in a future offering, regardless of when granted. See paragraphs (f)(2)(F) and (G) of Rule 5110. The proposal would maintain these requirements with one change to the limitation on duration as described below.
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[4] The reference to the termination of the engagement would be new and presumably would override FINRA’s current interpretation that these rights are prohibited when the member’s participation in the original transaction has been terminated.
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[5] Paragraph (b)(8) of Rule 5110 exempts from the requirements of the Rule – both the filing requirement and the requirements governing underwriting terms and arrangements – offerings of securities of “open-end” and “closed-end” investment companies, as defined in Section 5(a) of the Investment Company Act, that make periodic repurchase offers and offer their shares on a continuous basis pursuant to specified SEC rules.
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[6] See new subsection (h) of Rule 5110(b)(7).
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