FINRA and its predecessor NASD have long worked to promote fairness in the allocation of new issues of equity securities by prohibiting allocations to broker-dealers and persons who, among other things, own or control, directly or indirectly, more than 10% of a broker-dealer or who are portfolio managers (Restricted Persons).[1] FINRA Rule 5130 reflects these principles, and also includes exemptions and exclusions to recognize that some entities and offerings do not implicate new issue allocation concerns.[2] FINRA also has adopted Rule 5131 to, among other things, prohibit “spinning,” which refers to allocations of new issues to persons in a position to direct hiring of broker-dealers to provide investment banking services.[3] Rules 5130 and 5131 referred to together as the “Rules.”

The Proposal

FINRA filed a proposal on July 27 with the US Securities and Exchange Commission (SEC) that, if adopted, would provide much needed clarification on the application of the Rules to non-US investors, including non-US retirement plans, non-US investment companies, and sovereign wealth funds, as well as to non-US offerings of securities.[4] The proposed amendments would apply as follows:

  • Foreign Employee Retirement Benefit Plans: The proposed amendments to Rule 5130 would create a general exemption from Rule 5130 for foreign retirement benefit plans. The general exemption would be available for foreign employee retirement benefit plans that (i) have at least 10,000 participants and beneficiaries and $10 billion in assets, (ii) are operated such that a wide range of employees, regardless of income or position, can participate, (iii) are managed by fiduciaries acting in the best interest of the participants and beneficiaries, and (iv) are not sponsored by a broker-dealer. FINRA proposes a corresponding exemption in Rule 5131 as well.[5]
  • Foreign Investment Companies: FINRA proposes to expand the ways that a foreign investment company can fall within the current general exemption from application of Rule 5130. Currently, foreign investment companies are exempt from applicability of the Rule 5130 if they meet the threshold criteria of (1) being organized outside the US and authorized for sale to the public or traded on a foreign securities exchange, and (2) have no more than 5% of owners who are Restricted Persons.[6] FINRA proposes to exempt from Rule 5130 foreign investment companies that meet the threshold criteria but as an alternative to the 5% threshold of Restricted Persons, such funds could have at least 100 direct investors or at least 1000 indirect investors. A fund relying on this exemption would have to demonstrate that it was not formed specifically to invest in new issues. The proposed exemption would impact the current cross referenced exemption for foreign investment companies in Rule 5131 as well, so that foreign investment companies exempt under Rule 5130 also would be exempt under Rule 5131.[7]
  • Sovereign Wealth Funds: Rule 5130 would be amended to exclude sovereign wealth funds and their investment vehicles from the definition of restricted person. This exemption would recognize that, while a sovereign wealth fund may be or become a direct or indirect owner or control person of a broker-dealer, preventing a sovereign wealth fund and its investment vehicles (but not its affiliates) from receiving allocations is not necessary to achieve the public policy underlying the Rule.
  • Regulation S and other non-US Offerings of Securities: FINRA proposes to amend the definition of “new issue” in Rule 5130, which is also used in Rule 5131, to specifically exclude for purposes of both Rule 5130 and Rule 5131 offerings made under Regulation S or otherwise made outside the United States or its territories. It is worth noting that the definition of “new issue” currently is limited to initial public offerings of equity securities made pursuant to a registration statement or offering circular. Therefore, there is some question whether FINRA intended this express exemption to clarify, rather than amend, the scope of offerings to which Rule 5130 and Rule 5131 are applicable. It is possible that this amendment to the Rules will reverse the tendency of certain FINRA member firms to apply the Rules globally, including to new issuers managed by their non-US, non-FINRA member affiliates.

    The proposed amendments to the Rules would also expand and clarify the scope of the exemption for family offices in Rule 5130 and exclude from “covered non-public companies” in Rule 5131 “unaffiliated charitable organizations” that would otherwise fall within the definition, and adopt language making the provisions of the Rules consistent with regard to the exclusion for issuer directed securities. These proposed amendments are:

  • Family Offices: The proposed amendment to Rule 5130 clarifies and expands the exemption from the definition of Restricted Persons in Rule 5130 for family offices by making the terms used consistent with the Investment Advisers Act of 1940. This change would recognize that family offices often invest on behalf of multiple generations and also that key employees who are not family members may be beneficial owners of a family office account that seeks to receive allocations.
  • “Unaffiliated Charitable Organizations”[8]: FINRA proposes to amend Rule 5131 to exclude from “covered non-public companies” those charitable organizations that would otherwise, based on asset size, fall within the definition of “covered non-public company. FINRA does not believe that the appearance of impropriety or the potential to divide loyalty between officers and directors and the companies exists in relation to charitable organizations, in particular because these organizations are not likely to generate significant investment banking business. As a result, FINRA views as low risk the likelihood that a member or its associated persons would allocate new issues to officers and directors of charitable organizations in order to receive investment banking business. FINRA, in its filing to the SEC, specifies that this exclusion would be limited to 501(c)(3) organizations and the definition is limited to such organizations.
  • Issuer Directed Securities: FINRA proposes to amend Rule 5130 to align Rule 5130 with Rule 5131 when a new issue includes issuer directed allocations of securities. While both Rules have provisions excluding allocations that are issuer directed, Rule 5131 allows an affiliate or selling shareholder to direct allocations of securities, while Rule 5130 only exempts directions from issuers. Rule 5130 would be amended to also permit affiliates and selling shareholders to direct allocations.

Finally, FINRA proposes to add supplemental materials to Rule 5131 to add anti-dilution provisions, similar to those already in Rule 5130. Supplemental Material .04 would provide that if an executive officer or director of a public company or covered non-public company or a person materially supported by such a person has a beneficial interest in an account with an equity interest in an issuer or company acquired by the issuer in the year prior to the offering, the account can receive an allocation of the new issuer if the allocation would not increase the account’s equity ownership percentage above its level three months prior to the filing of the registration statement for the offering, there are no special terms, and securities acquired pursuant to the Supplemental Material .04 are essentially restricted for three months following the effective date of the offering.

Next Steps[9]

The SEC is expected to publish this proposal for notice and comment without delay. FINRA has proposed a 21-day comment period, beginning with the date of publication in the Federal Register. FINRA also has requested that the SEC act on the proposal within 45 days of the date of publication of the proposal. As a result, anyone considering commenting on this proposal should be prepared to submit comments quickly. Areas to consider commenting on include, but are not limited to:

  • The benefits of the proposal for issuers, FINRA members, and potential non-US investors
  • The benefits of the proposal for the US capital markets by attracting non-US investors previously precluded from IPOs
  • Any further refinements to the proposed amendments or points for clarification, such as:
    • Clarification of what is required for a foreign investment company to have been “authorized” for sale to the public
    • Clarification of whether a Regulation S tranche of a global offering would be exempt under the proposed general exemption
    • Specific language in Rule 5131 referencing that the charitable organizations exclusion from “covered private company” refers only to organizations that are 501(c)(3) organizations.