Restricted Persons

tamer hamed 1:30:00 AM
IPO shares in a hot company could be used as rewards, or to threaten people. The prohibited practice of spinning occurs when underwriting broker-dealers allocate shares of popular IPO stocks to investors who can then direct securities business to the firm as a thank-you. To prevent spinning, FINRA prohibits the practice of allocating IPO shares to officers and directors of companies if the company is an investment banking customer of the broker-dealer or becomes an investment banking customer in the next three months.

Clearly, it is not okay for an underwriting broker-dealer to force someone to buy 100,000 shares of an IPO by threatening to with hold shares of future offerings. Simi­larly, it would be a violation for the managing underwriter to offer to allot 1 million shares to a broker-dealer who first writes a favorable research report on the stock.

These violations could get the regulators to start using fancy phrases like "quid pro quo," which means you-scratch-my-back-I'll-scratch-yours in the original Latin.

 allocations of IPO shares are not allowed. why should the public investor be exposed to some bogus ''research report" that is overly enthusiastic due to the conflict of interest? Turns out they shouldn't be and that's why quid pro quo allocations are not allowed. You've likely noticed that virtually anything that threatens the integrity of the securities markets is not allowed by the SEC, FINRA or both.

To make sure public offerings of stock have integrity. FINRA has rules that will pre­vent you, dear reader, from buying IPO shares, period. The FINRA rules apply only to initial public offerings of common stock not to debt securities, preferred stock, mutual funds, or even additional offers of common stock.

So, we're only talking about the companies coming out-of-the-starting-gates with an IPO here. Even if it's a bond that converts to common stock    not subject to this rule.

Who is defined as a restricted person and, therefore, restricted from buying IPOs?
•    broker-dealer member firms
•    employees of broker-dealer member firms
•    anyone/ any entity owning 10% or more of a broker-dealer member firm
•    finders and fiduciaries acting on behalf of the managing underwriter (e.g., attorneys, accountants, financial consultants)
•    portfolio managers (mutual funds, banks, pension funds, insurance company, etc.) buying for their own account
•    any immediate family member of anyone above

So, if you own 10% or more of a FINRA member broker-dealer, or if you are a broker-dealer, or if you merely work for a broker-dealer, or have someone in your immediate family who fits any of those descriptions, you are basically not buying into an initial public offer of common stock.

What does "immediate family member" include? First, it includes anyone who receives material financial support from a re­stricted person. Then, it includes: parents and in-laws, spouses, siblings, and children of a restricted person. So, if your sister works for Morgan-Stanley, you are a restricted person as an immediate family member.

On the other hand, the following family members are considered too distant to worry about: aunts and uncles, grandparents, cousins. what if you have one of those old college buddies that just can't seem to catch a break? whether he lives with you is ir­relevant; remember that, among other reasons, you might want to keep your financial support to under 25°/o of his income. Yes, "material support" means providing more than 25°/o of an individual's personal income for the prior year.

While a receptionist for a member firm is a restricted person, if that individual is in a joint account, and that individual's ownership is no more than 10%, then the account can buy an equity IPO under the "de minim rule." You can see why broker-dealers who engage in underwriting activities need initial and annual statements obtained in the past 12 months or sooner from their customers verifying that they either are or are not a "restricted person". These are known as per-conditions for sale of an equity IPO.

Nothing is ever simple in this business. Even though we just said that broker-dealers are not allowed to buy shares of an equity IPO, there are exceptions. If a broker­ dealer usually one of the underwriters signs an agreement to act as a standby purchaser, then they can help an offering that is selling weakly by promising to buy any shares the public doesn't want. This arrangement must be in writing; it must be disclosed in the final prospectus; and the managing underwriter must state in writing that it was unable to find any other purchasers for the stock.

So, can a broker-dealer buy an equity IPO? No, except when they can e.g., by acting as a standby purchaser with a bona fide agreement in writing that is disclosed in the prospectus. Securities purchased through a standby agreement may not be re­ sold to investors for at least three months.

Also, it's not the underwriters' fault if the public just isn't that into this IPO. There­ fore, if the managing underwriter or other syndicate members end up buying the unsold shares of an undersubscribed offering and hold them in their investment account, that is not only okay, but is also common. The idea is that they can't pretend they couldn't sell all the good IPOs to end up keeping them for themselves    that, as we saw, is a violation.

FINRA rules state: the book-running managing underwriter of a new issue shall be required to file the following information in the time and manner specified by FINRA with respect to new issues:
  • the initial list of distribution participants and their underwriting com­mitment and retention amounts on or before the offering date; and
  • the final list of distribution participants and their underwriting commitment and retention amounts no later than three business days after the offering date.
A "distribution participant" is "an underwriter, prospective underwriter, broker, dealer, or other person who has agreed to participate or is participating in a distribu­tion."

An IPO is not to be treated as a quick buy-and-flip opportunity. If some investors are immediately selling their shares on the secondary market, that can push the market price of the stock downward. This is what FINRA must say about the process:

The term ''flipping "refers to the practice of selling new issues into the secondary market at a profit within 30 days following the offering date. Because these sales create downward pressure on the secondary market trading price, underwriters and selling group members may seek to discourage such sales. Under most syndicate selling agreement a managing underwriter is permitted  to impose a "penalty bid" on syndicate members to reclaim the selling concession for  allocations that were flipped. Separate and independent of any syndicate penalty bid, some firms have sought to recoup selling concessions from brokers when their customers - typically retail customers - flip a new issue.

[FINRA rules prohibit] any member from recouping 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. FINRA believes that it is only appropriate for a firm to recoup a broker 's compensation for selling a new issue in connection with a customer's decision to flip a security when the firm itself is required to forfeit its compensation to the managing underwriter(s) .   

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