On November 29, 2010, the Financial Industry Regulatory Authority, Inc. (“FINRA”) announced that FINRA Rule 5131 will take effect on May 27, 2011.1 FINRA Rule 5131 is intended to sustain public confidence in the initial public offering (“IPO”) process by regulating the allocation, pricing and trading of IPOs of equity securities (“New Issues”).2

While FINRA Rule 5131 only applies directly to FINRA members, including nearly all SEC-registered broker-dealers, it will indirectly impact all investment funds that participate in New Issues because broker-dealers will require representations from such funds as part of the IPO allocation process.

Spinning Prohibition

Prohibition. “Spinning” refers to the practice of allocating IPO securities to executive officers and directors of potential investment banking clients in exchange for investment banking business. FINRA Rule 5131(b)(2) prohibits any FINRA member, or any person associated with a FINRA member, from allocating shares of a New Issue to any account3 in which an executive officer or director of a public company4 or a covered non-public company,5 or a person materially supported by such executive officer or director (a “Covered Person”), has a beneficial interest:

  • if the company is currently an investment banking services client of the FINRA member or the FINRA member has received compensation from the company for investment banking services in the past 12 months;
  • if the person responsible for making the allocation decision knows or has reason to know that the FINRA member intends to provide, or expects to be retained by the company for, investment banking services within the next three months; or
  • on the express or implied condition that such executive officer or director, on behalf of the company, will retain the FINRA member for the performance of future investment banking services.

The spinning prohibition in FINRA Rule 5131(b)(2) may preclude investment funds from participating in New Issues if investors in the fund are Covered Persons.

Exceptions. FINRA Rule 5131(b)(3) excepts allocations of New Issues to certain types of accounts, generally consistent with the types of accounts excepted from FINRA Rule 5130, including U.S.-registered investment companies, common trust fund accounts, insurance company accounts, certain publicly traded entities listed or eligible to be listed on a U.S. exchange, non-U.S. investment companies, ERISA plans, state or municipal benefits plans, 501(c)(3) organizations and 414(e) church plans.

Importantly, the spinning prohibition also excepts allocations of New Issues to accounts in which the beneficial interests of Covered Persons of a particular company, in the aggregate, do not exceed 25 percent of the account. Thus, FINRA Rule 5131(b)(2) will not apply to an investment fund if the beneficial interests of Covered Persons as to a particular company do not exceed 25 percent of the fund. If the beneficial interests of Covered Persons as to a particular company exceed 25 percent of the fund, the fund must identify each Covered Person’s associated company and determine whether the conditions in FINRA Rule 5131(b)(2) apply to that company. If the conditions in FINRA Rule 5131(b)(2) apply to a particular company, the fund is generally prohibited from participating in New Issues allocated by broker-dealers associated with that company.

Compliance. To facilitate compliance with the spinning prohibition, investment funds may rely on written representations obtained within the prior twelve months from the beneficial owners of the fund as to whether such beneficial owners are executive officers or directors (or persons materially supported by an executive officer or director) and, if so, the companies on whose behalf such executive officers or directors serve. The initial representation must be made affirmatively, but subsequently may be updated annually through the use of negative consent letters. Prior to the May 27, 2011 FINRA Rule 5131 effective date, investment funds should contact their existing investors in order to obtain these additional representations, which will be required by broker-dealers as part of the IPO allocation process. Investment funds should also revise the questionnaires in their subscription documents as well as their Annual New Issue Questionnaires in order to obtain these additional New Issue representations on a going-forward basis.

Other Provisions in FINRA Rule 5131

FINRA Rule 5131 also regulates quid pro quo allocations, flipping and IPO pricing and trading practices, which primarily impact only FINRA members.