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FINRA Announces Effective Date of New Rule 5131 Prohibiting Abuses in the Allocation and Distribution of IPO Shares

In Regulatory Notice 10-60, issued on November 29, 2010, FINRA announced that its new Rule 5131, governing the IPO allocations process for underwriters, will become effective on May 27, 2011.  The prohibitions and requirements of Rule 5131 are directed at broker-dealers and their associated persons involved in the distribution of IPO shares, but will also indirectly affect purchasers.  In particular, investment funds that wish to purchase IPO shares may need to provide information to IPO underwriters about their beneficial interest holders sufficient to permit the underwriters to determine that they are not selling to a prohibited account.

The prohibitions and requirements of Rule 5131 include the following:

  • No Quid Pro Quo Allocations.  A firm participating in the underwriting may not offer or threaten to withhold IPO shares as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the firm.
  • Spinning – No Investment Banking Involvement in Allocations.  Member firms must have procedures to ensure that investment banking personnel have no involvement or influence, directly or indirectly, in the IPO allocation decisions made by the firm’s sales force.
  • Spinning – Restrictions on Allocations to Certain Persons.  Member firms participating in a distribution of IPO shares, and their associated persons, may not allocate shares to any account in which an executive officer or director of a public company or a non-public company meeting size requirements, specified in the Rule, based on income, revenue and shareholder equity, or a person materially supported by such an officer or director, has a beneficial interest:  (1) if the company is currently an investment banking services client of the member or the member has received compensation from the company for such services in the past year, (2) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide or be retained to provide investment banking services in the next three months, or (3) on the express or implied conditions that the executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.
  • Policies Concerning Flipping.  In order to reduce flipping of IPO shares (i.e., sales into the market within 30 days after the offering), underwriters have in the past imposed penalties on associated persons whose customers flip their shares.  The Rule prohibits the imposition of such penalties unless the managing underwriter has assessed a penalty bid on the entire syndicate.  Firms will also be required to maintain records of the assessment of penalty bids.
  • IPO Pricing – Indications of Interest.  The Rule will require the book-running lead manager to provide the issuer’s pricing committee (or if none, its board of directors) with regular reports of indications of interest before the offering and final allocations after settlement, including the names of institutional investors and number of shares indicated or purchased, and aggregate numbers for retail investors.
  • Lock-Up Agreements.  Any lock-up agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer entered into in connection with a new issue shall provide that (1) such restrictions will apply to their issuer-directed shares and (2) at least two business days before the release or waiver of the lock-up (other than a waiver to permit a transfer not for consideration to a party who has agreed to be bound by the same lock-up agreement), the book-running lead manager will notify the issuer of the impending release or waiver and announce the impending release or waiver through a major news service.
  • Returned Shares.  The agreement among underwriters must require that (to the extent not inconsistent with SEC Regulation M) 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 short position, either offered to fill unfilled customer orders pursuant to a random allocation methodology or sold on the secondary market with the profits donated to an unaffiliated charity on an anonymous basis.
  • No Acceptance of Pre-Issue Market Orders.  Member firms may not accept a market order for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market.

With respect to the prohibition on allocations to the “account” of certain persons, including executive officers and directors of companies to whom the member firm has or may provide investment banking services, FINRA notes that a hedge fund or other private investment fund is an account of a person who has a beneficial interest is the fund.  Rule 5131 permits member firms selling to funds to rely on information provided by fund managers about their beneficial owners (thus allowing fund managers to maintain the confidentiality of their investor lists) and also to use some of the exemptions provided by Rue 5130 (the New Issue Rule).

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