In late December, the Securities and Exchange Commission (“SEC”) approved FINRA’s proposed rule change,1 as modified by Amendment No. 1,2 to amend FINRA Rule 5131 (the “Rule”) to provide for a limited exception from compliance with the Rule’s “spinning provision”3 for certain unaffiliated private funds of funds. The SEC approved FINRA’s proposed rule change, as modified by Amendment No. 1, on an accelerated basis. As a result, the amended Rule becomes effective on February 3, 2014. Comments on the proposed rule change, as modified by Amendment No. 1, were due on December 26, 2013. As of the date of this Alert, any comments submitted were not yet available for viewing.
With respect to indirect beneficial owners of an unaffiliated private fund account investor (except for beneficial owners that are control persons of the adviser to the private fund), FINRA members may now comply with the Rule’s spinning provision by relying on a written representation from a person authorized to represent such account obtained within the 12 months prior to a new issue allocation to such account that such unaffiliated private fund investor (1) is managed by an investment adviser; (2) has assets greater than $50 million; (3) owns less than 25% of the account and is not a fund in which a single investor has a beneficial interest of 25% or more; and (4) was not formed for the specific purpose of investing in the account, so long as the member has no reason to believe that such representation is inaccurate.
Following the submission of FINRA’s proposed rule change to the SEC in September, we alerted clients that one of the proposed conditions appeared to unnecessarily restrict funds and threatened to overshadow the intended benefit of the proposed exception.4 Specifically, the proposed rule change would have required, among several other conditions, that a private fund must not have a beneficial owner that also is a control person of the private fund’s investment adviser to be eligible for the proposed exception.5 The SEC received two comment letters in response to the proposed rule change, both of which requested that FINRA eliminate this proposed condition.6
Both commenters noted that it is not at all uncommon for a private fund to have a beneficial owner that also is a control person of the private fund’s adviser. They also commented that not only is the arrangement beneficial in that it aligns the interests of a control person of the adviser with those of the investors in the private fund managed by the adviser, but restricting the arrangement does not further the purposes of the Rule. Both commenters recommended eliminating the proposed condition. FINRA adopted an alternative approach, however, that one of the commenters suggested.
Instead of making all private funds with a common beneficial owner and control person of the adviser ineligible for the exception, the commenter proposed that FINRA require that such a private fund look through with respect to the common beneficial owner and control person only. In other words, where a private fund investor that otherwise meets the exception’s conditions indicates in its written representation that it has a beneficial owner that also is a control person of the fund’s adviser, the FINRA member would be obligated to determine (1) if such beneficial owner is an executive officer or director of a public company or a covered non-public company, or a person materially supported by such executive officer or director and (2) whether the company is a current, recent or prospective recipient of investment banking services provided by such member. If the member determines that the beneficial owner meets these criteria and thus, is a covered person under the Rule’s spinning provision, the member may not allocate new issues to the account, unless the allocation would otherwise be permissible.7
In Supplemental Material to Amended Rule 5131, FINRA has adopted the approached described above. As a result, the Rule’s spinning provision, as finally amended and approved by the SEC, should present less of a compliance obstacle for members. However, when crafting their form of written representation, FINRA members should take care to include language that will elicit whether an unaffiliated private fund investor has a beneficial owner that also is a control person of the private fund’s adviser in addition to information about whether the private fund investor satisfies the four conditions enumerated in the amended Rule.
Alert Authors: Amy Natterson Kroll and Laura Flores
Contacts
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Kroll-Amy1 The text of the proposed rule change can be viewed here: http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p329146.pdf.
2 The text of Amendment No. 1 to the proposed rule change can be viewed here: http://www.finra.org/web/groups/industry/@ip/@reg/@rulfil/documents/rulefilings/p392523.pdf.
3 FINRA Rule 5131(b), the spinning provision, prohibits a member or person associated with a member from allocating shares of a new issue 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 executive officer or director, has a beneficial interest: (A) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months; (B) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next 3 months; or (C) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.
4 Our previous Legal Alert discussing FINRA’s proposed rule change, “FINRA Files With SEC to Amend Rule on “Spinning” New Issues,” can be viewed here: http://www.bingham.com/SearchResults?af=09%2f13%2f2013&at=01%2f20%2f2014.
5 The proposed rule change provided that FINRA members may rely upon a written representation obtained within the prior 12 months from a person authorized to represent an account that does not look through to the beneficial owners of a fund invested in the account, provided that such fund:
6 William G. Mulligan, CEO, Cordium US, and Stuart J. Kaswell, Executive Vice President & Managing Director, Managed Funds Association, submitted comment letters. The letters are available on the Commission’s website at http://www.sec.gov/comments/sr-finra-2013-037/finra2013037.shtml.
7 An allocation may be permissible, for example, if the beneficial owner’s beneficial interest in the account represents less than 25% of the account.
This article was originally published by Bingham McCutchen LLP.