Alert December 10, 2013

SEC Approves Limited Exception to Anti-Spinning Provision of FINRA Rule 5131

The SEC has issued an order (the “Order”) approving an amendment (the “Amendment”) to FINRA Rule 5131 relating to New Issue Allocations and Distributions (the “Rule”).   (The text of the Amendment is available in Exhibit 5 of FINRA’s filing with the SEC seeking approval of the Amendment.)  The Amendment provides a limited exception to the “anti-spinning” provision of the Rule by allowing members to rely subject to certain conditions on written representations from a fund of funds account that does not look through to the underlying beneficial owners of a private fund invested in the fund of funds (the “Amendment”).  The Amendment was proposed by FINRA in a rule proposal (the “Original Proposal”) filed with the SEC on August 23, 2013 (File No. SR-FINRA-2013-0357).   For a summary of other provisions of the Rule, please refer to the November 30, 2010 Financial Services Alert.

The Anti-Spinning Provisions of Rule 5131.  The Rule was designed by FINRA to address historical abuses in the allocation and distribution of IPO shares, which the Rule refers to as “new issues.”  For purposes of the Rule, “new issues” are any initial public offering 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.  Paragraph (b) of the Rule prohibits FINRA member firms participating in a distribution of IPO shares, and their associated persons, from allocating shares to any 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 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 condition that the executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.

The “anti-spinning” prohibitions in the Rule do not apply to allocations of IPO shares to certain classes of accounts or persons to whom IPO shares may also be sold notwithstanding the restrictions of FINRA Rule 5130, the New Issue Rule, including registered investment companies, certain common trust funds, insurance company general, separate or investment accounts that meet certain account size and other requirements, and certain retirement plans.  Additionally, the “anti-spinning” prohibitions in the Rule do not apply to allocations of IPO shares to any account in which the beneficial interests 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% of such account (the “de minimis exception”).

Supplementary Material 5131.02 to the Rule permits a FINRA member firm to rely on a written representation obtained within the prior 12 months from the beneficial owner(s) of an account, or a person authorized to represent the beneficial owner(s) of an account, as to whether any such beneficial owner is an executive officer or director or person materially supported by an executive officer or director and if so, the company on whose behalf such executive officer or director serves.  On the basis of this guidance, firms typically comply with the anti-spinning provision by issuing questionnaires to their customers to ascertain whether any person with a beneficial interest in a customer’s account falls in one of the categories of persons covered by Rule 5131 and as applicable, whether the ownership interest falls within the de minimis exception.

The Amendment.  Since the effective date of the “anti-spinning” provision in 2011, FINRA has received feedback from its member firms that obtaining the information necessary to ensure compliance with the Rule, and eligibility for the de minimis exception, has proved difficult.  In particular, FINRA member firms expressed that they (and their customers) have had difficulty obtaining, tracking and aggregating information from private funds regarding indirect beneficial owners, such as participants in a fund of funds, for use in determining an account’s eligibility for the de minimis exception and that these difficulties have resulted in compliance difficulties and restrictions, including in situations where the ability of an underwriter to confer any meaningful financial benefit to a particular investor by allocating IPO shares to the account is impracticable.

As a result, FINRA proposed, and the SEC has approved, an amendment to the Supplementary Material 5131.02 to permit FINRA member firms to rely upon a written representation obtained within the prior 12 months from a person authorized to represent a fund of funds account that does not look through to the beneficial owners of a fund invested in the fund of funds account,  except for beneficial owners that are control persons of the investment adviser to the  fund, provided that the fund:

  1. is a “private fund” as defined in the Investment Advisers Act of 1940;
  2. is managed by an investment adviser that does not have a control person in common with the investment adviser to the fund of funds;
  3. has assets greater than $50 million; 
  4. owns less than 25% of the account and has no single investor with a beneficial interest of 25% or more; and
  5. was not formed for the specific purpose of investing in the account.

As approved by the SEC, the Amendment does not include an additional condition that was part of the Original Proposal under which the fund could not have a beneficial owner that also was a control person of the investment adviser to the fund of funds.  This condition was eliminated  in response to industry comments. 

Implementation Date; Comments.  The SEC approved the Amendment on an accelerated basis and directed FINRA to announce the effective date for the Amendment in a Regulatory Notice to be published no later than January 26, 2014, with the effective date to be no later than March 27, 2014.  Comments on the Amendment are due no later than December 26, 2013.