With the mechanics of underwriting and exemptions covered, this section focuses on the rules designed to prevent abuse in the new-issue market: who can't buy IPOs, what conflicts must be disclosed, and how price manipulation is addressed during distributions.
Who Is Restricted from Purchasing IPO Shares?
Certain restricted persons may NOT purchase shares in new equity IPOs:
- Members (broker-dealers) and their associated persons
- Broker-dealer personnel
- Finders and fiduciaries acting on behalf of the managing underwriter
- Portfolio managers (e.g., at banks, insurance companies, investment advisers)
- Owners of a broker-dealer: anyone listed, or required to be listed, on the firm's ownership schedules, unless the ownership stake is under 10%
- Immediate family members of the above, under a test that depends on the category:
- Family of broker-dealer personnel: restricted if the person materially supports them or receives material support from them, works for (or is associated with) the firm, or an affiliate of the firm, selling them the new issue, or can control the allocation
- Family of broker-dealer owners: the same three tests, except that owning the selling firm (or its affiliate) replaces working for it
- Family of finders, fiduciaries, and portfolio managers: restricted only on material support
- Living in the same household counts as material support
What Is the De Minimis Exemption?
- An account is not considered restricted if restricted persons' beneficial interests do not exceed 10% of the account
Why Do These IPO Purchase Restrictions Exist?
- Ensure a bona fide public distribution of IPO shares to the investing public
- Prevent industry insiders from scooping up hot IPO shares before public investors have access
What Rules Govern New Issue Allocations and Distributions?
The new-issue-allocation rule targets specific abuses in IPO allocation:
- Prohibits spinning: Allocating IPO shares to executives or directors of investment banking clients as an inducement for business
- Prohibits quid pro quo allocations: Conditioning IPO allocations on the receipt of excessive compensation (e.g., requiring aftermarket purchases)
- Requires members to have written policies and procedures for IPO allocations
Exam Tip: Gotchas
"Spinning" is when an underwriter gives hot IPO shares to corporate executives to win future investment banking business. This is prohibited under the new-issue-allocation rule. A scenario may describe this conduct without using the word "spinning," so recognize the pattern.
How Are Public Offerings with Conflicts of Interest Handled?
Applies when a member firm has a conflict of interest in a public offering:
- The issuer is the member itself
- The issuer controls or is controlled by the member
- At least 5% of net proceeds go to the member
What Are the Requirements for Offerings With Conflicts of Interest?
- Prominent disclosure of the conflict
- One of the following safeguards:
- A qualified independent underwriter (QIU) participates
- The non-conflicted managing underwriter oversees the offering
- Securities have a bona fide public market
- Securities are investment grade rated
What Is a Fixed Price Offering?
- Members must sell securities in a fixed price offering at the stated public offering price during the distribution
- No sales above or below the fixed offering price while the syndicate is in effect
What Is Regulation M (Anti-Manipulation)?
Securities and Exchange Commission (SEC) Regulation M prohibits manipulative conduct during securities distributions.
What Are the Key Restrictions Under Regulation M?
| Restriction | What It Governs |
|---|---|
| Underwriter bidding ban | Underwriters and distribution participants may not bid for or purchase the security during the restricted period |
| Issuer bidding ban | Issuers and selling security holders may not bid for or purchase the security during the restricted period |
| Passive market making | Permits passive market making during the restricted period for Nasdaq securities (bids cannot exceed the highest independent bid) |
| Stabilization | Governs stabilization: the lead underwriter may place a stabilizing bid |
| Short-sale restriction | A person who sold the security short during the applicable short-sale restricted period generally may not buy the offered shares from an offering participant |
The short-sale restriction applies to firm-commitment cash equity offerings under a filed registration statement or a Form 1-A or Form 1-E notification. Its restricted period is the shorter of the five business days before pricing through pricing, or the period from the initial filing through pricing. The clock is measured from pricing, not simply from the start of an offering.
Unless an exception applies, a person who shorts during that period may not buy the offered shares from a participating underwriter, broker, or dealer. The prohibited act is the purchase in the offering, whether or not those shares cover the short. A short sale alone, or a short sale outside the applicable period, does not trigger this purchase restriction.
How Does Stabilization Work Under Regulation M?
- The lead underwriter may place a stabilizing bid at or below the public offering price to prevent the market price from declining during distribution
- The stabilizing bid must be at or below the offering price; never above it
- When an independent market already exists, the stabilizing bid may also be no higher than the highest independent (prevailing market) bid. In practice, the ceiling is the lower of the offering price or the current independent bid
- A stabilizing bid may follow the market down (be lowered), and may be raised only as far as the highest current independent bid in the principal market
- The syndicate (or sole distributor), including its members, may not maintain more than one stabilizing bid in any one market at the same price at the same time
- Must be disclosed in the prospectus
Exam Tip: Gotchas
A stabilizing bid can ONLY be placed AT or BELOW the public offering price; never above it. Stabilization is the ONLY form of legal price manipulation in the securities markets, and it must be disclosed in the prospectus.
What Are Penalty Bids?
- The lead underwriter may impose penalty bids, reclaiming the selling concession from a syndicate member whose customers sell (flip) shares in the immediate aftermarket
- Penalty bids discourage flipping and help maintain price stability after the offering