• SEC Approves FINRA Rule 5131 to Address Abuses in the Allocation and Distribution of New Issues
  • April 12, 2011 | Authors: Carl A. Ruggiero; Victor L. Zimmermann
  • Law Firm: Curtis, Mallet-Prevost, Colt & Mosle LLP - New York Office
  • On November 29, 2010, FINRA announced SEC approval of new Rule 5131. Rule 5131, which will take effect on May 27, 2011, seeks to prevent certain abuses in the allocation and distribution of new issues. One of the abuses that Rule 5131 targets is the allocation of new issues to executive officers and directors of companies for which the FINRA member provides investment banking services, a practice commonly referred to as “spinning.”

    Spinning Generally

    Spinning involves FINRA members allocating new issues1 to executives at third-party companies in order to curry favor and obtain employment for investment banking services2   with such third-party companies. Spinning is mutually beneficial, as the executives receive access to desirable new issues, while the FINRA member acquires additional business for its investment banking services. However, the practice has the potential to divide the loyalty of the executives, as agents of their respective third-party companies, from the principal on whose behalf such executives must act (i.e., the companies). At the very least, such practices create the appearance of impropriety. 

    The Rule 5131 Prohibition

    Rule 5131 will prohibit the allocation of new issues to executive officers and directors at certain types of companies for whom the FINRA member provides, or will provide, investment banking services. FINRA members will be required to establish, maintain and enforce 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 FINRA member.

    As a prophylactic measure, Rule 5131(b) specifically prohibits the allocation of new issues by a FINRA member to any account in which an executive officer or director of a public company or a non-public company that satisfies certain income and equity thresholds (a “covered non-public company”,3 and together with public companies, a “Company”), or a person materially supported by such executive officer or director (each such executive officer, director or person, a “Restricted Executive”), has a beneficial interest:

    (1) if the Company is currently an investment banking services client of such FINRA member or if such FINRA member has received compensation from the Company for investment banking services in the past twelve (12) months; 
    (2) if the person responsible for making the allocation decision knows or has reason to know that such FINRA member intends to provide, or expects to be retained by the Company for, investment banking services within the next three (3) months; or
    (3) on the express or implied condition that a Restricted Executive, on behalf of the Company, will retain such FINRA member for the performance of future investment banking services. 

    In determining whether a specific account is subject to these prohibitions, FINRA members are permitted to rely on written representations made within the prior 12 months by the beneficial owner(s) of such account. The beneficial owner(s) of the account must make an initial, positive, written representation as to whether such beneficial owner(s) is a Restricted Executive, and if so, the Company with which such Restricted Executive is associated. Subsequent updates may be made annually through the use of negative consent letters.

    Exceptions

    Certain types of accounts are excepted from the spinning prohibition in Rule 5131(b). The exceptions are generally consistent with the types of accounts excepted from restrictions under Rule 51304 , but additionally include certain accounts in which multiple persons have a beneficial interest. Paragraph (b)(3) of Rule 5131 permits allocations of new issues to an account in which the collective beneficial interest of Restricted Executives as to a particular Company does not exceed 25% of such account.

    Additionally, FINRA has clarified that the spinning prohibition does not apply to allocations directed in writing by the issuer, its affiliates or selling shareholders, so long as the FINRA member has no involvement or influence, directly or indirectly, in the allocation decisions of the issuer, its affiliates or selling shareholders with respect to such issuer-directed allocations. 

    Implications for Private Investment Funds

    When Rule 5131 takes effect beginning May 27, 2011, managers of private funds should ensure that they have policies and procedures in effect to comply with this Rule. Broker-dealers will likely ask for representations regarding eligibility of a private fund to acquire new issues in accordance with Rule 5131(b). If the beneficial ownership interests of Restricted Executives associated with a particular Company exceed 25% of a private fund’s aggregate beneficial ownership interest, then such fund will be precluded from participating in new issues, subject to a carve-out procedure.

    Managers will need to obtain annual representations from investors stating whether such investors are Restricted Persons. While the first representation will need to be an affirmative, written representation, subsequent annual representations may be in the form of negative consent letters.   Private fund managers should consider revising subscription agreements to account for Rule 5131(b) and should prepare questionnaires for existing investors in order to ensure compliance going forward.

     

    1 Rule 5131 incorporates the definition of “new issue” from FINRA Rule 5130. The term is generally defined as any initial public offering of an equity security, as such term defined in Section 3(a)(11) of the Exchange Act made pursuant to a registration statement or offering circular. Rule 5130 also includes 10 enumerated exceptions to this definition.

    2 “Investment banking services” include, without limitation:  acting as an underwriter, participating in a selling group in an offering for an issuer or otherwise acting in furtherance of a public offering of the issuer; acting as a financial adviser in a merger, acquisition or other corporate reorganization; providing venture capital, equity lines of credit, private investment, public equity transactions (PIPEs) or similar investments or otherwise acting in furtherance of a private offering of the issuer; or serving as placement agent for the issuer.

    3 To qualify as a “covered non-public company,” the company must have:  (i) income of at least $1 million in the last fiscal year or in two of the last three fiscal years and shareholders’ equity of at least $15 million; (ii) shareholders’ equity of at least $30 million and a two-year operating history; or (iii) total assets and total revenue of at least $75 million in the latest fiscal year or in two of the last three fiscal years.

    4 Accounts described in FINRA Rule 5130(c)(1) through (3) and (5) through (10) are also excepted from Rule 5131 regulation as regards spinning.