FINRA Rule 5131 Regarding Allocations Practices for New Issues Approved by SEC

Effective May 27, 2011

December 10, 2010

The SEC has approved FINRA Rule 5131, which will be effective May 27, 2011.1 This rule codifies specific limitations on broker-dealer practices in the allocation of “new issues” and articulates specific requirements for reporting final allocations, waiving certain lock-up restrictions, reallocating new issues shares returned to a syndicate member and accepting secondary market orders prior to the initiation of secondary market trading.

In 2003, as part of the settlement of enforcement actions involving conflicts of interest in research and investment banking,2 the firms that were party to the Global Research Settlement also agreed to a voluntary initiative to address new issue allocation practices. The firms agreed to implement policies and procedures reasonably designed to prevent allocations of “hot IPOs” to accounts of executive officers or directors of public companies. The policies and procedures also were required to be reasonably designed to prevent, among other practices, the allocation of new issues in exchange for or for the purpose of obtaining investment banking business.3 While the Voluntary Initiative applied only to the firms that were party to the Global Research Settlement, its concepts were widely incorporated into the policies and procedures of U.S. broker-dealers engaged in investment banking activities.

Not long after the Voluntary Initiative was announced by the Securities and Exchange Commission (“SEC”), NASD filed with the SEC a Proposed Rule 2712, now Rule 5131, that reflected the concepts of the Voluntary Initiative as well as additional issues related to “flipping” and lock-up waivers.4 NASD, and then FINRA, proposed four amendments to NASD Proposed Rule 2712/FINRA Rule 5131 between 2003 and 2010. FINRA has now, finally, obtained approval for this rule.

1. “New Issues.” For purposes of Rule 5131, FINRA defines “new issues” to have the same meaning as in Rule 5130(i)(9), specifically, any initial public offering of an equity security as defined in Section 3(a)(11) of the Securities Exchange Act of 1934 (“Exchange Act”), made pursuant to a registration statement or offering circular. This rule is not limited to allocations of “hot IPOs.” Certain offerings, however, are explicitly excluded from this definition.5

2. The Rule. Rule 5131(a) lays down the law — No Quid Pro Quo Allocations. New issue allocations can not be offered or threatened to be withheld by a FINRA member or associated person in order to obtain or induce payment of compensation that is excessive in relation to the services the member provides to the payer of the compensation.

Absent satisfaction of the terms of Rule 5131(b)(3), discussed below, Rule 5131(b) directs FINRA members to establish policies and procedures to prevent the involvement or influence of investment banking personnel in the allocation of new issues. Furthermore, Rule 5131(b) prohibits FINRA members from allocating new issue shares to any account in which an executive officer or director of a public company or a “covered non-public company,”6 or a person materially supported by such person, has a beneficial interest, if: (1) the company is an investment banking services client of the member or in the previous 12 months has compensated the member for investment banking services, (2) the person responsible for making allocation decisions knows or has reason to know that the member intends to provide or expects to be retained by the company for investment banking services in the next three months,7 or (3) there is an express or implied condition that the executive officer or director will retain the member for performance of investment banking services.

FINRA explains in Regulatory Notice 10-60 and in its submissions to the SEC that the prohibitions in Rule 5131(b) are intended to be a baseline. On the one hand, Rule 5131(b)(3) excludes from prohibited allocations those made to certain accounts8 and also to any account in which beneficial interest of executive officers, directors or their dependents of a company in aggregate does not exceed 25 percent. On the other hand, FINRA acknowledges that members may choose to adopt a policy flatly prohibiting allocations to executive directors and officers.9 Supplementary Material 5131.02 clarifies that member firms will be able to rely on annual attestations from account holders and beneficial owners of accounts that they are not executive officers or directors or persons materially supported by an executive officer or director. In Regulatory Notice 10-60, FINRA further clarifies that after an initial affirmative representation, member firms may use negative consent letters to obtain subsequent annual updated representations from such persons.

Rule 5131(c) addresses flipping; specifically member firms and their associated persons are prohibited from seeking to recoup or directly or indirectly recouping any portion of a commission or credit paid to an associated person for selling shares of a new issue that are subsequently “flipped”10 by a customer, unless the managing underwriter has assessed a penalty bid on the entire syndicate.11 Some firms’ policies and/or practices currently may endorse penalizing associated persons in an effort to discourage associated persons’ customers from flipping new issues. FINRA has concluded, however, that member firms’ associated persons may not be able to direct their customers’ practices and that such a policy is vulnerable to disparate application. Firms therefore should ensure that prior to the effective date of Rule 5131 their practices and policies and procedures conform to the requirements of the rule, limiting the use of penalties assessed on associated persons to situations where in a new issue a penalty bid is assessed on all syndicate members.

Rule 5131(d) articulates a set of requirements member firms must follow in connection with pricing and trading new issues. Rule 5131(d)(4) prohibits member firms from accepting market orders for secondary market purchases of new issue shares prior to the commencement of secondary market trading. Therefore, when Rule 5131(d)(4) is effective, prior to secondary trading commencing, members will only be allowed to accept limit orders. FINRA explains that this new rule is intended to prevent investors who perhaps were not recipients of an allocation in the new issue from “finding their orders filled at prices beyond their reasonable expectations.” FINRA also has stated that execution of market orders may contribute to the “unconstrained increase in the price of a new issue in the secondary market,” and therefore should not occur.12

Rule 5131(d)(3) dictates acceptable practices by syndicate members in connection with the disposition of new issue shares that are trading at a premium and are returned to a syndicate member. Specifically, syndicate members and the lead manager must agree in the agreement among underwriters (“AAU”) that, to the extent it is not inconsistent with Regulation M,13 any such returned new issue shares will be used to offset any existing syndicate short position. Furthermore, the AAU must state that 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, anonymously donating the proceeds from the sale to an unaffiliated 501(c)(3) organization.14

Rule 5131(d)(1) will require book-running lead managers to provide regular and final reports to an issuer’s pricing committee or, if none, the board of directors, with (1) detailed information about indications of interest from identified institutional investors and final allocations of shares to institutional investors, including the name of and allocation to each institutional purchaser; and (2) information about aggregate demand from retail investors and aggregate sales to retail investors.

Finally, Rule 5131(d)(2) will require the book-running lead manager (or its designee among the selling group) to provide notice to the issuer at least two days before the release or waiver of any lock-up or other restrictions of the issuer’s shares. The book-running lead manager also will be required to announce the impending release or waiver through a major news service, unless the release or waiver will only permit a transfer of securities with no consideration and the recipient agrees in writing to be bound by the terms of the lock-up agreement in place of the transferor.

3. The Road Ahead. In order to be prepared for the effectiveness of Rule 5131, FINRA member firms should review and as necessary enhance their policies and procedures in connection with allocation of new issues. Policies and procedures that may need to be added, or that may require revision include:

  • Policies and procedures reasonably designed to ensure that investment banking personnel are not involved in or have the ability to influence, directly or indirectly, new issue allocation decisions;
  • Policies and procedures specifically implementing information barriers between investment banking and syndicate functions;
  • Policies and procedures for obtaining and updating representations of status of account holders for purposes of Rule 5131(b) compliance (Firms likely will amend their 5130/2790 restricted person letters to encompass these representations also) and creating related records;
  • Policies limiting to penalty bid situations the ability of a firm to recoup commissions and credits if customers “flip”;
  • Additional books and records as required in connection with any penalties or disincentives assessed on associated persons in connection with penalty bids;
  • Processes for compiling the information that must be reported to lead managers with regard to indications of interest and allocations to institutional investors and retail investors;
  • Processes for providing notice to an issuer and through news channels (when required) prior to waiver or release of lock-ups, and
  • Policies prohibiting accepting market orders prior to commencement of secondary trading of a new issue.

Firms also will want to:

  • Review the form of their AAUs to ensure they address the requirements of Rule 5131(d)(3), and
  • Adjust their order entry process to ensure that limit orders can not be entered prior to the start of secondary market trading of new issues.

In light of the above‚ unless a firm flatly prohibit allocations to all accounts in which executive directors‚ officers or their dependents have a beneficial interest‚ it will want to review carefully its organizational and supervisory structure. Firms that locate their syndicate function at least nominally in investment banking or where syndicated desk members are supervised by investment banking will need to evaluate whether these are viable arrangements in light of Rule 5131. Because FINRA has stated that the forward-looking provisions of Rule 5131(b)(2)(B) will not be violated “if a member maintains effective information barriers between the investment banking and syndicate departments and the persons responsible for making new issue allocation decisions neither know or have reason to know of [a] prospective business relationship,”15 firms will want to consider a thorough review of how their investment bankers and syndicate desks interact to be sure that there are adequate safeguards in place when Rule 5131 becomes effective. Furthermore, while a firm that is fully compliant with Rule 5131(b)(3) and obtains all required representations from accounts with regard to status should not have worries, the definition of “investment banking services” in Rule 5131, which includes “participating in a selling group in an offering for the issuer or otherwise acting in furtherance of a public offering of the issuer. . .” may raise issues for a firm that is not as certain of its ability to be fully compliant with Rule 5131(b)(3). Therefore, again, a full review in advance of the effective date of Rule 5131 will allow a firm to evaluation any changes needed to ensure compliance once the rule is effective.


For additional information concerning this alert, please contact the following lawyers:

David Boch, Partner, Broker-Dealer Group, 617.951.8485

Amy Natterson Kroll, Partner, Broker-Dealer, 202.373.6118  

Roger P. Joseph, Practice Group Leader, Investment Management; Co-chair, Financial Services Area, 617.951.8247

Edwin E. Smith, Partner, Financial Restructuring; Co-chair, Financial Services Area, 617.951.8615

Tim Burke, Practice Group Leader, Broker-Dealer Group; Co-chair, Financial Services Area, 617.951.8620

1“Approval of New Issue Rule: SEC Approves New FINRA Rule to Address Abuses in the Allocation and Distribution of New Issues,” FINRA Regulatory Notice 10-60 (November 2010) (“Regulatory Notice 10-60”).
2Ten of Nation’s Top Investment Firms Settle Enforcement Actions Involving Conflicts of Interest Between Research and Investment Banking, (“Global Research Settlement”).
3Voluntary Initiative Regarding Allocations of Securities in "Hot" Initial Public Offerings to Corporate Executives and Directors,
4The proposed rule was first published for comment by the SEC on December 20, 2004. Self-Regulatory Organizations; Notice of Filing of Proposed Rule Changes by the New York Stock Exchange, Inc. and the National Association of Securities Dealers, Inc. Relating to the Prohibition of Certain Abuses in the Allocation and Distribution of Shares in Initial Public Offerings (“IPOs”),
5The definition of “new issue” in Rule 5130(i)(9) specifically excludes:

1. offerings pursuant to an exemption under Section 4(1), 4(2) or 4(6) of the Securities Act of 1933 (“Securities Act”) or Rule 504 under the Securities Act if the securities are “restricted securities” under Rule 144(a)(3), Rule 144A, Rule 505 or Rule 506 under the Securities Act;
2. offerings of exempted securities as defined in Section 3(a)(12) of the Exchange Act and rules thereunder;
3. offerings of securities of certain commodities pools;
4. rights offerings, exchange offers, or offerings pursuant to a merger or acquisition;
5. offerings of investment grade asset-backed securities;
6. offerings of convertible securities, including mandatory convertible securities;
7. offerings of preferred securities;
8. offerings of shares of investment companies registered under the Investment Company Act of 1940;
9. offerings of securities that have a preexisting market outside the United States; and
10. offerings of certain business development companies, certain direct participation programs and certain real estate investment trusts.

6“Covered non-public company” is defined in Rule 5131(e)(3) and is intended to apply the limitations on allocations to include executive officers, directors and their dependents of companies where there is the greatest potential for abuse — namely those non-public companies that are most likely to be candidates for investment banking services as defined in Rule 5131(e)(5). See “Self-Regulatory Organizations; Financial Industry Regulatory Authority, Inc.; Notice of Filing of Amendment No. 4 and Order Granting Accelerated Approval of a Proposed Rule Change, as Modified by Amendment Nos. 1 through 4, Relating to the Prohibition of Certain Abuses in the Allocation and Distribution of Shares in Initial Public Offerings “(“IPOs”), 75 Fed Reg at 61451, October 5, 2010 at 61542.
7See discussion in text with regard to the use of information barriers between investment banking and syndicate functions to avoid violation of the “forward-looking” provision articulated in Rule 5131(b)(2)(B). See also 75 Fed Reg at 61544.
8Specifically those accounts described in Rule 5130(c)(1) through (3) and (5) through (10) are excluded from the allocation prohibition.
9See 75 Fed Reg at 61543.
10“Flipped” is defined in Rule 5131(e)(4) as the initial sale of new issue shares purchased in an offering within 30 days following the offering date of the offering. FINRA specifically states that it chose this bright line definition to avoid confusion or inconsistent application of the rule. See 75 Fed Reg at 61546.
11Rule 5131(c) also requires FINRA members to promptly record and maintain information regarding any penalties or disincentives assessed on associated persons in connection with a penalty bid. This is explicitly in addition to any obligation to maintain records relating to penalty bids under Rule 17a-2(c)(1) under the Exchange Act.
12Regulatory Notice 10-60.
13Regulation M, 17 CFR 242.100-105.
14FINRA has confirmed that the time to determine whether new issue shares are trading at a premium [relative to] the public offering price is at the time the shares are returned. FINRA also affirmed its view that a random allocation methodology is a good, effective standard used elsewhere in FINRA rules. See 75 Fed Reg at 61545, n. 30.
1575 Fed Reg at 61544.

This article was originally published by Bingham McCutchen LLP.