Conflicts and Allocations
Quick Answer
The public-offering conflict-of-interest rule governs public offerings with conflicts of interest: when a member is the issuer, controls or is controlled by the issuer, or 5% or more of net proceeds flow to the member, a Qualified Independent Underwriter (QIU) must price the deal (with limited exceptions). The new-issue allocation rule for restricted persons prohibits the sale of new-issue equity to restricted persons (broker-dealer associated persons and their immediate family). The new-issue allocation rule for executives bans spinning (allocating new issues to corporate executives in exchange for investment-banking business) and regulates flipping, lock-up enforcement, and limit-price waivers in the immediate aftermarket. The prohibited-representations rule and the escrow rule require escrow of customer funds in best-efforts contingent offerings.
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 (or its parent, subsidiary, or control affiliate)
- 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 directed to the member or its affiliates (after deducting underwriting compensation and offering expenses)
- The member becomes an affiliate of the issuer as a result of the offering
When a conflict of interest exists, the offering may proceed only if:
- Prominent disclosure of the nature of the conflict appears on the prospectus cover page, AND
- One of the following:
| Path | When It Applies |
|---|---|
| (1) QIU participates and prices the deal | The member must engage a Qualified Independent Underwriter (QIU) to participate in due diligence and price the offering |
| (2) Investment-grade securities | The conflicted issuer's securities are investment grade (rated BBB-/Baa3 or better by an NRSRO) |
| (3) Bona fide independent market exists | A bona fide independent secondary market exists for the security |
| (4) Stated exemption | The offering otherwise qualifies for a stated exemption under the conflict-of-interest rule (e.g., certain ETF / closed-end fund offerings) |
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 less than 5% of the conflict-creating class of securities
- Agree to undertake the legal responsibilities of an underwriter under the registration-statement civil-liability regime (including due-diligence liability)
- Have served as underwriter in at least 3 prior public offerings of similar size and type during the 3 years before filing
- Participate in the preparation of the registration statement and prospectus
- Exercise due diligence and accept registration-statement civil-liability exposure
Exam Tip: Gotchas
- The 5% test is on NET proceeds, not gross. Underwriting compensation and expenses are deducted before the 5% calculation. A deal where 7% of gross goes to the member but only 4% of net (after the underwriting spread) does not trigger the conflict-of-interest rule.
- 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
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:
| Provision | What It Prohibits / Requires |
|---|---|
| Quid pro quo allocations | A member may not allocate new issues as consideration for a customer paying excessive compensation on other transactions |
| Spinning | A member may not allocate new-issue shares to an account in which an executive officer or director of a public or covered nonpublic company (or person materially supported) has a beneficial interest as a quid pro quo for investment banking business |
| Limit-price waivers | Waivers of customer market orders or limit orders during the immediate-aftermarket period must be documented |
| Lock-up agreements | On directors and officers of the issuer; must include specific carve-outs and notification requirements; members must enforce them |
| Flipping | A member may not directly or indirectly recoup or reduce a selling concession on a customer who flips shares within 30 days of pricing; but the member may forfeit its concession to the syndicate if its customer flips |
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.
| Type of Account | Restricted Under the Spinning Rule? |
|---|---|
| Public-company executive officer / director | Yes, if quid pro quo is involved |
| Covered nonpublic-company executive / director (the company has used or is likely to use the member for banking) | Yes |
| Hedge fund where a public-company executive has a beneficial interest | Yes - the look-through reaches the executive |
| Hedge fund where no covered executive has an interest | No |
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 rule does NOT prohibit flipping itself. A customer is free to flip. The rule prohibits the firm from PUNISHING the customer (recouping the concession) for flipping. The firm itself can lose its concession to the syndicate, but the customer is held harmless.
Related Rules: Prohibited Representations and Escrow
Three rules complete the IPO-distribution regime:
| Rule | What It Does |
|---|---|
| FINRA secondary-market reporting rule | Governs secondary-market transactions in IPO shares; coordinates with the flipping rule and Reg M restricted-period mechanics |
| Prohibited-representations rule | It is fraudulent to represent an offering is being made on an all-or-none or at least minimum contingent basis if the offering is NOT in fact being held on those terms |
| Escrow rule for contingent offerings | In best-efforts contingent offerings, customer payments must be promptly deposited in a separate bank escrow account or transmitted to a third-party trustee. Funds may be released to the issuer only when the contingency is satisfied; otherwise, promptly returned to subscribers |
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.