New FINRA Rule 5131
By Cydney Posner
The SEC has jumped on a FINRA rule proposal that was originally filed by the NASD in 2003 and, in 2010, granted accelerated approval. (A prize goes to the person with the best explanation for "why now?". Anything to do with termination of parts of the global settlement?) (Hat tip to Corporate Counsel. You would think that, as a FINRA rule, the SEC would post releases about this rule under FINRA, but don't look for it there. Instead, look under NASD, where it's the only rule posted in the preceding two years.) The rule is designed to prohibit certain abuses in the allocation and distribution of shares in IPOs. And, in a novel approach to rulemaking, at least in my experience, the rule even mandates charitable donations by members in certain circumstances. FINRA will announce the effective date of the proposed rule change in a Regulatory Notice to be published within 60 days after SEC approval.
The new rule will prohibit the following types of activity:
Quid Pro Quo Allocations
Rule 5131(a) will prohibit FINRA members (or persons associated with members) from offering or threatening to withhold shares of a new issue it allocates as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the member. Whether or not compensation is excessive depends on the facts and circumstances including, where applicable, the level of risk and effort involved in the transaction and the rates generally charged for those services.
Prohibition on Spinning
Rule 5131(b) will prohibit, with certain exceptions, the allocation of new issue shares to any account in which an executive officer or director of a public company or a "covered non-public company," or a person "materially supported" by the executive officer or director, has a "beneficial interest" in the following circumstances:
1) if the company is currently an investment banking client of the member or the member has received compensation from the company for "investment banking services," as defined in the rule, in the past 12 months;
2) if the person making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next three months; or
3) on the express or implied condition that the executive officer or director, acting on behalf of the company, will retain the member to perform future investment banking services.
According to FINRA, "if a member maintains effective information barriers between the investment banking and syndicate departments and the persons responsible for making new issue allocation decisions neither know nor have reason to know of the prospective business relationship, the forward-looking provision will not be violated." Note, however, that if an executive officer or director receives an allocation and the investment bank subsequently is retained to perform investment banking services within the three-month window, FINRA will conduct an investigation, including a review of the communications and systems.
A "covered non-public company" is defined in the rule as a non-reporting company satisfying specified financial criteria based on the quantitative initial listing standards for the Nasdaq Global Market. "Beneficial interest" mean any economic interest, such as the right to share in gains or losses, excluding management- or performance-based fees for operating a collective investment account or other fees for acting in a fiduciary capacity. "Material support" means directly or indirectly providing more than 25% of a person's income in the prior calendar year. In addition, persons living in the same household are deemed to provide each other with material support.
In determining whether a beneficial owner is an executive officer or director or person materially supported by an executive officer or director, a member can rely on a written representation obtained within the prior 12 months from the beneficial owners of the account, or an authorized representative, so long as the member does not believe, or have reason to believe, that the representation is inaccurate. The initial representation must be an affirmative representation, but can be updated annually through negative consent letters. However, the information obtained from the customer is not, by itself, sufficient to make a determination of whether a customer is eligible to purchase a new issue; members must also determine whether each account involves an executive officer or director (or materially supported person) of a current or prospective client that falls within the scope of the rule. A member must retain account eligibility records in its files for at least three years following the member's allocation to that account.
These prohibitions are inapplicable where the allocations of securities are directed in writing by the issuer, its affiliates or selling shareholders, so long as the member has no involvement or influence, directly or indirectly, in the allocation decision. The spinning prohibitions would also be inapplicable to allocations to any account described in FINRA Rule 5130(c)(1) through (3) and (5) through (10) (generally, investment companies, charities, trust funds, etc.), or to any other account in which the beneficial interests of executive officers and directors of the company and persons materially supported by any of them do not, in the aggregate, exceed 25% of the account. <br> <br>Under the rule, members will also be required to establish policies and procedures reasonably designed to ensure that investment banking personnel have no involvement or influence, directly or indirectly, in the new issue allocation decisions of the member. FINRA believes that these procedures, currently customary at members, are essential to managing conflicts of interest between investment banking and syndicate activities. <br> <br>Note that the spinning prohibition applies to all new issues, as defined in the rule, not just to hot IPOs, as earlier proposed. The SEC had requested comment in an earlier release as to whether FINRA should include, as part of the spinning provisions, a mandatory ban prohibiting members from seeking or providing investment banking services to a company for a period of 12 months following any allocation of IPO shares to an account of an executive officer or director of the company. In light of an especially negative comment, the provision was not adopted; however, the SEC will continue to take comments into account in "considering whether any future action is warranted." (Some subtle encouragement to the investment banks to comply with the rules?)
Policies Concerning "Flipping," Apparently, a Term of Art
Rule 5131(c) will prohibit members and associated persons from directly or indirectly recouping, or attempting to recoup, any portion of a commission or credit paid or awarded to an associated person 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. "Flipping" is actually a defined term meaning the initial sale, within 30 days following the offering date, of new issue shares purchased in an offering. A "penalty bid" is an arrangement that permits the managing <br>underwriter to reclaim a selling concession from a syndicate member when the securities originally sold by the syndicate member are purchased in syndicate-covering transactions. Members are required to record and maintain information regarding any penalties or disincentives assessed on associated persons in connection with a penalty bid.
New Issue Pricing and Trading Practices
Rule 5131(d) will require bankers to report indications of interest and allocations to the issuer, impose requirements regarding lockup agreements and mandate procedures regarding returned shares and market orders.
Reports of Allocations. In a new issue, the book-running lead manager will be required to provide to the issuer's pricing committee regular reports of indications of interest, including the names of institutional investors and the number of shares as reflected in the manager's book as well as a report of aggregate demand from retail investors. After the settlement date, the manager must provide a report of the final allocation of shares to institutions, including names and numbers, and aggregate sales to retail investors. This rule is designed to allow greater participation by issuers in pricing and allocation decisions, thus helping ensure that those decisions are consistent with the fiduciary duty of directors and management, and to facilitate management evaluation of the underwriter's performance.
Lock-ups. The rule will also require that any lock-up agreement or other restriction on transfer entered into by officers and directors in connection with a new issue must also apply to their issuer-directed shares (i.e., shares they purchase in "friends and family" programs). In addition, if the book-running lead manager intends to release or waive any lock-up restrictions, it must, at least two business days before the release or waiver, notify the issuer and announce the impending release or waiver through a major news service, except where the transfer of securities is not for consideration and the transferee has agreed in writing to be bound by the same lock-up agreement terms. Although the responsibility remains that of the book-running lead manager, the announcement may be made by the manager, another member or the issuer, so long as it complies with the requirements of the rule.
Returned Shares. The agreement between the book-running lead manager and other syndicate members must require, to the extent not inconsistent with Reg 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 must be used to offset the existing syndicate short position or, if there is no syndicate short position, the member must either:
i) offer returned shares at the public offering price to unfilled customers' orders using a random allocation methodology, or
(ii) sell returned shares on the secondary market and donate profits from the sale to an unaffiliated, 501(c)(3) charity, as defined in the rule, on an anonymous basis to avoid reputational benefit to the member.
This rule appears to be designed to ensure that IPO allocations returned to the underwriter are not used to benefit favored clients of the underwriter. The appropriate time to determine whether returned shares are trading at a premium to their IPO price is at the time the securities are returned. The release states that "random allocation" does not include anonymous, ordinary course sales on a national securities exchange.
Market Orders. No member may accept a market order for the purchase of shares of a new issue in the secondary market prior to commencement of trading in the secondary market. This rule is apparently designed to protect retail investors from themselves in light of past problems arising out of the volatility of IPO shares, but it's been a while….
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