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If your company is structured as a limited liability company (“LLC”) rather than as a corporation and you want to raise money through a public offering of your company’s securities, whether by way of a registration statement filed with the Securities and Exchange Commission (the “SEC”), under Section 5 of the Securities Act of 1933 or through an offering statement qualified by the SEC in a Regulation A offering, you may have to pay attention to, and potentially comply with, Rule 2310 of the Financial Industry Regulatory Authority (“FINRA”), governing direct participation programs (“DPPs”).

File a 5110 Application

If your company wants to sell its securities through an SEC registered and FINRA member broker-dealer you will have to file with FINRA what is called a 5110 application listing all of the direct and indirect compensation (e.g., cash commissions, warrants, broker legal fees, accountable expenses, trail commissions, rights of first refusal) that the company intends to pay to the broker-dealer who will be selling the offering, and FINRA will have to approve the reasonableness of this compensation.  If FINRA determines that the amount of “all in” compensation to the broker-dealer is too high, that is, unreasonable, it will not allow the broker-dealer to participate in the offering unless the broker-dealer’s compensation is reduced to what FINRA considers, according to its analysis of applicable FINRA rules and its subjective interpretation of those rules, a “reasonable” amount.

If your company’s offering is deemed by FINRA to be a DPP, not only will FINRA limit the amount of direct and indirect compensation you can pay your broker-dealer/selling agent but if FINRA thinks your company’s organization and offering (“O&O”) expenses are too high, it will not allow the FINRA member broker-dealer to participate in the offering at all, unless O&O expenses are appropriately reduced.

What Are O&O Expenses?

Under Rule 2310(a)(12), FINRA defines O&O expenses as those expenses incurred in preparing a direct participation program for registration (or qualification) and subsequently offering interests in the program to the public.  Under this rule, O&O expenses would include, for example, SEC and FINRA filing fees, exchange application and listing fees, legal and accounting expenses, and printing and blue-sky fees. Rule 2310 also includes within O&O expenses all forms of compensation paid to underwriters, broker-dealers or their affiliates in connection with the DPP offering. FINRA Rule 2310 caps O&O expenses for a DPP at 15% of the gross proceeds of the offering. Included within this 15% cap is a 10% cap on the total amount of all forms of compensation from whatever source that can be paid to the broker-dealer.

If your company’s offering is not a direct participation program, FINRA Rule 2310 and its limitations on O&O expenses will not apply (although FINRA caps on underwriting fees will still apply).

Understanding Direct Participation Programs

FINRA Rule 2310 defines a direct participation program as “a program which provides for flow-through tax consequences regardless of the structure of the legal entity or vehicle for distribution including, but not limited to, oil and gas programs, real estate programs, agricultural programs, cattle programs, condominium securities, Subchapter S corporate offerings and all other programs of a similar nature, regardless of the industry represented by the program, or any combination thereof.”

A DPP provides investors with access to cash flow and tax benefits. DPPs were popular investment vehicles in the 1980s and 1990s when they were structured as limited partnerships investing, typically, in real estate pools or oil and gas development programs. Although these types of direct participation programs are no longer in vogue, FINRA DPP rules are still in effect.

Choose Your Tax Structure Carefully

If your company is structured as a limited liability company and it chooses to be taxed as a limited partnership rather than as a corporation, no matter what the industry or business of the company, if you chose to conduct a public offering through a registered broker-dealer, FINRA’s DPP rules, specifically its limitations on O&O expenses and broker-dealer compensation, will apply. You may choose taxation as a limited partnership to avoid double taxation and to provide greater cash flow to your shareholders, but beware, FINRA will be watching … and limiting your flexibility!