Tag Archives: FINRA Rule 5131

FINRA Rule 5131 Effective September 26, 2011

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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.

FINRA Rule 5131 – New Issue Allocations and Distributions

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Full Text of FINRA Rule 5131

The following is the full version of FINRA Rule 5131 effective as of September 26, 2011.  This rule, in conjunction with FINRA Rule 5130, governs the manner in which investors may participate in New Issues.  Specifically, Rule 5131 prevents “spinning” which is the practice of allocating new issues to executive officers and directors of current or potential clients in exchange for investment banking business.

The following rule can also be found on the FINRA website here.

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5131. New Issue Allocations and Distributions

(a) Quid Pro Quo Allocations

No member or person associated with a member may offer or threaten to withhold shares it allocates of a new issue as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the member.

(b) Spinning

(1) No member or person associated with a member may allocate shares of a new issue to any account in which 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, has a beneficial interest:

(A) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months;

(B) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next 3 months; or

(C) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.

(2) The prohibitions in this paragraph shall not apply to allocations of shares of a new issue to any account described in Rule 5130(c)(1) through (3) and (5) through (10), or to any other account in which the beneficial interests of executive officers and directors of the company and persons materially supported by such executive officers and directors in the aggregate do not exceed 25% of such account.

(c) Policies Concerning Flipping

(1) No member or person associated with a member may directly or indirectly recoup, or attempt to recoup, any portion of a commission or credit paid or awarded to an associated person for selling shares of a new issue that are subsequently flipped by a customer, unless the managing underwriter has assessed a penalty bid on the entire syndicate.

(2) In addition to any obligation to maintain records relating to penalty bids under SEA Rule 17a-2(c)(1), a member shall promptly record and maintain information regarding any penalties or disincentives assessed on its associated persons in connection with a penalty bid.

(d) New Issue Pricing and Trading Practices

In a new issue:

(1) Reports of Indications of Interest and Final Allocations. The book-running lead manager must provide to the issuer’s pricing committee (or, if the issuer has no pricing committee, its board of directors):

(A) a regular report of indications of interest, including the names of interested institutional investors and the number of shares indicated by each, as reflected in the book-running lead manager’s book of potential institutional orders, and a report of aggregate demand from retail investors;

(B) after the settlement date of the new issue, a report of the final allocation of shares to institutional investors as reflected in the books and records of the book-running lead manager including the names of purchasers and the number of shares purchased by each, and aggregate sales to retail investors;

(2) Lock-Up Agreements. Any lock-up agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer entered into in connection with a new issue shall provide that:

(A) Any lock-up agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer shall provide that such restrictions will apply to their issuer-directed shares; and

(B) At least two business days before the release or waiver of any lock-up or other restriction on the transfer of the issuer’s shares, the book-running lead manager will notify the issuer of the impending release or waiver and announce the impending release or waiver through a major news service, except where the release or waiver is effected solely to permit a transfer of securities that is not for consideration and where the transferee has agreed in writing to be bound by the same lock-up agreement terms in place for the transferor;

(3) Agreement Among Underwriters. The agreement between the book-running lead manager and other syndicate members must require, to the extent not inconsistent with SEC Regulation M, that any shares trading at a premium to the public offering price that are returned by a purchaser to a syndicate member after secondary market trading commences:

(A) be used to offset the existing syndicate short position, or

(B) if no syndicate short position exists, the member must either:

(i) offer returned shares at the public offering price to unfilled customers’ orders pursuant to a random allocation methodology, or

(ii) sell returned shares on the secondary market and donate profits from the sale to an unaffiliated charitable organization with the condition that the donation be treated as an anonymous donation to avoid any reputational benefit to the member.

(4) Market Orders. No member may accept a market order for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market.

(e) Definitions

For purposes of this Rule, the following terms shall have the meanings stated below.

(1) A “public company” is any company that is registered under Section 12 of the Exchange Act or files periodic reports pursuant to Section 15(d) thereof.

(2) “Beneficial interest” shall have the same meaning as in FINRA Rule 5130(i)(1).

(3) “Covered non-public company” means any non-public company satisfying the following criteria: (i) income of at least $1 million in the last fiscal year or in two of the last three fiscal years and shareholders’ equity of at least $15 million; (ii) shareholders’ equity of at least $30 million and a two-year operating history; or (iii) total assets and total revenue of at least $75 million in the latest fiscal year or in two of the last three fiscal years.

(4) “Flipped” means the initial sale of new issue shares purchased in an offering within 30 days following the offering date of such offering.

(5) “Investment banking services” include, without limitation, acting as an underwriter, participating in a selling group in an offering for the issuer or otherwise acting in furtherance of a public offering of the issuer; acting as a financial adviser in a merger, acquisition or other corporate reorganization; providing venture capital, equity lines of credit, private investment, public equity transactions (PIPEs) or similar investments or otherwise acting in furtherance of a private offering of the issuer; or serving as placement agent for the issuer.

(6) “Material support” means directly or indirectly providing more than 25% of a person’s income in the prior calendar year. Persons living in the same household are deemed to be providing each other with material support.

(7) “New issue” shall have the same meaning as in Rule 5130(i)(9).

(8) “Penalty bid” means an arrangement that permits the managing underwriter to reclaim a selling concession from a syndicate member in connection with an offering when the securities originally sold by the syndicate member are purchased in syndicate covering transactions.

(9) “Unaffiliated charitable organization” is a tax-exempt entity organized under Section 501(c)(3) of the Internal Revenue Code that is not affiliated with the member and for which no executive officer or director of the member, or person materially supported by such executive officer or director, is an individual listed or required to be listed on Part VII of Internal Revenue Service Form 990 (i.e., officers, directors, trustees, key employees, highest compensated employees and certain independent contractors).

• • • Supplementary Material: ————–

.01 Issuer Directed Allocations. The prohibitions of paragraph (b) above shall not apply to allocations of securities that are directed in writing by the issuer, its affiliates, or selling shareholders, so long as the member has no involvement or influence, directly or indirectly, in the allocation decisions of the issuer, its affiliates, or selling shareholders with respect to such issuer-directed securities.

.02 Annual Representation. For the purposes of paragraph (b), a member may rely on a written representation obtained within the prior 12 months from the beneficial owner(s) of the account, or a person authorized to represent the beneficial owner(s) of the account, as to whether such beneficial owner(s) is an executive officer or director or person materially supported by an executive officer or director and if so, the company(ies) on whose behalf such executive officer or director serves. A member may not rely upon any representation that it believes, or has reason to believe, is inaccurate. A member shall maintain a copy of all records and information relating to whether an account is eligible to receive an allocation of the new issue under paragraph (b) in its files for at least three years following the member’s allocation to that account.

.03 Lock-up Announcements. For the purposes of this Rule, the requirement that the book-running lead manager announce the impending release or waiver of a lock-up or other restriction on the transfer of the issuer’s shares shall be deemed satisfied where such announcement is made by the book-running lead manager, another member or the issuer, so long as such announcement otherwise complies with the requirements of paragraph (d)(2) of this Rule.

Amended by SR-FINRA-2011-017 eff. Sept. 26, 2011.

Adopted by SR-NASD-2003-140 eff. May 27, 2011.

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Cole-Frieman & Mallon LLP is a hedge fund law firm.  Bart Mallon can be reached directly at 415-868-5345.