The Financial Industry Regulatory Authority, Inc. (“FINRA”) recently has adopted, and the Securities and Exchange Commission has approved, new FINRA Rule 5131 (“Rule 5131”), which will become effective on May 27, 2011. Rule 5131 addresses certain conduct of FINRA broker-dealers and prohibits “spinning”. This rule will result in an additional new issues-related screen that hedge fund managers will need to administer when allocating new issue income to their investors.

What is “Spinning”?

“Spinning” generally refers to the allocation of new issues¹ by a FINRA broker-dealer to certain persons who are affiliated with a company that is a current, former or prospective investment banking client. As discussed in further detail below, in the case of our investment management clients, Rule 5131 will only be relevant whenever a hedge fund (or other private fund) is more than 25% owned by Covered Investors (defined below) of any one particular company.

What is Prohibited?

Rule 5131 prohibits the allocation of new issues by a FINRA broker-dealer² to an account in which an executive officer or director of a public company³ or a covered non-public company⁴ (each, a “Company”), or a person materially supported⁵ by such executive officer or director (collectively, a “Covered Investor”), has a beneficial interest if: (i) the Company is currently an investment banking services client of such FINRA broker-dealer (a “Related Broker”) or the Related Broker has received compensation from the Company for investment banking services in the past twelve months; (ii) the person responsible for making the allocation decision knows or has reason to know that the Related Broker intends to provide, or expects to be retained by the Company for, investment banking services within the next three months; or (iii) new issues are allocated on the express or implied condition that such executive officer or director, on behalf of the Company, will retain the Related Broker for the performance of future investment banking services.

Preconditions for an Allocation

Before allocating a new issue to an account, a FINRA broker-dealer must in good faith have obtained within twelve months of such allocation a representation from the beneficial owner(s) of the account, or a person authorized to represent the beneficial owner(s) of the account, as to whether such beneficial owners are Covered Investors, and if so, the Companies they serve. Correspondingly, hedge fund managers will need to elicit such data from their investor base in order to deliver this representation.

The initial verification from the account must be an affirmative written representation. Subsequent verifications may be made through the use of negative consent letters.

Exemptions

Rule 5131 will not apply to allocations of new issues to the following accounts or persons, whether directly or through accounts in which such persons have a beneficial interest: (1) registered investment companies; (2) certain common trust funds; (3) certain insurance company general, separate or investment accounts; (4) accounts (e.g., hedge funds) in which the collective beneficial interests of Covered Investors of a particular Company do not exceed 25% (the “de minimis exemption”); (5) certain publicly traded entities; (6) foreign investment companies listed on a foreign exchange (or authorized for sale to the public by a foreign regulator); (7) certain ERISA plans; (8) state or municipal government benefit plans; (9) certain tax-exempt charities; and (10) certain church plans. Accordingly, the foregoing accounts and persons would not be considered Covered Investors, if they were to invest in a hedge fund.

With regard to (4) above, in the case of a hedge fund (and most other entities), if 25% or less of the hedge fund is owned by Covered Investors of any one particular Company (including the interest of the hedge fund portfolio manager), then the hedge fund falls within the de minimis exemption (i.e., since the de minimis exemption is calculated on a Company by Company basis, it is highly unlikely that any hedge fund will be unable to rely upon it, so long as it does not have an investor concentration from a particular Company) and thus the hedge fund will be able to receive a new issue allocation without allocating any profits from such new issue away from the Covered Investors. In addition, even if more than 25% of the hedge fund is owned by Covered Investors of any one particular Company, if the broker allocating the new issue is not a Related Broker, then the hedge fund still falls within the de minimis exemption and new issue profits do not have to be allocated away from such Covered Investors.

However, even if over 25% of the hedge fund is owned by Covered Investors of a particular Company and a new issue is being allocated by a Related Broker, then the hedge fund could still rely on the de minimis exemption by “carving down” the portion of the new issue allocation being made to Covered Investors so that the beneficial interests by such Covered Investors in the new issue is no more than 25% (for example, a hedge fund owned 30% by Covered Investors of a particular Company could “carve down” a new issue allocation from a Related Broker to such Covered Investors so that they receive no more than 25% of the new issue allocation).

Application of the Rule

If you currently manage any accounts or funds that purchase new issues, you will need to contact your existing investors (both U.S. and Non-U.S.) to determine the accounts’ or funds’ status under Rule 5131. You may also need to amend fund offering and subscription documents and charter documents.

Based on a fund’s complexity, there are many different approaches that a fund may consider taking in order to be eligible to participate in new issues under Rule 5131. For example, a fund may take any of the following approaches:

1. Aggregate the interests of all Covered Investors in the fund without regard to the particular Companies with which they are affiliated when measuring the 25% de minimis limit;
2. Analyze the interests of Covered Investors on a Company-by-Company basis when measuring the 25% de minimis limit (and, if needed, determine whether the fund is doing business with any Related Broker); or
3. Impose a 10% de minimis limitation to match with the de minimis exemption under FINRA Rule 5130 (i.e., the rule governing restrictions on the purchase and sale of new issues), whether it aggregates the interests of Covered Investors across the fund without regard to the particular Companies they serve, or whether it analyzes the interests of Covered Investors on a Company-by-Company basis.

Ultimately a fund will decide on an approach to take after weighing the costs and benefits of each potential course of action.

We have prepared model representations and form questionnaires that you can utilize. If you would like us to assist you in this process and provide you with these documents, or if you have any questions generally regarding Rule 5131, please contact your principal attorney in the Investment Management Group at Seward & Kissel LLP.

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¹ Rule 5131 contains the same meaning of “new issue” as FINRA Rule 5130.

² Rule 5131(b) will not apply to allocations of securities that are directed in writing by the issuer, its affiliates, or selling shareholders, so long as the FINRA broker-dealer has no involvement or influence, directly or indirectly, in the allocation decisions of the issuer, its affiliates, or selling shareholders, with respect to such issuer-directed securities.

³ Rule 5131(e)(1) defines a “public company” as any company that is registered under Section 12 of the Securities and Exchange Act of 1934 or files periodic reports pursuant to Section 15(d) thereof.

⁴ Rule 5131(e)(3) defines a “covered non-public company” as any non-public company with: (i) an income of at least $1 million in the last fiscal year or in two of the last three fiscal years and shareholders’ equity of at least $15 million; (ii) shareholders’ equity of at least $30 million and a two-year operating history; or (iii) total assets and total revenue of at least $75 million in the latest fiscal year or in two of the last three fiscal years.

⁵ Rule 5131(e)(6) defines “material support” as directly or indirectly providing more than 25% of a person’s income in the prior calendar year. Persons living in the same household are deemed to be providing each other with material support.