Who Is a Restricted Person Under FINRA Rule 5130?

FINRA Rule 5130 governs the sale and purchase of initial equity public offerings (IPOs), aiming to protect the integrity of the public offering process. Its primary purpose is to prevent practices such as “spinning,” where brokerage firms allocate shares of “hot” IPOs to favored clients to obtain or retain business. By limiting who can purchase these shares, Rule 5130 promotes fair allocation and equal opportunities for all investors.

Categories of Restricted Persons

FINRA Rule 5130 outlines specific categories of individuals and entities considered “restricted persons” who are generally prohibited from purchasing new issue shares. This prohibition extends to certain immediate family members, preventing conflicts of interest and ensuring equitable access to IPOs. The rule defines “beneficial interest” as any economic interest, including the right to share in gains or losses from the new issue.

FINRA member firms and their employees constitute a primary category of restricted persons. This includes any officer, director, general partner, associated person, or employee of a FINRA member firm or any other broker-dealer, with the exception of limited business broker-dealers. An associated person is any natural person registered with FINRA, or someone who is a sole proprietor, partner, officer, director, or branch manager, or performs similar functions.

The rule also extends to immediate family members of these broker-dealer personnel. An immediate family member includes a person’s parents, mother-in-law or father-in-law, spouse, brother or sister, brother-in-law or sister-in-law, son-in-law or daughter-in-law, and children. Additionally, any other individual to whom the person provides material support, defined as directly or indirectly providing more than 25% of their income in the prior calendar year, is included. Immediate family members living in the same household are presumed to be providing each other material support.

Finders and fiduciaries involved with a new issue are also considered restricted persons. A finder is someone who receives compensation for identifying potential investors in an offering. Fiduciaries include attorneys, accountants, consultants, and financial advisors to the issuer or underwriter who are involved in the new issue.

Portfolio managers, defined as individuals with the authority to buy or sell securities for financial institutions such as banks, savings and loan institutions, insurance companies, investment companies, or investment advisors, are restricted. This category also includes their immediate family members who materially support or receive material support from them.

Accounts closely linked to restricted persons, known as “tied-in accounts,” are also subject to the rule. This refers to any account in which a restricted person has a beneficial interest. The rule generally prohibits sales of new issues to such accounts.

Persons owning a broker-dealer are also typically restricted. This applies to any person listed, or required to be listed, in Schedule A of a Form BD, with exceptions for those identified by an ownership code of less than 10%. However, sovereign entities that acquire an ownership interest in a registered broker-dealer are specifically excluded from this category.

Permitted Sales and Exemptions

While Rule 5130 broadly restricts certain persons from purchasing new issues, it also provides specific exemptions and conditions under which sales are permitted.

A de minimis exemption allows a restricted person to have a limited beneficial interest in an account that purchases new issues. This exemption applies if the restricted person’s beneficial interest in the account, in the aggregate, is 10% or less.

Investment companies, such as mutual funds, can often purchase new issues even if they have restricted persons among their investors. An investment company organized under foreign laws may be exempt if it is listed on a foreign exchange or authorized by a foreign regulatory authority. Additionally, no single restricted person can own more than 5% of the shares, or the company must have 100 or more direct investors, or 1,000 or more indirect investors. The foreign investment company must also not have been formed specifically to permit restricted persons to invest in new issues.

Certain broad-based employee retirement plans are also exempt from the rule. This includes U.S. and foreign employee retirement plans that meet specific conditions, such as having at least 10,000 participants and beneficiaries and $10 billion in assets. These plans must operate non-discriminatorily, allowing employees regardless of income or position to participate, and be administered by fiduciaries acting in the best interests of participants. Charitable organizations under Internal Revenue Code Section 501(c)(3) are also generally exempt.

Issuer-directed shares represent another exemption. Securities specifically directed in writing by the issuer, an affiliate, or a selling shareholder to otherwise restricted persons are generally permitted. This allows issuers to allocate shares to employees, directors, or their immediate family members, including those of franchisees, even if restricted. However, such directed shares cannot be sold to broker-dealers or accounts where restricted persons have a beneficial interest, unless the restricted person is an employee or director of the issuer or its affiliates.

The rule also includes anti-dilution provisions, allowing a restricted person who is an existing equity owner of an issuer to purchase shares in a public offering to maintain their percentage equity ownership. Specific conditions apply, such as having held an equity interest for at least one year prior to the offering’s effective date. The sale must not increase the restricted person’s ownership above the level held three months prior to the registration statement’s filing, and the purchased shares cannot be sold for three months following the offering.

Compliance and Verification for Firms

FINRA member firms have specific responsibilities to ensure compliance with Rule 5130 when participating in new issues. Firms must make a good-faith effort to determine if a purchaser is a restricted person before selling new issue shares.

To fulfill this obligation, firms must obtain affirmative representations from purchasers. These representations, which can be written, electronic, or verbal, confirm that the account is eligible to purchase new issues in compliance with the rule. These representations must be obtained within the 12 months prior to the sale. A firm cannot rely on a representation if it believes, or has reason to believe, it is inaccurate.

Firms are required to maintain comprehensive records and documentation demonstrating their compliance with Rule 5130. This includes copies of all representations and information related to an account’s eligibility to purchase new issues. These records must be preserved for at least three years following the firm’s last sale of a new issue to that account, with the first two years in an easily accessible location.

Beyond obtaining initial representations, firms have an ongoing obligation to exercise reasonable diligence. This involves continuously assessing customer eligibility and ensuring that their internal procedures effectively filter out restricted persons. The firm’s supervisory systems and written supervisory procedures must be designed to achieve compliance and are subject to periodic review.

Non-compliance with Rule 5130 can result in regulatory action and penalties. FINRA can impose monetary sanctions, ranging from approximately $2,500 to $20,000, and in more serious cases, suspension or a bar of up to two years. Violations can also lead to fines and disgorgement of revenues generated from improper transactions.