Broker-dealers selling interests in IPOs need to have adequate supervisory systems to ensure that registered representatives do not make actual sales before the securities are registered, according to a settlement of a formal disciplinary proceeding announced by FINRA yesterday. In this particular case, FINRA found that for a little  more than a year, a firm had failed to adequately supervise the pre-registration solicitation of retail interest in IPOs because the firm had not distinguished between “indications of interest” and “conditional offers” in its policies and procedures.

The case reflects FINRA’s renewed focus on the IPO market, which, FINRA observed in its 2014 regulatory and examination priorities letter, has been showing renewed life. Specifically, FINRA cautioned firms to adopt practices and controls to comply with all relevant rules in this area, and specifically identified compliance with Rule 5131, which prohibits quid pro quo allocations and “spinning” —  that is, allocating shares of hot IPOs to officers or directors of companies in exchange for investment banking business. The priorities letter also stated FINRA’s plans to review underwriters’ due diligence activities, their filings made with FINRA’s Corporate Finance Department, and the risk that bad actors will be drawn to the IPO market. Given those priorities, it is expected that FINRA’s examiners will be taking a close look at issues related to the IPO market in the coming year.

FINRA explained in its settlement order that, under Section 5 of the Securities Act, a firm cannot enter into a contract for the purchase or sale of a security before the registration statement is declared effective by the SEC. Prior to the effective date, a broker-dealer can solicit indications of interest, which must be reconfirmed with the investor once the registration is effective in order to be a permissible sale. In the alternative, a firm can obtain a conditional offer to purchase the securities, provided that the customer is given a meaningful opportunity to withdraw the offer once the registration statement is effective.

As is often the case, FINRA’s case focused on the firm’s failure to have an adequate supervisory system, and found no underlying violation of Section 5. FINRA found that the firm had failed to provide sufficient guidance and training to its sales staff regarding solicitation of conditional offers, and had failed to document and adequately monitor the solicitation of conditional offers for compliance with its policies and the law, resulting in a situation where it was unclear whether conditional orders were being properly solicited.

Our Takeaways

There are a variety of acceptable ways to handle pre-registration solicitations of interest in an IPO. However, the FINRA case reminds firms that however they handle these solicitations, their supervisory systems should include the following:

  • Clear written procedures that ensure that conditional offers are actually conditional, and ensure that they provide for a meaningful opportunity to withdraw;
  • Documentation of conditional orders and indications of interest;
  • Training of salespeople as to the policy; and
  • Monitoring of pre- and post-registration activity to ensure that salespeople are complying with the policy.    

While the FINRA order relates specifically to the IPO context, there are other types of offerings that may raise comparable compliance questions. For example, in the structured note context (where the relevant shelf registration statement became effective well before the offering), a broker may accept conditional offers to purchase, provided that the offering prices are within the “range” (maximum return, participation rate, interest rate, etc.) specified in the applicable red herring. Similarly, in a follow-on offering of equity securities, an investor may make a conditional offer to purchase the shares if the pricing occurs within a specified range. In these types of offerings as well, brokers must be mindful to ensure that investors understand the nature of their order, and how they may cancel or change an order prior to the pricing date.