Conflicts and Allocations

These rules exist because a syndicate manager has the power to allocate scarce new-issue shares, and FINRA is concerned that the allocation will be used as an inducement, a kickback, or a self-dealing channel. The principal supervising a primary distribution must affirm that none of these patterns is in play.

Public Offerings With Conflicts of Interest

A "conflict of interest" exists under the public-offering conflict-of-interest rule if any of the following are true:

• The securities are issued by the member
• The issuer controls, is controlled by, or is under common control with the member or its associated persons
• At least 5% of the net offering proceeds will be used to repay a loan or credit facility from, or otherwise be directed to, the member, its affiliates and its associated persons, in the aggregate (net proceeds are after all issuance and distribution expenses, and underwriting compensation does not count toward the 5%)
• As a result of the offering and any transactions contemplated at the time of the offering, the member will be an affiliate of the issuer, the member will become publicly owned, or the issuer will become a member (or form a broker-dealer subsidiary)

An affiliate is an entity that controls, is controlled by or is under common control with the member. Control means any of:

• Beneficial ownership of 10% or more of an entity's outstanding common equity or preferred equity
• The right to 10% or more of a partnership's distributable profits or losses
• The power to direct the entity's management or policies

Each ownership test counts any right to receive the interest within 60 days of the member's participation in the offering.

When a conflict of interest exists, the member may participate only through one of two routes:

A bona fide public market exists when the issuer has reported under the Exchange Act for at least 90 days and is current, its securities trade on a national securities exchange with average daily trading volume of at least $1 million, and its common equity public float is at least $150 million. A market that is merely active or liquid does not qualify.

A member may make prominent disclosure in either of two ways:

• In a prospectus subject to Regulation S-K: a "(Conflicts of Interest)" notation after the Plan of Distribution entry in the table of contents, plus disclosure in the Plan of Distribution section and any Prospectus Summary
• In a document not subject to Regulation S-K: disclosure on the front page, with a cross-reference to the discussion inside the document and in the summary if there is one

The rule reaches only a public offering. These are outside it:

• A private placement, including a Regulation D offering under the private-placement safe harbor
• An institutional resale offering to qualified institutional buyers
• A Regulation S offering
• Exempted securities, such as U.S. government and municipal securities

The rule has no other list of exempt offering types. FINRA may separately exempt a member in exceptional and unusual circumstances.

A member with a conflict also may not sell the security to a discretionary account unless the account holder gives specific written approval of the transaction, and the member keeps documentation of that approval.

QIU Requirements

A Qualified Independent Underwriter must:

• NOT have its own conflict of interest under the rule
• NOT be an affiliate of any conflicted member
• Beneficially own no more than 5% of the class of securities that would give rise to the conflict, including any right to receive those securities within 60 days
• Agree to undertake the legal responsibilities and liabilities of an underwriter under the Securities Act, specifically including registration-statement civil liability
• Have served as underwriter in at least 3 prior public offerings of similar size and type during the 3 years before filing
• Have no supervisory associated person responsible for organizing, structuring or performing due diligence on public offerings who, within the prior 10 years, was convicted of, permanently enjoined for, or suspended or barred for an anti-fraud violation in connection with an offering
• Participate in the preparation of the registration statement and prospectus
• Exercise due diligence and accept registration-statement civil-liability exposure

Exam Tip: Gotchas

• A QIU is only one route, and disclosure is required on every route. An offering with an unconflicted lead manager, a bona fide public market or investment grade securities needs no QIU, but it still needs prominent disclosure of the conflict.
• The QIU has no separate duty to price the offering. Its stated duties are participating in preparing the registration statement and other offering documents and exercising due diligence. Do not describe the QIU as the safeguard that "prices the deal."
• The 5% test is on NET proceeds, not gross. The base is offering proceeds less all issuance and distribution expenses, and underwriting compensation does not count toward the 5%. Because net is the smaller base, a loan repayment of 4.8% of gross can be over 5% of net.
• Becoming an affiliate AS A RESULT of the offering is itself a conflict. A debt-for-equity exchange that gives the underwriter a 15% stake post-deal triggers the conflict-of-interest rule even if no proceeds flow to the underwriter directly.
• The QIU must take on due-diligence liability. A QIU that participates without accepting underwriter liability has not satisfied the QIU requirement. The QIU is a real underwriter for liability purposes, not a paper signer.

Restrictions on Purchases of Initial Equity Public Offerings

The new-issue allocation rule for restricted persons prohibits a member from selling shares of a "new issue" (initial equity public offering) to any account in which a "restricted person" has a beneficial interest. The rule exists because new issues are frequently underpriced; allowing industry insiders to access the spinout would convert public-offering allocation into an industry kickback. (This rule is sometimes called the free-riding and withholding rule.)

Restricted Persons

A "restricted person" includes:

• Broker-dealers and their associated persons
• Finders and fiduciaries in the offering (attorneys, accountants representing the issuer or underwriters)
• Immediate-family members of the foregoing if materially supported by the restricted person
• Certain portfolio managers with discretion over investments who would benefit personally
• Owners of 10% or more of a broker-dealer (the owners listed on the broker-dealer's Form BD ownership schedules)

Exemptions and De Minimis

The rule has several built-in exemptions:

• De minimis carve-outs for collective investment vehicles (e.g., a fund where restricted persons own less than 10% of the equity)
• Issuer-directed allocations if the allocation is documented and not facilitated by the underwriter
• Standby and rights-offering mechanics
• ERISA accounts in many circumstances

Documentation

Members must obtain a written representation (within the prior 12 months) from each account holder that the account is eligible to purchase new issues. The representation is renewed annually.

Exam Tip: Gotchas

• The 12-month written representation is a HARD requirement. A firm that allocates new-issue shares without a current eligibility representation has violated the restricted-persons rule even if the customer is in fact unrestricted.
• Immediate family is restricted only if materially supported. A registered rep's adult child who is financially independent is not a restricted person. The "materially supported" test matters.
• The restricted-persons rule covers EQUITY new issues only. A new bond offering is not covered; it can be allocated freely (subject to spinning rules if applicable).

New Issue Allocations and Distributions

The new-issue allocation rule for executives layers on top of the restricted-persons rule and addresses several distinct allocation problems:

Spinning in Detail

The spinning prohibition targets a specific abuse pattern: a syndicate manager allocates IPO shares to the personal account of a corporate executive whose company is also a banking client (or a prospective banking client). The IPO shares pop on day one; the executive's reward is a price-driven gift. The reverse leg of the deal is the executive's company directing future banking business to the syndicate manager.

The spinning prohibition prevents this by banning new-issue allocations to accounts in which executive officers or directors of public companies (or covered nonpublic companies that have hired or are likely to hire the firm) have a beneficial interest, when the allocation is a quid pro quo for banking business.

Think of it this way: The restricted-persons rule is about industry insiders. The spinning prohibition is about corporate clients. The two rules cover different conflict patterns and operate independently. A hedge-fund account may be a "covered" account under the spinning rule (because a portfolio company executive has a beneficial interest) but not a "restricted person" (no broker-dealer affiliation). Both rules can apply simultaneously.

Exam Tip: Gotchas

• The restricted-persons rule and the new-issue allocation rule for executives are SEPARATE rules with SEPARATE lookbacks and exemptions. A hedge-fund account can satisfy the restricted-persons test (no broker-dealer affiliation) but fail the spinning test (a portfolio company executive has a beneficial interest). The principal must check both.
• Spinning requires a quid pro quo connection to investment banking business. Allocating to a public-company CEO with NO banking relationship is permitted under the spinning rule (though the restricted-persons rule may still bar it if other conditions apply). The quid pro quo element matters.
• The flipping provision protects associated-person commissions and credits. It does not prohibit the customer's resale. Without the required syndicate-wide penalty bid, a member cannot recoup the representative's commission because the customer flipped. Analyze customer charges under their own applicable rules and agreements.

Related Rules: Prohibited Representations and Escrow

Two rules complete the IPO-distribution regime:

In a best-efforts contingent offering (e.g., minimum-maximum or all-or-none), the issuer does not get any proceeds until the contingency is met. Direct receipt and use of customer funds before satisfying the contingency is a fraud violation under both the prohibited-representations rule and the escrow rule.

Exam Tip: Gotchas

• The escrow rule is required for CONTINGENT offerings only. A simple firm-commitment offering does not require escrow because the underwriter buys the entire issue and the customer is paying for shares already committed. Best-efforts mini-max and all-or-none contingencies do trigger escrow.
• A misrepresentation about contingency is a SEPARATE fraud violation. A firm that markets the deal as "all or none" but releases funds before the minimum is reached has violated both the prohibited-representations rule and the escrow rule.
• The escrow agent must be a bank or third-party trustee, not the broker-dealer. A firm that holds customer funds in its own clearing account during the contingency period violates the escrow rule even if the funds are segregated.

What Should You Check on Exam Day?

• Can you state the 5% test for the conflict-of-interest rule, and confirm it applies to net proceeds, not gross?
• Do you know how often a firm must renew a customer's written representation of eligibility to buy new-issue equity?
• Can you distinguish the restricted-persons rule from the spinning prohibition, and state which one requires a quid pro quo for banking business?
• Do you know when the escrow rule requires customer funds held by a bank or third-party trustee rather than the broker-dealer?