Interpretive Letter to Lawrence Cohen, Gordon Rees Scully Mansukhani, LLP
Representations under Rules 5130 and 5131 may be obtained electronically through a mobile application, provided that the method for obtaining representations complies with SEC and FINRA guidance regarding the use of electronic communications, and the representations satisfy the requirements set forth in Rules 5130 and 5131.
December 11, 2017
Gordon Rees Scully Mansukhani, LLP
111 W. Monroe Street, Suite 1600
Phoenix, AZ 85003
Re: Request for Interpretive Guidance Regarding the Use of a Mobile Application to Satisfy Written Representations under FINRA Rules 5130 and 5131
Dear Mr. Cohen:
In your letter dated July 26, 2017, on behalf of Click IPO Securities, LLC, (“ClickIPO”) and its parent, Click Holdings, LLC, you request interpretive guidance regarding whether a member’s mobile application (the “app”) for initial public offerings (“IPOs”) may satisfy the written representation provisions of FINRA Rules 5130 (Restrictions on the Purchase and Sale of Initial Equity Public Offerings) and 5131 (New Issue Allocations and Distributions).
Based on your letter and conversations with FINRA staff, we understand the facts to be as follows. Your client, ClickIPO, a registered broker-dealer and FINRA member, holds the exclusive and perpetual license for the app, which was developed by its parent holding company. The app allows individuals who subscribe to it (hereinafter, the “subscribers” or “subscriber”), through their mobile devices to: (1) access and review information about IPOs and secondary offerings; (2) receive related prospectuses; and (3) place conditional orders for securities offered in an IPO or a secondary offering, provided that certain steps are taken.
Upon subscribing to the app, subscribers establish a unique password-protected account to which they must link an online brokerage account, either an existing online brokerage account with a broker-dealer with which ClickIPO has a selling agreement or a new online brokerage account with one of a select group of broker-dealers that has a selling agreement with ClickIPO. At the time the account is linked, subscribers are provided with a disclaimer regarding Rules 5130 and 5131 and links to the text of the rules. Subscribers are also prompted to click a box indicating whether they are eligible under the rules to receive new issues. If a subscriber does not affirm eligibility by checking the box, then he or she is not able to connect the app with the online brokerage account or to continue accessing the information provided in the app. If a subscriber indicates that he or she is eligible to receive new issues, he or she may place a conditional order for the securities shown on the app. At the time a subscriber attempts to place the conditional order, he or she is again shown a disclaimer regarding Rules 5130 and 5131 and is prompted to attest as to his or her eligibility under the rules. The app requires each eligible subscriber to annually review the disclosures and positively attest, by clicking a box, that he or she continues to be eligible under the rules to receive securities offered through the app.
Once an eligible subscriber places a conditional order, the order is processed through the broker-dealer with which he or she has the online account and routed to ClickIPO, which aggregates orders and presents them to the managing underwriter for the offering. The managing underwriter reviews the data and allocates shares to ClickIPO, which, in turn, allocates shares to the respective broker-dealer with which the subscriber has the online account, with instructions to allocate shares to the subscriber’s account.
You seek clarification whether the described click-the-box electronic attestation in a password-protected subscriber account, coupled with a binding electronic signature,1 may satisfy the precondition representation required for Rule 5130(b) (Preconditions for Sale) and the written representation condition of the limited exception to Rule 5131(b) (Spinning).
Rule 5130 protects the integrity of the public offering process by ensuring that: (1) members make bona fide public offerings of securities at the offering price; (2) members do not withhold securities in a public offering for their own benefit or use such securities to reward persons who are in a position to direct future business to members; and (3) industry insiders, including members and their associated persons, do not take advantage of their insider position to purchase new issues2 for their own benefit at the expense of public customers. Rule 5131 addresses abuses in the allocation and distribution of new issues. Paragraph (b) of the rule prohibits the practice of “spinning,” which occurs when an underwriter allocates new issue shares to executive officers and directors of a company as an inducement to award the underwriter with investment banking business, or as consideration for investment banking business previously awarded.3
Both rules contain provisions relating to representations. Rule 5130 requires, as a precondition for sale of a new issue, that the member must have from the account holder(s), or person authorized to represent the beneficial owner(s) of the account, a representation that the account is eligible to receive the new issue. Rule 5131.02 (Written Representations) permits firms to rely upon a written representation as to the status of the account’s beneficial owner(s).4 To comply with the written representation provisions, firms typically issue questionnaires to their customers to ascertain their status under Rules 5130 and 5131.
The rules do not prescribe the form in which the representations must take, and the rules permit the use of electronic communications in accordance with the standards adopted by the SEC and FINRA for the use of such communications.5 FINRA staff agrees that the representations under Rules 5130 and 5131 may be obtained electronically through a mobile application as described in your letter, provided that the method for obtaining the representations complies with SEC and FINRA guidance regarding the use of electronic communications and the representations satisfy the requirements set forth in Rules 5130 and 5131.
In stating that the member may obtain the representations for Rules 5130 and 5131 electronically, as described, in connection with the use of the app, FINRA staff is not making any representation or determination regarding the accuracy or adequacy of the app’s explanation to the subscriber of the representations that the subscriber must make.6 As stated in the rules, a member may not rely on any representation that it believes or has reason to believe is inaccurate.7 Accordingly, the explanation must be consistent with the rules and sufficient for the subscriber to understand the facts as to which he or she is representing. For Rule 5130 purposes, the explanation must be sufficient for the subscriber to make a determination as to the eligibility of the account to receive new issues, which, among other things, requires an understanding of the categories of restricted persons under the rule.8 For purposes of Rule 5131.02(a), the explanation must be sufficient for the subscriber to determine whether any beneficial owner of the account is an executive officer or director, or a person materially supported, as defined,9 by an executive officer or director and, if so, the companies on whose behalf such executive officer or director serves. In addition, for purposes of Rule 5131.02(b), the explanation must be sufficient for the subscriber to determine the conditions for satisfying the exception for unaffiliated private funds.
Regarding ClickIPO’s arrangement to obtain this information on behalf of the broker-dealers licensing the app, FINRA staff has previously stated that Rule 5130 does not preclude members from using third parties to aid in their compliance with the precondition of sale requirement of paragraph (b). Likewise, FINRA staff believes that Rule 5131 does not preclude firms from using third parties in such a manner. However, in doing so, a member maintains full responsibility for complying with the rules.10 As such, broker-dealers licensing the app must make a determination whether the information provided to the subscribers (i.e., their customers) is sufficient for the subscribers to make a reasonable attestation regarding the relative provisions of the rules.
Finally, members are required to maintain a copy of all records and information relating to whether an account is eligible to receive an allocation of new issues for at least three years following the firm’s allocation to that account, and must preserve such records in a format that complies with SEA rules, including, if stored using electronic storage media, in a manner that complies with SEA Rule 17a-4(f).11
We trust that this letter is responsive to your request. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the FINRA Board of Governors. This letter responds only to the issues raised based on the facts as you have described them, and does not address any other rule or interpretation of FINRA, or all the possible regulatory or legal issues involved. In addition, you should be aware that any changes in the facts as you have described them will require further consideration and may cause us to reach a different conclusion.
If you have any questions on this matter, please do not hesitate to contact me at (202) 728-8018.
cc: Afshin Atabaki, FINRA
1 You indicate that the electronic signature meets the requirements of the Electronic Signatures in Global National Commerce Act, 15 U.S.C. 7001 et seq.
2 For purposes of Rules 5130 and 5131, “new issue” means any IPO of an equity security as defined in Section 3(a)(11) of the Securities Exchange Act of 1934, made pursuant to a registration statement or offering circular, subject to some exceptions. See Rules 5130(i)(9) and 5131(e)(7).
3 The spinning provision generally provides that no member or person associated with a member may allocate shares of a new issue to any account in which an executive officer or director of a public company or a covered non-public company, or a person materially supported by such executive officer or director, has a beneficial interest: (1) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months; (2) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next three months; or (3) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services. See Rule 5131(b).
4 Paragraph (a) (Annual Representation) of Rule 5131.02 provides that, for the purposes of the spinning provision, a member may rely upon a written representation obtained within the prior 12 months from the beneficial owner(s) of an account, or a person authorized to represent the beneficial owner(s), as to whether such beneficial owner(s) is an executive officer or director or person materially supported by an executive officer or director and, if so, the company on whose behalf such executive officer or director serves. Paragraph (b) (Indirect Beneficial Owners) of Rule 5131.02 permits firms to rely upon a written representation obtained within the prior 12 months from a person authorized to represent an account that does not look through to the beneficial owners of any unaffiliated private fund invested in the account, except for beneficial owners that are control persons of the investment adviser to the private fund, if the unaffiliated private fund: (1) is managed by an investment adviser; (2) has assets greater than $50 million; (3) owns less than 25 percent of the account and is not a fund in which a single investor has a beneficial interest of 25 percent or more; and (4) was not formed for the specific purpose of investing in the account.
5 See Notice to Members 03-79 (December 2003) (announcing SEC’s approval of NASD Rule 2790 (now FINRA Rule 5130)); Securities Act Rel. No. 7288 (May 9, 1996), 61 FR 24644 (May 15, 1996) (providing guidance on the electronic delivery of required information by broker-dealers); Securities Act Rel. No. 7856, 65 FR 25843 (May 4, 2000).
6 In addition, this letter is limited to the form of representations for Rules 5130 and 5131. In this regard, FINRA staff is making no statement as to the permissibility of the use of such platforms for offerings, including with respect to the Securities Act of 1933 and the rules and regulations thereunder.
7 See Rules 5130(b) and 5131.02(c).
8 The categories of restricted persons are set forth in Rule 5130(i)(10).
9 The term “material support” means directly or indirectly providing more than 25 percent 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. See Rule 5131(e)(6).
10 See Letter from Gary Goldsholle, NASD, to Tom Fleming, Dealogic, dated Feb. 17, 2004.
11 You have represented that a record of each attestation, along with logs of all subscriber activity, is made and preserved in an unalterable write-once, read-many (“WORM”) format. Moreover, you note that if a user changes his or her attestation, the change is separately recorded with chronological attribution and no changes will be made to the previous record. FINRA staff reminds the member that if it intends to act as a recordkeeping service provider for the broker-dealers with which the subscribers maintain their accounts, then all corresponding requirements must be met, including filing an undertaking with the SEC pursuant to SEA Rule 17a-4(i) to the effect that the records in question constitute records of, and are the property of, the broker-dealers custodying the accounts, and that such records will be surrendered promptly on the request of the broker-dealer. Further, broker-dealers are responsible for the filing of relevant notices and representations pursuant to SEA Rule 17a-4(f) and providing the appropriate disclosures regarding the arrangement on their respective Form BD (Uniform Application for Broker-Dealer Registration).