FINRA and SEC Approve New FINRA Rule 5131 re: “Spinning”
May 18, 2011
James S. "Jay" Crenshaw- Orlando
Scott R. MacLeod- Orlando
Rule 5131 Summary
The Financial Industry Regulatory Authority, Inc. ("FINRA") has recently adopted, and the Securities and Exchange Commission has approved, new FINRA Rule 5131 ("Rule 5131"). Rule 5131 was initially to become effective on May 27, 2011, but has been delayed until September 26, 2011. Rule 5131 addresses, and seeks to regulate, the practice of "spinning" (i.e., the "quid pro quo" practice of FINRA member broker-dealers ("broker-dealers") allocating new issues (i.e., U.S. initial public offering shares) to certain Covered Persons that are affiliated with certain Companies that are former, current or prospective investment banking clients). Rule 5130, by contrast, addresses the allocation of new issues to "restricted persons" (i.e., persons in the securities industry). However, like Rule 5130, Rule 5131 will require broker-dealers to attain separate representations from investment managers regarding certain status issues under Rule 5131. As a result, in order for investment managers of private funds and/or accounts to make such representations to broker-dealers, they will in turn need to obtain similar representations from their underlying Fund investors or clients.1
Immediate Action Needed
Although the effective date of Rule 5131 has been delayed until September 26, 2011, we nevertheless are already seeing many broker-dealers and funds seeking these certifications now from their underlying investors (particularly with respect to our fund of fund clients). Accordingly, if you currently manage any accounts or private funds that purchase new issues, directly or indirectly through other funds, we are advising you to immediately:
1. obtain Rule 5131 certifications from account holders and/or your underlying private fund investors; and
2. amend your fund and/or related account documents, including, but not limited to, subscription agreements.
Holland & Knight is prepared to assist you in amending your fund documents and preparing investor status certifications re: Rule 5131.
Spinning Prohibitions of Rule 5131
Rule 5131 prohibits the allocation of new issues by a broker-dealer to any account in which an executive officer or director of a public company2 or a covered non-public company3 (each, a "Company"), or a person materially supported4 by such executive officer or director (collectively, a "Covered Person"), has a beneficial interest if: (i) the Company is currently an investment banking services client of such broker-dealer or such broker-dealer has received compensation from the Company for investment banking services in the past twelve months; (ii) the person responsible for making the allocation decision knows or has reason to know that the broker-dealer intends to provide, or expects to be retained by the Company for, investment banking services within the next three months; or (iii) new issues are allocated on the express or implied condition that such executive officer or director, on behalf of the Company, will retain the broker-dealer for the performance of future investment banking services (with broker-dealers in the foregoing items (i) - (iii) collectively being referred to herein as "Related Brokers").
Exemptions
With respect to a private fund, Rule 5131 permits allocation of new issues to a private fund (without the need for such private fund to utilize "carve-outs" (as described more fully below)) if 25% or less of the private fund is owned by Covered Persons of any one particular Company (including the interest of the private fund's investment manager) (the "25% Exemption"). Because the 25% Exemption is calculated on a Company-by-Company basis (i.e., more than 25% of the private fund would need to be owned by Covered Persons of a particular Company), it is very likely that most private funds will qualify for the 25% Exemption.5
Similar to Rule 5130, Rule 5131 will exempt from its prohibitions certain persons (i.e., they will not be considered Covered Persons if investing in a private fund), including: (1) registered investment companies; (2) certain common trust funds; (3) certain insurance company accounts; (4) certain publicly traded entities listed or eligible to be listed on a U.S. exchange; (5) non-U.S. investment companies listed on a foreign exchange (or authorized for sale to the public by a foreign regulator); (6) most ERISA plans; (7) state or municipal benefit plans; (8) 501(c)(3) tax-exempt entities; and (9) 414(e) church plans.
Determining/Monitoring Rule 5131 Compliance
There are various approaches a private fund may consider when determining its eligibility to receive new issue allocations under Rule 5131. For example, a private fund may:
1. aggregate the interests of all Covered Persons in the private fund without regard to the particular Companies with which they are affiliated when determining compliance with the 25% Exemption
2. analyze the interests of Covered Persons on a Company-by-Company basis when determining compliance with the 25% Exemption (and, if needed, determine whether the private fund is doing business with a Related Broker)
3. impose a 10% limitation to coincide with the 10% exemption under FINRA Rule 5130, while either: (a) aggregating the interests of Covered Persons across the private fund without regard to the particular Companies they serve; or (b) analyzing the interests of Covered Persons on a Company-by-Company basis
Naturally, there are different costs and benefits of each potential course of action, so a private fund will need to decide which approach suits its specific needs.
Annual Certifications
Broker-dealers may rely on written representations obtained within the prior 12 months from the beneficial owner(s) of the account, or a person authorized to represent the beneficial owner(s) of the account, as to whether such beneficial owner(s) is a Covered Person and if so, the Company(ies) on whose behalf such Covered Person serves. The initial representation must be an affirmative representation, but FINRA will permit such representation to be updated annually through the use of negative consent letters. Correspondingly, private fund investment managers will need to elicit, similarly, such data from their underlying investors in order to make this representation.
1 Such investment managers already have a duty under Rule 5130 to obtain annual certifications from underlying Fund investors or clients re: their “restricted person” status under Rule 5130.
2 Rule 5131(e)(1) defines a "public company" as any company that is registered under Section 12 of the Securities and Exchange Act of 1934 or files periodic reports pursuant to Section 15(d) thereof.
3 Rule 5131(e)(3) defines a "covered non-public company" as any non-public company with: (i) an 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 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 of the last three fiscal years.
4 Rule 5131(e)(6) defines "material support" as directly or indirectly providing more than 25% of a person's income in the prior calendar year. Persons living in the same household are deemed to be providing each other with material support.
5 It should be noted that, if more than 25% of the private fund is owned by Covered Persons of a particular Company, and if the broker-dealer allocating the new issue is not a Related Broker of such particular Company, then such private fund still falls within the 25% Exemption and, accordingly, "carve-outs" are not necessary with respect to such Covered Persons. However, in the unlikely scenario where over 25% of the private fund is owned by Covered Persons of a particular Company, and a new issue is being allocated by a Related Broker to such particular Company, then the private fund could still comply with the 25% exemption by allocating away or "carving out" the portion of the new issue allocation being made to Covered Persons so that the beneficial interests by such Covered Persons in the new issue is no more than 25%. For instance, a private fund owned 40% by Covered Persons of a particular Company could "carve out" a new issue allocation from a Related Broker to such Covered Persons so that they receive no more than 25% of the new issue allocation.
Related Practices