Penalty Bids

A penalty bid operates between the managing underwriter and the syndicate. What a firm then does to its own registered representatives is governed separately, and the two are often confused in a stem.

What Is a Penalty Bid, and What Is a Syndicate Covering Transaction?

Regulation M's definitions supply both terms, and the new issue allocation rule repeats the penalty bid definition word for word.

• A penalty bid is an arrangement that permits the managing underwriter to reclaim a selling concession from a syndicate member in connection with an offering when the securities originally sold by that syndicate member are purchased in syndicate covering transactions.
• A syndicate covering transaction is the placing of any bid or the effecting of any purchase on behalf of the sole distributor or the underwriting syndicate or group to reduce a short position created in connection with the offering.

The two definitions are linked. A penalty bid is triggered by purchases made in syndicate covering transactions, so the covering activity is what identifies the shares whose concession can be reclaimed.

Exam Tip: Gotchas

• A penalty bid is not a bid in the market. It is a contractual arrangement inside the syndicate, despite the word "bid" in its name.
• A syndicate covering transaction reduces a short position created in connection with the offering. Ordinary short covering by a firm trading for its own account is not one.

What Does It Mean for Shares to Be Flipped?

The new issue allocation rule defines flipped as the initial sale of new issue shares purchased in an offering within 30 days following the offering date of that offering.

Three elements are all in that sentence: the sale must be the initial sale of the shares, the shares must have been purchased in the offering, and the sale must fall within 30 days following the offering date.

Exam Tip: Gotchas

• The 30 days run from the offering date, not from the customer's purchase or from settlement. A sale on day 31 is not a flip under this definition.

When May a Firm Recoup a Representative's Concession?

No member or person associated with a member may directly or indirectly recoup, or attempt to recoup, any portion of a commission or credit paid or awarded to an associated person for selling shares of a new issue that are subsequently flipped by a customer, unless the managing underwriter has assessed a penalty bid on the entire syndicate.

The permission is narrow. It requires an assessment by the managing underwriter, and it requires that assessment to reach the entire syndicate rather than one member.

Exam Tip: Gotchas

• The rule is a prohibition with a single exception. Recoupment is barred unless a penalty bid has been assessed on the entire syndicate, so a penalty aimed at one member does not unlock it.
• An attempt is enough. The rule names recouping and attempting to recoup, so a clawback that fails still violates it where no penalty bid was assessed on the entire syndicate.
• The customer's flip is the trigger, not the representative's conduct. Nothing in the rule requires that the representative encouraged the sale.

What Notice and Records Does a Penalty Bid Require?

Two duties attach, one to the market and one to the firm's own books.

Any person effecting a syndicate covering transaction or imposing a penalty bid shall provide prior notice to the self-regulatory organization (SRO) with direct authority over the principal market in the United States for the security for which the covering transaction is effected or the penalty bid is imposed.

Regulation M's stabilization rule also makes it unlawful for any person, directly or indirectly, to stabilize, to effect any syndicate covering transaction or to impose a penalty bid in connection with an offering of any security, in contravention of its provisions.

Separately, in addition to any obligation to maintain records relating to penalty bids under the stabilizing records rule, a member shall promptly record and maintain information regarding any penalties or disincentives assessed on its associated persons in connection with a penalty bid.

That second duty belongs to the member and covers what the firm did to its own people. It does not describe what the syndicate did to the firm, and it sits on top of the manager's recordkeeping rather than replacing it.

Where the security is an over-the-counter equity security, a separate FINRA notice regime applies. Those notices are covered in the lesson on required notification related to IPOs and secondary offerings, and the manager's stabilizing records are covered in the lesson on stabilizing bids.

Exam Tip: Gotchas

• The notice is due before the activity, and it goes to one named recipient. It runs to the self-regulatory organization with direct authority over the principal market in the United States for that security.
• The member's record duty is additive. The rule opens "in addition to", so a firm cannot point to the manager's syndicate records to satisfy its own.

What Should You Check on Exam Day?

• Confirm the shares were purchased in the offering and sold within 30 days of the offering date before treating a sale as a flip.
• On a recoupment question, look for an assessment by the managing underwriter on the entire syndicate; anything narrower leaves the ban in place.
• Check that prior notice of a penalty bid or syndicate covering transaction went to the self-regulatory organization over the United States principal market.
• Separate the two record duties: the manager records syndicate activity, the member records penalties assessed on its own associated persons.
• Remember that, absent a penalty bid assessed on the entire syndicate, attempting to recoup violates the rule even where nothing is actually recovered.