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Frequently Asked Questions about FINRA Rule 5131 (New Issue Allocations and Distributions)

FINRA Rule 5131 (New Issue Allocations and Distributions) addresses potential misconduct in the allocation and distribution of new issues.1 Since the adoption of the rule, FINRA has received several interpretive questions concerning its scope and application. The following frequently asked questions (FAQs) provide guidance on the rule. The FAQs include questions that were published in Regulatory Notice 11-29, as well as new questions. FINRA will periodically update the FAQs as new questions arise.

Section 1: Spinning

Paragraph (b) of FINRA Rule 5131 prohibits the practice of "spinning," which refers to a member firm's allocation of new issue shares to an account in which an executive officer or director of a public company2 or covered non-public company,3 or a person materially supported4 by such executive officer or director, has a beneficial interest5 as an inducement to award the member firm with investment banking business6 or as consideration for investment banking business previously awarded.

Questions

1.1 I am an executive officer of a covered non-public company and wish to invest in a forthcoming IPO of another company. My company is not a current, recent or potential investment banking client of the member firm allocating the IPO shares. Does FINRA Rule 5131(b) prohibit the member firm from allocating IPO shares to my brokerage account based solely on my status as an executive officer of a covered non-public company?
 
No. FINRA Rule 5131(b)'s prohibitions apply to allocations to an executive officer of a covered non-public company only: (1) if the company is a current or recent (within the past 12 months) investment banking client of the member firm; (2) if the person responsible for making the allocation decision knows or has reason to know that the member firm intends to provide or expects to be retained for investment banking services by the company within the next three months; or (3) if the allocation is on condition that the executive officer, on behalf of the company, will retain the member firm for the performance of future investment banking services.

Section 2: New Issue Pricing and Trading Practices - Market Orders

Paragraph (d)(4) of FINRA Rule 5131 prohibits member firms from accepting any market order for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market. This provision addresses the inherent volatility of a new issue as it commences trading in the public markets, and the potential for a wide variance between the public offering price of the new issue and the price at which trading in the secondary market commences. As a result, investors who place market orders for a new issue may find their orders filled at prices beyond their reasonable expectations, and such transactions may further contribute to the unconstrained increase in the price of a new issue in the secondary market.

Questions

2.1 Does the market orders provision of FINRA Rule 5131 apply to both OTC Equity Securities and NMS Stocks?
Yes. The market orders provision of FINRA Rule 5131 applies to shares of a new issue. FINRA Rule 5130(i)(9), which is referenced in the definitions of FINRA Rule 5131, defines "new issue" to mean "any initial public offering of an equity security as defined in Section 3(a)(11) of the Exchange Act, made pursuant to a registration statement or offering circular," with enumerated exceptions, and does not restrict its scope to either NMS Stocks or OTC Equity Securities.
2.2 FINRA Rule 5131(d)(4) prohibits the acceptance of market orders for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market. What constitutes commencement of trading for the purposes of this provision?
For the purposes of the market orders provision, the commencement of trading in the secondary market of shares of a new issue that is an NMS Stock would be evidenced by the first trade on the national securities exchange listing the security, as indicated by the dissemination of an opening transaction in the security by that exchange. For OTC Equity Securities, commencement of trading in the secondary market would be evidenced by the first regular way, disseminated trade reported to the OTC Reporting Facility during normal market hours.
2.3 Does FINRA Rule 5131(d)(4) apply to "not held" orders?
Generally, a "not held" order is an unpriced, discretionary order voluntarily categorized as such by the customer and with respect to which the customer has granted the firm price and time discretion. As such, "not held" orders are not considered "market orders" for the purposes of FINRA Rule 5131(d)(4).7
2.4 Does the prohibition on market orders apply only to inbound customer orders?
FINRA Rule 5131(d)(4) applies to the acceptance of any market order, whether from a customer of the firm, a customer of another broker-dealer or another broker-dealer. However, priced orders, such as limit orders, are not subject to the prohibition.
2.5: Does the prohibition on market orders extend to proprietary trading?
As noted above, the market order prohibition applies to the acceptance of any market order, including a proprietary market order from another broker-dealer. Therefore, if a member firm were to route its proprietary market order in a new issue to another member firm, that other firm would be prohibited from accepting the market order. To the extent a firm sends its market order directly to an exchange and such order is not otherwise "accepted" by a firm, it would not be prohibited by this rule.
2.6 Does a member firm need to reject a market order at the time it is first received, or can the firm reject an order previously accepted as long as it does so prior to executing the order or routing the order to another broker-dealer or an exchange?
For purposes of compliance with FINRA Rule 5131(d)(4), a firm may reject a market order for a new issue at any point within its order management system prior to executing or routing the order. If a firm rejects a previously accepted customer order that is OATS reportable, it must indicate in its OATS report that the firm, not the customer, cancelled the order.

1.  "New issue" means any initial public offering (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 FINRA Rules 5130(i)(9) and 5131(e)(7).

2. A "public company" is any company that is registered under Section 12 of the Securities Exchange Act of 1934 or files periodic reports pursuant to Section 15(d) thereof. See FINRA Rule 5131(e)(1).

3. The term "covered non-public company" means any non-public company satisfying the following criteria: (i) 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. See FINRA Rule 5131(e)(3).

4. "Material support" means 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. See FINRA Rule 5131(e)(6).

5. "Beneficial interest" means any economic interest, such as the right to share in gains or losses (the receipt of a management or performance based fee for operating a collective investment account, or other fees for acting in a fiduciary capacity, is not be considered a beneficial interest in the account). See FINRA Rules 5130(i)(1) and 5131(e)(2).

6. "Investment banking services" include, without limitation, acting as an underwriter, participating in a selling group in an offering for the issuer or otherwise acting in furtherance of a public offering of the issuer; acting as a financial adviser in a merger, acquisition or other corporate reorganization; providing venture capital, equity lines of credit, private investment, public equity transactions (PIPEs) or similar investments or otherwise acting in furtherance of a private offering of the issuer; or serving as placement agent for the issuer. See FINRA Rule 5131(e)(5).

7. This does not alter other firm obligations with respect to the handling of customer orders, including “not held” orders (see e.g., FINRA Rules 2010 and 5310).