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New FINRA Rule 5131 Relating to Allocation and Distribution of Shares in IPOs Approved by the SEC

March 23, 2011

On November 29, 2010, the Financial Industry Regulatory Authority, Inc. ("FINRA") announced that FINRA Rule 5131, approved by the Securities and Exchange Commission ("SEC"), will be effective on May 27, 2011. The rule is intended to address abuses in the allocation, pricing and trading of shares in initial public offerings ("New Issues"), thereby encouraging public confidence in the initial public offering ("IPO") process. The rule incorporates the definition of "new issue" from Rule 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings), specifically, any IPO of an "equity security" as defined in Section 3(a)(11) of the Securities Exchange Act of 1934 made pursuant to a registration statement or offering circular, subject to certain enumerated exceptions. Rule 5131 applies to FINRA members, including nearly all SEC-registered broker-dealers, and will likely have an indirect impact on investment funds participating in New Issues, as broker-dealers will require representations from such funds as part of the IPO allocation process.

Quid Pro Quo Allocations

Rule 5131(a) prohibits a member firm or person associated with the member firm from making or threatening to withhold New Issue allocations in order to obtain compensation that is excessive in relation to the services provided by such member. Whether compensation is deemed “excessive” for purposes of this rule is based on the surrounding facts and circumstances, including the level of risk and effort involved in the transaction, and the rates charged for such services. The rule prevents member firms from seeking excessive aftermarket commissions from customers in exchange for favorable allocations of New Issues. Although the FINRA Staff has pursued member firms for these kinds of quid pro quo arrangements under its customer profit-sharing prohibition,1  it will now have better ammunition in its rulebook to use against member firms.  


Rule 5131(b) prohibits the allocation of New Issues to executive officers and directors of a public company, a "covered non-public company" or a person materially supported thereby with a beneficial interest if: (i) the company is an investment banking services client of the member, or the member has received compensation from the company for investment banking services in the past twelve (12) months; (ii) the person responsible for making the allocation decisions knows or has a 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 (3) months; or (iii) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for future investment banking services.

The term "covered non-public company" applies to any non-public company (i) with an income of at least $1 million in the last fiscal year, or in two of the last three (3) 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 (2) of the last three (3) fiscal years.  Because executive officers and directors of a public company are often in a position to hire member firms on behalf of the company, allocating New Issues to such persons creates the appearance of impropriety, and has the potential to divide the loyalty of the agents of the company. 

To protect against such risks, the spinning prohibition requires that members establish, maintain and enforce policies and procedures reasonably designed to ensure that investment banking personnel have no influence in the New Issue allocation decisions of the member. To facilitate compliance with the spinning prohibition, Supplemental Material .02 permits members to rely on written representations obtained within the prior twelve (12) months from beneficial owners of the account and, in the case of accounts whose beneficial owner(s) is an executive officer or director, the company on whose behalf such executive officer or director serves. Alternatively, members may choose to adopt a policy prohibiting allocations to executive directors and officers altogether.

Notwithstanding the above, Supplemental Material .01 provides that the spinning prohibition does not apply to allocations directed in writing by the issuer, its affiliates or selling shareholders, so long as the member has no direct involvement in the allocation decisions of the issuer, its affiliates, or selling shareholders with respect to such issuer-directed allocations.  The spinning prohibition also does not apply to allocations made to accounts held by investment companies, trusts, insurance companies, publicly-traded companies, ERISA plans, state benefit plans, charitable organizations, and church plans (as described in FINRA Rule 5130(c)(1) through (3) and (5) through (10)), or to any other account in which the beneficial interest of executive officers and directors of the company and persons materially supported by such executive officers and directors in the aggregate do not exceed 25%.


Rule 5131(c) seeks to discourage member firms and their associated persons from “flipping”, or selling New Issues into the secondary market at a profit within thirty (30) days following the effective date. While some firm’s policies and/or practices may already support penalizing associated persons by imposing a “penalty bid” on syndicate members to reclaim selling concessions for allocations that were flipped, member firms’ associated persons may be unable to direct such practices by their customers, making the policy subject to uneven application. As a result, Rule 5131(c) prohibits any member or its associated persons from recouping or attempting to recoup any portion of a commission or credit paid to an associated person for selling New Issues that are subsequently flipped by a customer unless the managing underwriter has assessed a penalty bid on the entire syndicate. FINRA believes that it is only appropriate for a member firm to recoup a particular broker’s compensation for selling a New Issue in connection with a customer’s decision to flip a security when the member firm itself is required to forfeit its compensation to the managing underwriters.

Pricing and Trading Practices

Indications of Interest

In order to provide issuers and their pricing committees with greater transparency, Rule 5131(d) requires the book-running lead manager to provide the issuer’s pricing committee (or the issuer’s board of directors, if no such pricing committee exists) (i) a regular report of indications of interest, including the names of interested institutional customers and the number of shares indicated by each, and a report of aggregate demand from retail customers; and (ii) after the settlement date of a New Issue, a report of the final allocation of shares to institutional customers, including the names of the institutional customer purchasers and the number of shares purchased by each, and the aggregate number of shares sold to retail customers.

Lock-Up Agreements

Any lockup agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer must expressly provide that the issuer-directed shares are subject to such transfer restrictions. The book-running lead manager must also notify the issuer at least two (2) days prior to the release or waiver of any lock-up or other restriction, and announce the impending release or waiver through a major news service, unless the release or waiver only permits a transfer of securities without consideration and the recipient agrees, in writing, to be bound by the terms of the lock-up agreement in place of the transferor.

Agreement Among Underwriters

Rule 5131(d)(3) provides that the syndicate members and the lead manager must agree in the underwriting agreement that, to the extent not inconsistent with Regulation M, any shares trading at a premium to the public offering price that are returned by a purchaser after secondary market trading commences be used to offset the existing syndicate short position. If no syndicate short position exists, the syndicate member receiving the shares must either offer the returned shares at the public offering price to unfilled customer orders using a random allocation methodology, or sell the returned shares and donate the proceeds from the sale to an unaffiliated charitable organization that qualifies under Section 501(c)(3) of the Internal Revenue Code.

Market Orders

Member firms are prohibited from accepting market orders for secondary market purchases of New Issue shares prior to the commencement of secondary market trading. This new rule is intended to prevent customers — especially those that did not receive shares in the offering —from finding their market orders filled at prices beyond what they reasonably anticipated.  FINRA believes that these market orders may further exacerbate the increases in price that often occur in New Issues in the secondary market.

Investment funds should, among other things, contact their investors to obtain the additional representations required under the new rule as part of the IPO allocation process, and review and revise their policies and procedures in connection with New Issue allocations. Investment funds should also revise the questionnaires in their subscription documents, and have investors complete their Annual New Issue Questionnaires in order to obtain such additional New Issue representations going forward.


1 See, e.g., SEC v. Credit Suisse First Boston Corp., Final Judgment of Permanent Injunction and Other Relief, available at http://www.sec.gov/litigation/complaints/judglr17327.htm.