Background

The Rules are designed to “protect the integrity of the public offering process,” by preventing financial services industry insiders from gaining access to new issues while potentially excluding public investors, and preventing “spinning” (as explained below), flipping and quid pro quo allocations of new issues, as well as other pricing and trading abuses in initial public offerings.

Rule 5130 generally prohibits the offer and sale of new issues to any account in which a “restricted person” has a “beneficial interest,”4 unless there is an applicable exemption. Restricted persons include, among others, portfolio managers5 of certain investment vehicles, broker-dealers, broker-dealer “personnel,” and certain owners of broker-dealers.

Rule 5131(b) limits “spinning” (i.e., allocating shares of a new issue to influence the awarding of investment banking business), by prohibiting FINRA member firms and their associated persons from allocating shares of a new issue to any account in which: (i) executive officers or directors of a public company6 or “covered non-public company” (covered person) have a beneficial interest that exceeds 25%, in the aggregate, of such account; and (ii) the company is a current or prospective investment banking client of the FINRA member firm.

Since the adoption of the Rules, certain interpretive issues have arisen regarding the scope of persons to which offers and sales of new issues can be made, including family offices and their key employees, executives and directors of non-profit organizations, and certain foreign entities. The Proposed Amendments seek to clarify these issues.

Family Offices

Under Rule 5130, an FIV may be owned only by “immediate family members,” which is defined as “a person’s parents, mother-in-law or father-in-law, spouse, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children, and any other individual to whom the person provides material support.” This FIV exemption is lost if a portfolio manager, or any other key employee of the family office who is not an immediate family member, invests in the FIV, even though investment by such individuals is a common element of most family office structures that comply with the Family Office Rule under the Advisers Act.

The Proposed Amendments would broaden the definition of FIV to include accounts or funds that are beneficially owned by “family clients” as defined in the Family Office Rule,7 which also includes lineal descendants and key employees. The proposed new definition of FIV now includes three categories of investment vehicles:

  • An investment vehicle that is owned solely by “immediate family members” as defined under FINRA Rule 5130;
  • An investment vehicle that is owned solely by “family members” as defined under the Family Office Rule; and
  • An investment vehicle that is owned solely by “family clients” as defined under the Family Office Rule, provided that if the beneficial owners of the investment vehicle are not solely persons described in categories 1 or 2 (e.g., if key employees also have invested in the vehicle), then the person with sole investment authority must be an immediate family member under Rule 5130.

The requirement that an immediate family member have sole investment authority with respect to purchases and sales of securities by a family office, will effectively mean that most family offices will remain restricted persons for purposes of Rule 5130. 

Non-Profit Organizations

Rule 5131(b) prohibits FINRA member firms from allocating new issues to an account owned by an executive officer or director of a public or covered non-public company, because executive officers and directors of those companies have the ability to make the decision to hire investment bankers. Accordingly, FINRA takes the view that “allocating new issues to such persons creates the appearance of impropriety.” The Proposed Amendments provide an explicit exclusion from the definition of “covered non-public company,” so that executive officers and directors of non-profit organizations would not be covered persons subject to the prohibition under Rule 5131.

Further, even though Rule 5131(b) provides an exemption from the spinning restrictions for certain accounts described in the new issue rule (e.g., 501(c)(3) organizations) (exempted accounts), the current rule is silent as to whether executive officers and directors of these exempted accounts are deemed to be covered persons if the exempted account qualifies as a covered non-public company. Therefore, an account that is beneficially owned by an executive officer or director of a non-profit company that is large enough to be a covered non-public company may be subject to the restrictions under Rule 5131(b).

Charitable organizations are specific types of non-profit organizations that FINRA believes “are not likely to generate significant investment banking business and, thus, there is a low risk, if any, that improper incentives would motivate a member’s or an associated person’s decision to allocate shares to the account of executive officers or directors of such organizations.” Accordingly, the Proposed Amendments expressly exclude executive officers and directors of these types of non-profit organizations form being covered persons.

Foreign Entities

Sovereign Entities

Currently, Rule 5130 includes as restricted persons direct and indirect owners of a registered broker-dealer, which are required to be listed on the broker-dealer’s Form BD. Under this criteria, certain sovereign entities, including sovereign wealth funds that have purchased direct or indirect interests in a U.S. broker-dealer as a result of a larger private equity transaction, have become restricted persons and are prevented from purchasing new issues. The Proposed Amendments are intended to “address the unintended application of FINRA Rule 5130 to sovereign entities” and exclude sovereign entities from being owners of broker-dealers subject to Rule 5130.

Foreign Retirement Funds

Because employee retirement benefit plans invest in new offerings on behalf of potentially “hundreds of thousands” of beneficial owners, determining whether or not any beneficial owner is a restricted person may be impossible. Accordingly, Rule 5130 provides a general exemption to retirement benefit plans that are subject to the Employee Retirement Income Security Act (ERISA) and qualified under the Internal Revenue Code (ERISA plans), provided that the ERISA plan is not sponsored solely by a broker-dealer. The exemption, as currently written, would not apply to foreign retirement plans because they are not subject to ERISA. The Proposed Amendments would incorporate FINRA staff relief to foreign employee retirement benefit plans8 and provide a similar exemption afforded to ERISA plans, provided certain conditions are met.

Foreign Investment Companies

The Proposed Amendments also would provide relief to foreign investment companies. Currently, Rule 5130 exempts sales of new issues to foreign investment companies, provided that: (i) the foreign investment company is publicly offered on a foreign exchange or authorized for sale to the public by a foreign regulatory authority; and (ii) no restricted person owns more than 5% of the shares of the investment company. However, the 5% restricted person ownership limitation is impractical to administer in most cases, because foreign investment company shares are often purchased through nominee intermediaries and the foreign investment company is unable to determine the restricted person status of such owners. The Proposed Amendments would provide an alternative route to the 5% test for a foreign investment company to meet the conditions of the exemption – a foreign investment company would be determined to be “widely held” if it has at least 100 direct owners or at least 1,000 indirect owners.

Conclusion

The Proposed Amendments would provide long sought-after clarity and operational relief for family offices, non-profit organizations and certain foreign entities, although a case may be made that further relief should be provided for family offices. If approved by the SEC, FINRA will publish the Proposed Amendments as a Regulatory Notice within 60 days of SEC approval, and the Proposed Amendments would become effective no more than 30 days after publication of the Regulatory Notice.