July 31, 2011

KEEPING CURRENT: New FINRA Rule 5131 Will Affect Lock-Up Agreements for IPO Shares Held by Officers and Directors of the Issuer

FINRA Rule 5131 (the Rule), portions of which became effective on May 27, 2011, provides new prohibitions and requirements for underwriters when they are pricing and allocating IPO shares. While the Rule technically applies only to FINRA member firms, as a practical matter the Rule will affect IPO issuers and venture capital investors with board seats holding shares subject to lock-up agreements. The spinning prohibition in the Rule will also affect investment funds and others who purchase "new issues" under the Rule because FINRA member firms will require representations from each purchaser about the purchaser and, in the case of an investment fund, the purchaser's beneficial interest holders. These representations will be necessary to permit the underwriters to determine that they are not selling to a prohibited account.


The Rule had its origins in the IPO market of the late 1990s and 2000. During that period, IPO shares would often begin trading in the market immediately at prices significantly above the IPO price. As a result, allocations of IPO shares were in high demand. In the course of its investigations into certain IPO offerings during the so-called IPO bubble, the SEC learned that some underwriters had a practice of allocating IPO shares to executive officers and directors of companies for whom they were providing investment banking services or hoped to provide investment banking services. This practice came to be known as "spinning." At the same time, there were complaints by some IPO issuers that their shares had been priced too low in the public offering.

In 2003, many of the major investment banks entered into what has become known as the Voluntary Initiative, which specifically curtailed the practice of spinning. By its terms, the Voluntary Initiative was due to expire when FINRA (at that time, the NASD) adopted a rule regulating the practice, but no later than 2008. Although there was not a FINRA rule during the period from 2008 to May 2011, the signatories to the Voluntary Initiative, along with other investment banks, generally continued to abide by its terms. The rulemaking process that the NASD began in 2003 has culminated in Rule 5131.

Spinning and Pricing Provisions

Some provisions of the Rule have gotten a lot of attention, notably the so-called spinning prohibition, which prohibits the allocation of IPO shares by an underwriter to an account in which an executive officer or director of a public company or covered non-public company, or a person materially supported by such an officer or director, has a beneficial interest if the underwriter is currently providing, or expects to provide, investment banking services to the public or covered non-public company. Because of concerns about the ability of firms to implement programs for compliance with the spinning prohibition (which will require certifications not only by purchasers to firms but by fund investors to funds that seek to purchase new issue shares from underwriters), FINRA has extended the effective date of that provision to September 26, 2011.

The provisions on IPO pricing are effective as of May 27. These are designed to create greater transparency for issuers around the indications of interest process. The Rule will require the book-running lead manager to provide the issuer's pricing committee (or if none, its board of directors) with regular reports of indications of interest before the offering, and of final allocations after settlement, including the names of institutional investors and number of shares indicated or purchased by each, and aggregate numbers for retail investors. Since most private funds (generally those with at least $50 million in assets) will be treated as institutional investors, the names of private funds indicating an interest in receiving allocations will be made known to the issuer.

New Requirements for Lock-Up Agreements

The provisions relating to lock-up agreements covering shares held by the issuer's officers and directors, which have not been as widely discussed as the spinning prohibition, are in effect for lock-up agreements executed on or after May 27, 2011. The Rule affects new lock-up agreements in two ways. First, if a lock-up agreement applies to shares held by an officer or director of the issuer, it must apply to the officer or director's issuer-directed shares as well as to shares acquired before the IPO. Second, the agreement must provide that, at least two business days before the release or waiver of any lock-up restriction on the transfer of the issuer's shares, the book-running lead manager will:

  • Notify the issuer of the impending release or waiver, and
  • Announce the impending release or waiver through a major news service.

The Rule does not by its terms limit the notification and announcement requirement to cases of discretionary release or waiver by underwriters. Notification and announcement are not required when the lock‑up period expires, but FINRA has advised informally that notice to the issuer and public announcement would be necessary in the case where release occurs before expiration as a result of satisfaction of price conditions in the lock-up agreement.

Notification and announcement are not required where the release or waiver is effected solely to permit a transfer of securities that is not for consideration and where the transferee has agreed in writing to be bound by the same lock-up agreement. The public announcement requirement may be satisfied by an announcement made by the book-running lead manager, another member of the syndicate or the issuer.

The requirements for lock-up agreements apply only to agreements to which the members of the underwriting syndicate are parties (i.e., underwriter lock-ups). They also apply only to shares of officers and directors of the issuer. Unlike the spinning prohibition, the lock‑up provision does not limit its application to officers who are executive officers. Venture capital investors who hold seats on the boards of issuers and enter into underwriter lock-up agreements will have their agreements subject to both of the provisions mandated by the rule. Of particular significance is the fact that any release or waiver of the lock-up restrictions before the expiration of the lock-up period will be the subject of a public announcement. Venture capital investors who are board members and who do not want release of their lock-up agreements to be publicly announced may wish to consider resigning from the board before signing the lock-up agreement.