United States: FINRA Files With SEC To Amend Rule On "Spinning" New Issues

Last Updated: September 20 2013
Article by Amy Natterson Kroll and Laura E. Flores

FINRA has filed with the Securities and Exchange Commission ("SEC") a proposed rule change to amend FINRA Rule 5131 (the "Rule")1 to except from compliance with the Rule's "spinning provision"2 certain private funds of funds that satisfy a group of proposed preconditions.

Rule 5131 is intended to curb abuses by FINRA members ("Members") and their associated persons in the allocation and distribution of "new issues."3 The spinning provision is specifically designed to prevent the allocation and distribution of new issues to accounts in which executive officers and directors of investment banking clients, and persons materially supported by such executive officers and directors, have a beneficial interest in exchange for investment banking business.4 

In its current form, the spinning provision excepts allocations of new issues to (1) accounts in which the aggregate beneficial interests of executive officers, directors and persons materially supported by such executive officers and directors do not exceed 25% of such account and (2) certain types of accounts that typically have large and diverse investor bases, such as registered investment companies.5 Private funds are not currently an excepted account type unless they are eligible for one of the articulated exceptions. Private funds therefore go to great lengths to gather information about their beneficial owners, in order to demonstrate that they are eligible to receive new issue allocations. Gathering that information is particularly difficult, if not impossible, for many funds of funds.

The Rule provides that a Member may rely on a written representation from the beneficial owners of an account, or a person authorized to represent such beneficial owners, to determine whether the beneficial owners, and thus the account, are within the scope of the spinning provision.6 The use of a written representation was intended to help facilitate Members' compliance with the spinning provision; however, it has become apparent that identifying and aggregating indirect beneficial ownership information for private funds of funds presents a significant obstacle to Member compliance because often a fund of funds does not have the ability to gather information about the beneficial owners of the funds in the fund of funds.

To ameliorate this obstacle, FINRA is proposing to expand the account types excepted from the spinning provision to include accounts that do not look through to the indirect beneficial owners of a fund, such as funds of funds, and satisfy certain conditions. The conditions, set forth below, are designed to capture funds that pose minimal risk of spinning.

To rely on the exception, a fund must:

  • be a "private fund" as defined in the Investment Advisers Act of 1940;
  • be managed by an investment adviser;
  • have assets greater than $50 million;
  • own less than 25% of the account and not have a single investor with a beneficial interest of 25% or more;
  • not have a beneficial owner that also is a control person of the fund's investment adviser;
  • be "unaffiliated" with the account in that the private fund's investment adviser does not have a control person in common with the account's investment adviser; and
  • not have been formed for the specific purpose of investing in the account.

Members would be permitted to rely on a written representation that an account satisfies the foregoing conditions and could rely on the proposed exception, unless the Member believes, or has reason to believe, that such representation is inaccurate.7 

In its Notice of Proposed Rulemaking, FINRA noted that it considered several alternative approaches to address the obstacle, including an exception available to all private funds with certain asset thresholds, but ultimately determined that the proposed exception struck the right balance of preserving the protections of the Rule and limiting the availability of the exception to situations that are not vulnerable to spinning.

While the purpose of the proposed rule change is commendable, and would help a limited number of fund of funds, certain of the proposed conditions appear to be unnecessarily restrictive and threaten to overshadow the intended benefit of the proposed exception. In particular, the fifth condition would prevent a fund that is invested in a fund of funds from availing itself of the proposed exception if its fund manager owns an interest in the fund and is a control person, as that term is defined in Form ADV, of the fund's investment adviser — a scenario that is not uncommon. This would be the result even if the fund manager owned a single share of the fund and despite the fact that the fund has a less than 25% interest in the fund of funds in compliance with the fourth condition and is unaffiliated with the investment adviser to the fund of funds in compliance with the sixth condition. It seems unlikely that the "proportional benefit to [the fund manager in this scenario] would be of an amount that would further spinning."8 Nonetheless, the proposed exception would operate to exclude the fund and fund of funds in this scenario from benefitting from the proposed exception to allow their participation in new issue allocations. The contemplated result seems anomalous to FINRA's intent, in light of the fact that an account in which executive officers and directors of investment banking clients, and persons materially supported by such officers and directors, beneficially own in the aggregate 25%, is eligible to receive new issue allocations in reliance on the Rule's existing de minimis exception. Arguably there is a greater opportunity for spinning in the latter scenario. Furthermore, given the Rule's existing de minimis exception, it is curious that FINRA did not include a similar 25% beneficial ownership threshold in the fifth condition. The inclusion of such a threshold could adequately address FINRA's balancing concerns.

To ensure that FINRA is aware of these flaws to its proposed rule change, we encourage fund advisers and other investment advisers, as well as Members, to comment on the proposed rule change. Submissions of comment letters should refer to File Number SR-FINRA-2013-037 and should be submitted on or before October 1, 2013.


1 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 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: (1) 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. 

3 "New issues" is defined in FINRA Rule 5130(i)(9).

4 FINRA explained that "such persons are often in a position to hire members on behalf of the companies they serve, allocating new issues to such persons creates the appearance of impropriety and has the potential to divide the loyalty of the agents of the company (i.e., the executive officers and directors) from the principal (i.e., the company) on whose behalf they must act." FINRA Regulatory Notice 10-60, Approval of New Issue Rule, November 2010, available at http://www.finra.org/web/groups/industry/@ip/@reg/@notice/documents/notices/p122490.pdf.

5 The excepted account types are set forth in FINRA Rule 5130(c)(1) through (3) and (5) through (10).

6 Supplementary Material .02 provides that "for purposes of paragraph (b), a member may rely on a written representation 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 an executive officer or director or person materially supported by an executive officer or director and if so, the company(ies) on whose behalf such executive officer or director serves." 

7 Members that avail themselves of the proposed exception must comply with the recordkeeping requirements set forth in Supplementary Material .02.

8 Proposed Rule Change at 7.


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