New FINRA Rule 5131(b) Requires Changes to Hedge Fund IPO Procedures

By David Mainzer

July 2011

On September 26, 2011, the new FINRA Rule 5131(b) will come into effect.  FINRA Rule 5131(b) seeks to stop an underwriting practice called “spinning,” by generally prohibiting underwriters from allocating shares of an initial public offering of an equity securities (an “IPO”) to any hedge fund or other account in which executive officers or directors of certain public or non-public companies, or persons that are materially supported by these executive officers or directors, have a beneficial interest of greater than 25%.

Managers of hedge funds that intend to invest in IPOs will therefore be required to certify to the underwriters that their hedge funds are not prohibited accounts under FINRA Rule 5131(b).  This requirement is similar to the certifications that are currently required under FINRA Rule 5130.

In order to make the required certifications under FINRA Rule 5131(b), we expect that hedge funds will generally need to determine which of their investors are executive officers or directors of public or non-public companies, or persons that are materially supported by such executive officers or directors.   This will typically require (1) updating the investor questionnaire portion of the hedge fund’s subscription documents, to add a certification as to the investor’s status under FINRA Rule 5131(b), and (2) circulating an annual questionnaire to investors to update this certification.

With the September 26 deadline fast approaching, we recommend that hedge fund managers begin addressing these changes as soon as possible.

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