I.          Background.  In an effort to further improve the integrity of the initial public offering process, FINRA and the SEC adopted new FINRA Rule 5131¹.  With the exception of the rule’s anti-spinning provision, described in greater detail below, FINRA Rule 5131 became effective on May 27, 2011.  The rule imposes various obligations on FINRA member firms (i.e., most broker-dealers) and their associated persons with respect to new issue allocations and distributions in addition to the obligations already in place under FIRNA Rule 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings).  The anti-spinning provision of FINRA Rule 5131 will take effect on September 26, 2011.   Although FINRA Rule 5131 applies to FINRA members, private fund managers that plan to participate in new issue offerings need to be familiar with the rule’s anti-spinning provision and will likely need to obtain additional information from fund investors since a broker-dealer’s compliance with this provision requires representations from a fund manager about the company affiliations of the fund’s investors.

II.        The Spinning Prohibition of FINRA Rule 5131 and the 25% De Minimis Exemption.

A.        Anti-Spinning Rule. FINRA Rule 5131(b), the anti-spinning provision, generally prohibits FINRA members and their associated persons from “spinning” or allocating new issues to executive officers or directors (or people materially supported by them) of certain companies in exchange for the receipt of investment banking business from the applicable company.  Accordingly, FINRA Rule 5131(b) prohibits FINRA members and their associated persons from allocating shares of “new issues” to an account in which an executive officer or director of a “public company” or a “covered non-public company”, or a person “materially supported” by such executive officer or director, has a “beneficial interest” (see Part III below for definitions): (1) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months; (2)  if the person responsible for making the allocation decision knows or has reason to know that the FINRA member intends to provide, or expects to be retained by the company for, investment banking services within the next 3 months; or (3) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services (collectively “Covered Persons”).

B.        The 25% De Minimis Exemption.  FINRA’s spinning prohibition, however, does not apply to new issue allocations made to certain specified accounts (e.g., accounts of registered mutual funds and certain ERISA plans) or to any account in which the beneficial interests of Covered Persons do not, in the aggregate, exceed 25% of such account.  As with FINRA Rule 5130’s 10% de minimis exemption, a carve-out of new issue allocations to Covered Persons may be implemented to cause a fund account to meet the requirements of FINRA Rule 5131’s de minimis exemption.

III.       Definitions.  FINRA Rule 5131 adopts the definitions of “new issue” and “beneficial interest” set forth in FINRA Rule 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings).  Generally, a “new issue” is any initial public offering of an equity security, subject to certain limited exceptions.  “Beneficial interest” means any economic interest, such as the right to share in gains or losses, but does not encompass fees for acting in a fiduciary capacity, such as management or performance based fees for operating a collective investment account.  FINRA Rule 5131 defines  a “public company” as any company that is registered under Section 12 of the Exchange Act or files periodic reports pursuant to Section 15(d) of the Exchange Act and defines a “covered non-public company” as any non-public company satisfying the following criteria: (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 or 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.  “Material support,” within the meaning of FINRA Rule 5131, 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 be providing each other with material support.

IV.       Complying with the Spinning Prohibition.  FINRA members may comply with the anti-spinning provision by relying on written representations obtained within the prior 12 months from the beneficial owners of an account (or a person authorized to represent the beneficial owners of an account, such as a hedge fund manager) as to whether such beneficial owners are executive officers or directors (or persons materially supported by an executive officer or director) and if so, the company(ies) on whose behalf such executive officer or director serves.  The initial representation must be an affirmative representation but such representation may be updated annually through the use of negative consent letters.  Thus, before participating in new issues, fund managers should expect that they will be required to provide broker-dealers with the written representations specified by FINRA Rule 5131 and to annually assess the accuracy of these representations.  Accordingly, fund managers that wish to participate in new issues should consider preparing investor questionnaires to identify who may be Covered Persons under FINRA Rule 5131 and/or amending existing fund documents to reflect the new anti-spinning rule and its applicable requirements. 

If you would like additional information about anything discussed in this memorandum, please contact Geraldine Cunningham (GCunningham@kmollp.com; 212-906-8310).

Disclaimer

This memorandum may be considered attorney marketing and/or advertising.  The information contained in this memorandum is for informational purposes only and is not intended and should not be considered legal advice on any subject matter.  Recipients of this memorandum should not act or refrain from acting on the basis of any information included in this memorandum without seeking appropriate legal or other professional advice.  This information is presented without any warranty or representation as to its accuracy or completeness, or whether it reflects the most current legal developments.

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