FINRA “Anti-Spinning” Rule 5131

The anti-spinning provisions of FINRA Rule 5131, which addresses certain conflicts of interest in allocation of New Issues, will go into effect September 26, 2011. Although Rule 5131 only applies to FINRA members (broker-dealers), hedge funds that invest in initial public offerings will be required to provide certain representations to their broker-dealer before they will be allowed to participate in New Issues. The definition of “New Issues” for purposes of Rule 5131 is the same as for FINRA Rule 5130, and includes most initial public offerings of equity securities.

Please note: Rule 5131 does not replace Rule 5130 and it creates additional requirements with respect to New Issues.

Spinning Prohibition

The purpose of the anti-spinning provision of FINRA Rule 5131 is to prohibit the practice of broker-dealers from allocating New Issues to executive officers and directors of current or potential clients in exchange for investment banking business (the practice commonly known as “spinning”).

Rule 5131 generally prohibits a broker-dealer from allocating New Issues to any account (including an account maintained by a hedge fund) in which beneficial interests are held by the following persons, if the broker-dealer currently has or has the expectation of a relationship with that company:

• an executive officer or director of a public company or a covered non-public company, or
• a person materially supported by such executive officer or director.

25% De Minimus Exemption

In addition to specific exemptions for certain types of accounts, the prohibition does not apply to an account where the interests of executive officers or directors of a public company or a covered non-public company, or persons materially supported by them, are less than 25% of such account. This means that if two investors in a hedge fund are both directors of the same public company but their combined interest in the fund is 20% of the fund, the broker-dealer will not be prohibited from allocating New Issues to that hedge fund.

Broker-Dealer Compliance with Rule 5131

Before allocating New Issues to any account, a broker-dealer will need to confirm the following:

• whether the underlying investors in the account are executive officers or directors of a public company or a covered non-public company, or persons materially supported by them;
• if yes, what company that investor is associated with, and
• whether the interests of any one company are more than 25% of the account.

Correspondingly, investment managers will need to obtain this information from the underlying investors in their fund.

Implications for Investment Managers

If you currently manage a fund that invests in New Issues, you will likely be asked to complete a Rule 5131 certification by your broker-dealer. You will need to contact your existing investors and obtain written representations regarding their status, which may be done in the form of a questionnaire. You will also need to revise your hedge fund subscription documents to include similar representations for each new investor. Investor representations will need to be updated annually, which may be done through the use of a negative consent letter.

Even if more than 25% of the fund is owned by executive officers or directors (or persons materially supported by them) of one company, the fund may still participate in New Issues by implementing “carve-out” procedures to reduce the beneficial interests of those persons below 25%. Managers wishing to make use of such carve-outs should make sure the operating documents of their fund allow such procedures.

Please contact us if you need assistance in preparing questionnaires, revising offering documents or if you have questions regarding your ability to participate in New Issues under Rule 5131.

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Cole-Frieman & Mallon LLP is a firm with a practice focused on investment management law.  Bart Mallon is a hedge fund attorney and can be reached directly at 415-868-5345.