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April 12, 2011
FINRA Rule 5131: What Fund Managers and Broker-Dealers Should Think About Before May 27, 2011

By Marie T. DeFalco, Esq., Scott H. Moss, Esq., and Douglas N. Cohen, Esq.

On May 27, 2011, FINRA Rule 5131, New Issue Allocations and Distributions, becomes effective. Rule 5131, which supplements existing FINRA Rule 5130, Restrictions on the Purchase and Sale of Initial Equity Public Offerings, provides regulatory requirements with respect to the allocation, pricing, and trading of new issues.

Application of Rule 5131 to Fund Managers

Fund managers that currently manage accounts or funds that purchase new issues should be aware of Rule 5131’s prohibition on spinning. Under Rule 5131, FINRA members may not, in general, allocate shares of a new issue to any account in which executive officers and directors of current, as well as certain former or prospective, investment banking clients have a beneficial interest.

FINRA member broker-dealers that allocate new issues to funds or accounts of fund managers will need to determine whether the underlying investors in the funds or accounts are executive officers and directors of current, former, or prospective investment banking clients of the broker-dealers.

The prohibitions on spinning in Rule 5131 do not generally apply to allocations of shares of a new issue to:

  1. the institutional accounts exempted in Rule 5130(c), which are, generally, certain registered investment companies, common trust funds, insurance companies, publicly traded entities, ERISA benefit plans, and charitable organizations; or 
  2. any accounts in which the beneficial interests are owned to a “de minimis” extent by executive officers and directors of the company and persons materially supported by such executive officers and directors (“Officers and Directors”).

For the purposes of Rule 5131, ownership to a “de minimis” extent means an aggregate 25% beneficial interest in such account. Please note that Rule 5130 contains a different “de minimis” exception applicable to certain restricted persons with an aggregate 10% beneficial interest of an account.

What Fund Managers Should Think About

Although FINRA Rule 5131 applies directly only to FINRA members, which means most U.S. broker-dealers, these broker-dealers will require FINRA 5131-related representations from fund managers that manage accounts or funds that purchase new issues. Fund managers that manage accounts or funds that purchase new issues should consider:

  • contacting existing investors (including non-U.S. investors) at least annually to determine compliance with Rule 5131; and
  • requiring written representations from the beneficial owners of the accounts or funds. Fund managers may rely on representations from beneficial owners obtained within the prior 12 months as to whether they are Officers and Directors and, if so, the companies on whose behalf they serve.

Fund managers may also want to consider:

  • amending fund offering, subscription, and other documents to address the requirements of Rule 5131;
  • analyzing the aggregate ownership by Officers and Directors prior to each purchase of a new issue;
  • imposing an aggregate 25% limit on beneficial interests (or carve-back of allocations) of an account or fund by Officers and Directors of the same company; and/or
  • imposing an aggregate 10% limit on beneficial interests (or carve-back of allocations) of an account or fund by any restricted person, including Officers and Directors of the same company, consistent with the 10% exception in Rule 5130. Please note that this 10% carve-back will be more restrictive than the requirements of Rule 5131 but will allow for easier administration.

Application of Rule 5131 to Broker-Dealers

FINRA-member broker-dealers will have to comply with the following Rule 5131 requirements for new issue allocation and distribution:

  • Quid Pro Quo Allocations. FINRA members may not use allocations of new issues to obtain or induce excessive compensation (“kickbacks”) from a recipient of the new issues.

  • Spinning. FINRA members must establish policies and procedures to ensure that investment banking personnel have no involvement or influence, directly or indirectly, in new issue allocation decisions. As discussed above, FINRA members may not, generally, allocate shares of a new issue to any account in which executive officers and directors of current, as well as certain former or prospective, investment banking clients have a beneficial interest.

  • Flipping. Flipping is the practice of selling new issue shares purchased in an offering into the secondary market within 30 days following the date of the offering. FINRA members may not directly or indirectly recoup, or attempt to recoup, any portion of a commission or credit paid 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.

  • Reports of Indications of Interest and Final Allocations. In connection with a new issue, the book-running lead manager must provide the issuer’s pricing committee (or, if the issuer has no pricing committee, its board of directors) with (a) a regular report of indications of interest, including the names of interested institutional investors and the number of shares indicated by each, and (b) a report of the final allocation of shares to institutional investors.

  • Lockup Agreements. Any lockup agreement or other restriction on the transfer of an issuer’s shares by officers and directors of the issuer shall provide that (a) such restrictions will apply to their issuer-directed shares, and (b) at least two business days before the release or waiver of any lockup or other restriction on the transfer of the issuer’s shares, the book-running lead manager must notify the issuer of the impending release or waiver and announce the impending release or waiver through a major news service.

  • 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, be (i) offered at the public offering price to unfilled customers’ orders, or (ii) sold on the secondary market and any profits donated to a charitable organization on an anonymous basis.

  • Market Orders. No FINRA 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.

What Broker-Dealers Should Think About

Broker-dealers should review and revise their policies and procedures to ensure their compliance with the new issue allocation and distribution requirements of Rule 5131.

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Should you have any questions regarding new FINRA Rule 5131 or its specific application to your business, or require any assistance, please do not hesitate to contact any member of Lowenstein Sandler’s Investment Management Group.

 

 


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