New-Issue Allocation Rules

Rule 5130 and restricted persons

FINRA Rule 5130 prohibits a member or an associated person from selling a new issue to any account in which a restricted person has a beneficial interest, from purchasing a new issue into an account in which the member or associated person has a beneficial interest, and from continuing to hold new issues acquired as an underwriter except in limited circumstances.

A new issue is defined narrowly: any initial public offering of an equity security, made under a registration statement or offering circular. That definition excludes a great deal. Secondary and follow-on offerings are not new issues. Neither are private placements, rights offerings, preferred stock, convertible securities, investment company offerings, or securities with a pre-existing market outside the United States. A question describing a restricted person buying a follow-on offering of common stock is describing something the rule does not reach.

Restricted persons are, in outline: FINRA members and other broker-dealers; officers, directors, general partners, associated persons and employees of a member or other broker-dealer; finders and any person acting in a fiduciary capacity to the managing underwriter; portfolio managers who buy securities for institutional accounts; persons owning ten percent or more of a broker-dealer; and immediate family members of those persons where a material support relationship exists.

Immediate family is defined by the rule and includes parents, mother-in-law and father-in-law, spouse, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children. Material support means directly or indirectly providing more than twenty-five percent of a person's income, or living in the same household.

The practical consequence for a representative is direct: you may not buy an IPO, and neither may your spouse, your children living with you, or your parents whom you materially support. This is one of the rules that most visibly shapes a registered person's own investing life.

Before selling a new issue to any account, a member must obtain a representation that the account is eligible, made within the twelve months preceding the sale, from the account holder or from a bank, broker-dealer or investment adviser acting as conduit. Records must be preserved for at least three years. The verification is annual, not once at account opening, which is the detail the exam tests.

There are general exemptions for accounts where restricted persons have limited interests — registered investment companies, ERISA plans that are not sponsored by a broker-dealer, certain publicly traded entities, and accounts in which restricted persons hold in aggregate no more than ten percent — the de minimis provision.

Rule 5131 — spinning, quid pro quo and flipping

Rule 5130 stops insiders taking allocations. Rule 5131 stops allocations being used as currency, and it has four distinct prohibitions.

Quid pro quo allocations. A member may not offer or threaten to withhold an allocation of a new issue as consideration for the receipt of compensation that is excessive in relation to the services provided.

Spinning. A member may not allocate a new issue to an account in which an executive officer or director of a public company, or a covered non-public company, has a beneficial interest, where the member has received investment banking compensation from that company in the past twelve months, expects to receive it in the next three months, or where the allocation is expressly or implicitly conditioned on future investment banking business. The name comes from the practice of spinning shares to executives to win their company's mandates. The prohibition is not absolute — there are exceptions for allocations to certain accounts where the beneficiaries are broad — but the conflict it addresses is the reason the rule exists.

Flipping. A member may not recoup a selling concession from a representative whose customer flipped a new issue, unless the managing underwriter has imposed a penalty bid on the entire syndicate. The rule prevents a firm punishing a representative for a customer's legitimate decision to sell.

Policies and procedures. Members must have policies on IPO pricing and trading, including a requirement that the book-running lead manager provide the issuer's pricing committee with a regular report of indications of interest and, after the offering, a report of the final allocation.

Rule 5131 also addresses lock-up agreements: a member must notify the issuer of any release or waiver of a lock-up and announce it publicly, so that the market learns when insiders are freed to sell earlier than expected.

Research quiet periods

Research is a distribution problem of a different kind. A firm that underwrote an offering has an interest in the security trading well, and its research analysts' opinions are therefore not disinterested in the period immediately after the deal.

FINRA Rule 2241 requires members to define quiet periods during which they must not publish or distribute research reports, and research analysts must not make public appearances, relating to the issuer: a minimum of 10 days following the date of an initial public offering where the member participated as an underwriter or dealer, and a minimum of 3 days following the date of a secondary offering where the member acted as a manager or co-manager.

Note the difference in who is caught. The IPO quiet period applies to any member that participated as underwriter or dealer; the secondary quiet period applies only to managers and co-managers. The restrictions do not apply to emerging growth companies or covered investment funds.

The wider rule separates research from investment banking structurally: analyst compensation may not be based on specific investment banking transactions, investment banking personnel may not supervise analysts or pre-approve research, and research reports must disclose the firm's conflicts, its ratings distribution and its price target methodology.

The municipal counterparts

Municipal new issues have their own allocation and disclosure regime, covered in lesson 4.5 and worth restating here in the primary-market frame.

MSRB Rule G-11 governs primary offering practices, requiring disclosure of the syndicate's terms and the priority provisions, and requiring that allocations follow the stated priority — presale, group net, designated, member — unless a departure is documented and disclosed.

MSRB Rule G-32 requires delivery of the official statement to a new-issue purchaser by settlement, satisfied through submission to EMMA.

MSRB Rule G-34 requires CUSIP assignment and new issue information submission.

MSRB Rule G-38 restricts the use of paid solicitors to obtain municipal securities business, and Rule G-37 restricts a dealer from engaging in municipal securities business with an issuer for two years after certain political contributions to officials of that issuer. G-37 has a narrow de minimis exception for a modest contribution by an individual to a candidate they are entitled to vote for, and the consequences of getting it wrong fall on the whole firm rather than the individual.

The underlying principle across FINRA's rules and the MSRB's is identical: the allocation of a scarce new issue must be made on the merits of the order, not as payment for something else.