Overview
FINRA’s Rule 5131 bans a practice known as “spinning” by generally prohibiting a FINRA member from allocating a new issue to any account (e.g., private investment fund) in which an executive officer or director of a public company, [1] or a covered non-public company,[2] or a person materially supported,[3] by such an executive officer or director (each, a “Rule 5131 Restricted Person”), has a beneficial interest[4] if such Rule 5131 Restricted Person’s company has or expects to have an investment banking relationship with the FINRA member. The Rule contains a “carve out” similar to the 10 percent carve out in FINRA Rule 5130 (also known as the “New Issue Rule”), under which new issues may be allocated to accounts in which the beneficial interests of the Rule 5131 Restricted Persons of a particular public company or covered non-public company do not exceed 25 percent. In anticipation of the Rule’s May 27 effective date, broker-dealers have been sending questionnaires to their account holders, including private investment fund managers, asking for certain representations concerning the beneficial ownership of their funds by Rule 5131 Restricted Persons and we have advised managers with respect to amending their subscription documents and supplementing their Rule 5130 questionnaires to elicit the relevant information from their investors.
Recently, FINRA submitted a proposal to the Securities and Exchange Commission (“SEC”) seeking approval to revise Rule 5131 in certain respects that do not bear upon the above prohibition on allocations to Rule 5131 Restricted Persons. Specifically, FINRA proposed to delete a ban on involvement by investment banking personnel of broker-dealer firms in the firms’ new issue allocation decisions. As part of that proposal, FINRA also requested SEC approval to extend the implementation date of certain parts of Rule 5131, including the new issue allocation provisions that indirectly impact fund managers, to Sept. 26, 2011.
It appears likely that the SEC will approve an extension of the implementation date; however, fund managers will still need to be able to respond to broker-dealer questionnaires regarding their Rule 5131 Restricted Persons. As noted above, FINRA’s proposed changes to the Rule do not impact the new issue allocation provisions relating to Rule 5131 Restricted Persons; accordingly, the questionnaires that have already been distributed by broker-dealers should not be expected to change. Likewise, the supplemental questions regarding Rule 5131 Restricted Person status that fund managers have developed for inclusion in their subscription documents and questionnaires to existing investors can be used, without revision, to elicit the information concerning Rule 5131 Restricted Persons that is needed to respond to broker-dealer questionnaires.
Authored by Ida Wurczinger Draim.
If you have any questions concerning this Alert, please contact your attorney at Schulte Roth & Zabel or the author.
[1] For purposes of Rule 5131, the term “public company” means any company that is registered under Section 12 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), or files periodic reports pursuant to Section 15(d) thereof.
[2] For purposes of Rule 5131, the term “covered non-public company” means any non-public company satisfying the following criteria: (i) income of at least $1 million in the last fiscal year or in two of the 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 fiscal years.
[3] For purposes of Rule 5131, the term “material support” means directly or indirectly providing more than 25 percent 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.
[4] For purposes of Rule 5131, the term “beneficial interest” means any economic interest such as the right to share in gains or losses. The receipt of a management or performance based fee for operating a collective investment account, or other fee for acting in a fiduciary capacity, is not considered a beneficial interest in the account. For purposes of this Alert, the term “beneficial owner” means any person that has a beneficial interest.
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