New-Issue Credit Restrictions and Related Exemptions

The new-issue credit restriction is the 30-day cooling-off rule for selling-syndicate and selling-group members:

• The rule's design is to break the loop where a firm could prop up the price of a security it just helped distribute by extending margin credit to buyers of the same security
• The exemptions are narrow and conditional; each applies only when its stated conditions are met
• A separate SEC rule adds disclosure and suitability duties for covered credit arrangements, and another conditions the use of financial statements that reflect offering proceeds

The 30-Day Prohibition

A firm that is both a broker and a dealer may NOT extend or maintain credit, or arrange for another lender to do so, for a customer on a security that was part of a new issue it distributed as a member of a selling syndicate or selling group within the 30 days before the transaction.

This limits how the customer pays, not whether the customer may buy the security. The firm can execute a fully paid cash purchase during the cooling-off period because it extends no credit. Unless an exemption applies, it must decline a margin purchase that leaves the customer owing the firm part of the price.

What Counts as Distribution Participation

The test is membership. A firm is covered if it participated in the distribution as a member of a selling syndicate or group:

• Underwriter in the selling (underwriting) syndicate
• Selling group member, including a dealer that took an allotment from the syndicate for resale at the offering price

A firm that simply executes a customer's secondary-market purchase of the same security, without having been a syndicate or selling-group member in the distribution, is not subject to the 30-day prohibition.

What "Extend or Maintain Credit" Means

The prohibition covers:

• Lending the customer money to buy the security
• Holding the security in a margin account where the customer has any debit balance
• Maintaining an existing margin loan secured by the security after the 30-day clock starts
• Arranging for another lender to extend or maintain such credit

Shares a customer already held before the offering, bought through a different firm or in a different transaction, were not part of the new issue. The prohibition reaches only credit on a security that was part of the new issue, so credit on those older shares is not restricted.

Why This Matters

Without the 30-day rule, a firm that helped distribute a hot IPO could simultaneously extend margin credit to retail customers buying the same IPO. Customers would be using the firm's own credit to bid up the firm's own distribution. The rule severs that loop.

Think of it this way: The new-issue credit restriction treats the firm as having just "owned" the security through the distribution. The firm doesn't get to play both seller and lender to its customer at the same time. The 30 days is the cooling-off period during which the firm must keep its distribution role and its margin role separate.

Exam Tip: Gotchas

• The new-issue credit restriction is the 30-DAY cooling-off rule for selling-syndicate and selling-group members. They can sell the security but cannot extend, maintain, or arrange customer credit on the new-issue shares during the 30-day window. The exam frames this as a conflict-of-interest containment rule.
• The 30 days run from the firm's participation, not from the offering's start. The statute counts back 30 days from the credit transaction to the firm's participation. A syndicate or selling-group member normally participates until the distribution ends, so for most firms the window runs from the END of the distribution, which can take days or weeks.

DPP Exemption

A separate SEC exemption treats qualifying Direct Participation Program (DPP) securities as exempted securities, but only for the arranging provisions of the margin-credit and new-issue credit restrictions.

What DPPs Are

A direct participation program is a non-corporate, pass-through investment vehicle, most commonly a limited partnership, that allows investors to participate directly in the cash flows and tax benefits of an underlying business. Common DPP forms:

• Real estate limited partnerships
• Oil and gas limited partnerships
• Equipment leasing programs

DPP securities generally provide flow-through tax consequences and are not actively traded during the pay-in period. The definition excludes real estate investment trusts, S corporation offerings, and registered investment companies, among others. The exemption applies to qualifying mandatory deferred payments, not every illiquid partnership interest.

Conditions for the Exemption

The exemption permits specified deferred-payment arrangements that meet its conditions. Securities must be registered or qualify for the specified intrastate route, and deferred contributions must reasonably relate to a disclosed business development plan.

Investors must pay at least 50% at sale. Full payment is due within three years for specified-property programs or two years for non-specified-property programs, measured from the earlier of offering completion or one year after effectiveness.

Exam Tip: Gotchas

• The DPP exemption has payment and program conditions. Illiquidity or limited-partnership status alone does not establish the exemption from the arranging provisions.

Specified-Transactions Exemption

A separate SEC exemption, the specified-transactions exemption, lifts the new-issue credit restriction in five listed situations:

• The firm did not sell the security to the customer or buy it for the customer's account
• The customer got the security from the issuer in exchange for another of the issuer's securities on which credit was lawfully maintained
• The customer is a broker, dealer, or bank
• The customer got the security by exercising stockholder rights from a warrant or certificate expiring within 90 days after issuance
• The new issue is 50% or less of the class outstanding or being distributed, and the firm sold the security on a day it was not participating in the distribution

For the last item, a firm is still participating while it owns undistributed securities of the issue, is stabilizing, is party to a syndicate agreement permitting stabilization, or is party to an executory agreement to purchase or distribute the issue.

Exam Tip: Gotchas

• The specified-transactions exemption is a closed list. A firm's belief that the conflict is absent, a customer's wealth, or a customer's consent does not create an exemption.

Investment Company Shares as Margin Collateral

A specific exemption permits credit on shares of a registered open-end fund or unit investment trust when the customer has owned them for more than 30 days, or acquired them through automatic reinvestment of dividends. It does not permit financing an ordinary new fund-share purchase merely by calling the shares collateral.

Why This Exemption Exists

A BD that is part of a mutual fund's distribution could otherwise be barred from extending or maintaining credit on that fund's shares during the 30-day window. The exemption draws its line by how long the customer has owned the shares and how the customer got them, not by what the credit is used for:

• Shares the customer has owned for more than 30 days, or bought through automatic dividend reinvestment, qualify, so the firm may extend or maintain credit on them
• Shares the customer is buying now in the distribution meet neither condition, so this exemption does not cover a margin purchase of the fund's new shares, which stays barred unless the specified-transactions exemption applies

Exam Tip: Gotchas

• Ownership time or automatic dividend reinvestment determines eligibility. The label "margin collateral" alone does not establish the investment-company exemption.

Disclosure When Extending Credit

For a covered securities-and-loan transaction, the SEC's credit-extension disclosure rule requires the following before any purchase, loan, or related element of the transaction is entered into:

Check coverage first. Credit a broker-dealer extends or arranges in compliance with Regulation T (Reg T), only to purchase or carry the security offered or sold, is excluded. Credit used for anything other than purchasing or carrying the security sold, such as paying insurance premiums, is outside the exclusion; municipal-security transactions and certain exempt over-the-counter (OTC) derivatives dealer transactions have separate exclusions.

A timely lender statement, prospectus, or offering circular containing all required information can satisfy the disclosure prong. The firm's written suitability basis remains required for a covered transaction.

What "Extends or Arranges" Means

A firm "extends" credit when it lends customer money directly. A firm "arranges" credit when it facilitates a third-party loan. Either can be covered, subject to the rule's exclusions; using a bank lender does not by itself resolve coverage.

Exam Tip: Gotchas

• For a covered transaction, the credit-extension disclosure rule requires a written statement AND a determination that the entire transaction is suitable, based on the customer's financial information. Both are required; one alone does not satisfy the rule. The exam may probe scenarios where the firm provided written terms but did not check suitability; both are required.
• Coverage comes before either requirement. Ordinary margin credit that meets Reg T and funds only the security being sold is outside the rule.

Pro Forma Balance Sheets

The SEC's pro forma rule is an anti-fraud rule aimed at broker-dealers. It treats the use of a financial statement that gives effect to the receipt and application of offering proceeds as a manipulative, deceptive, or fraudulent device, unless each statement's caption clearly sets out the assumptions the statement is based on.

What the Rule Covers

The rule reaches financial statements that purport to give effect to the receipt and application of any part of the proceeds from a sale or exchange of securities. The common example is a pro forma balance sheet showing the issuer as it would look once an offering's proceeds are received and applied, for instance to repay a bank loan.

A forecast that gives effect to no securities proceeds, such as a projection of next year's sales, is outside this rule.

What the Rule Requires

The rule does not ban these statements. It conditions their use on the caption:

• The assumptions each statement is based on must be clearly set forth as part of its caption
• The caption must be printed in type at least as large as the type used generally in the body of the statement

A footnote or a separate note does not satisfy the rule, because the assumptions must appear in the caption itself. The rule sets no audit, filing, or "reasonable basis" condition.

The rule works by defining a device under the Exchange Act's broker-dealer anti-fraud provision, which bars a broker or dealer from effecting a transaction in, or inducing the purchase or sale of, a security by such a device.

Exam Tip: Gotchas

• The pro forma rule does NOT ban statements that reflect offering proceeds; it requires their assumptions in the caption. Assumptions stated only in a footnote, or captioned in type smaller than the body, make the use a fraudulent device.

What Should You Check on Exam Day?

• Do you know the 30-day cooling-off period during which a distribution participant may not extend or maintain credit on that security?
• Can you state the conditions for the limited DPP mandatory-deferred-payment exemption?
• Can you name the five situations the specified-transactions exemption lists, such as a customer that is a broker, dealer, or bank?
• Can you apply the investment-company exemption's ownership-period or automatic-reinvestment condition?
• Do you know the two required elements of the credit-extension disclosure rule for a covered transaction: a written statement and a determination that the entire transaction is suitable?