Study guide
Function 5 supplies 32 of the 150 scored questions and covers the investment banking side of the house: registering and distributing securities, running syndicates within FINRA's compensation limits, allocating new issues fairly, trading lawfully during distributions, and keeping research honest. The recurring theme is managing conflicts between the firm's banking clients and everyone else.
The Registration Process and Prospectus Delivery
The Securities Act of 1933 requires securities offered publicly to be registered with the SEC unless an exemption applies, and it divides an offering into three periods. In the pre-filing period, offers and sales are both prohibited; issuers and underwriters avoid publicity that could condition the market. During the waiting period, after the registration statement is filed but before it is effective, oral offers are permitted, the preliminary prospectus, called a red herring because of its red legend, may circulate, and tombstone announcements may run, but no sales may occur and no orders may be accepted; indications of interest are permissible precisely because they are not binding. Free writing prospectuses, which are written offers outside the statutory prospectus, are available on a sliding scale, with well-known seasoned issuers enjoying the most freedom. Once the registration statement is effective, sales may occur with delivery of the final prospectus, and under the access-equals-delivery standard, filing the final prospectus with the SEC generally satisfies delivery for investors who purchased. Dealers also face aftermarket prospectus delivery periods when selling in the secondary market shortly after an offering: 25 days for an IPO that will be listed on an exchange or Nasdaq, 90 days for an IPO that will not be listed, and 40 days for a follow-on offering of unlisted securities. Example: Cascade Robotics prices its Nasdaq-listed IPO on a Tuesday; dealers trading the stock owe prospectus delivery for 25 days. A supervising principal confirms the offering timeline, polices communications in each period, and ensures reps take only indications of interest before effectiveness.
Exempt Offerings: Regulation D, Rule 144, and Rule 144A
Regulation D exempts private placements from registration. Under Rule 506(b), an issuer may raise unlimited amounts from unlimited accredited investors plus up to 35 sophisticated non-accredited investors, but general solicitation is prohibited. Under Rule 506(c), general solicitation is allowed if every purchaser is accredited and the issuer takes reasonable steps to verify that status, such as reviewing tax returns or obtaining professional letters. A Form D notice is filed with the SEC within 15 days of the first sale, and bad actor provisions disqualify offerings involving felons and certain sanctioned persons. Accredited investors include institutions, insiders of the issuer, individuals with income above 200,000 dollars, or 300,000 dollars jointly, individuals with net worth above one million dollars excluding the primary residence, and holders of certain securities licenses. Securities bought in private placements are restricted, and Rule 144 governs their resale: non-affiliates of a reporting issuer may resell freely after a six-month holding period, twelve months for non-reporting issuers, while affiliates face ongoing volume limits, generally the greater of one percent of shares outstanding or the average weekly trading volume over the prior four weeks, plus manner-of-sale conditions and a Form 144 notice for larger sales. Rule 144A creates a separate safe harbor for resales of unregistered securities to qualified institutional buyers, institutions managing at least 100 million dollars in securities, with a lower 10 million dollar threshold for broker-dealers, and it powers the institutional private debt market. Supervisors verify investor status, watch for general solicitation leaking into 506(b) deals, and ensure reps are not distributing restricted stock in disguise.
Underwriting, Syndicates, and the Corporate Financing Rule
Underwriting commitments allocate risk. In a firm commitment, underwriters buy the entire issue from the issuer and resell it, bearing the risk of unsold shares; in a best efforts deal, the underwriter acts as agent and returns what it cannot sell; all-or-none and mini-max variants cancel the offering if targets are not met, with investor funds held in escrow under SEA Rule 15c2-4. The syndicate is organized by a managing underwriter under an agreement among underwriters that sets each member's allotment, the manager's fee, and authority to stabilize; selling group members are pure agents with no commitment risk. The underwriting spread divides into the manager's fee, the underwriting fee compensating risk, and the selling concession, with a reallowance sometimes available to dealers outside the group. FINRA Rule 5110, the corporate financing rule, polices what underwriters earn: offering documents are generally filed with FINRA within three business days of SEC filing, FINRA reviews proposed underwriting compensation for fairness and issues a no-objections opinion before the offering proceeds, and all items of value received in connection with the offering count toward compensation. Securities the underwriter receives as compensation are locked up, generally for 180 days from the start of sales, and arrangements deemed unreasonable, such as unlimited expense reimbursements or overly long rights of first refusal, are prohibited. Syndicate accounts must be settled promptly after the offering closes, generally within 90 days. Example: Brightwater Capital manages an IPO and receives warrants from the issuer; the warrants are underwriting compensation, count against 5110 limits, and cannot be sold during the lock-up.
New Issue Allocations and Regulation M
FINRA Rules 5130 and 5131 keep new issue allocations honest. Rule 5130 prohibits selling new issues, meaning IPOs of equity securities, to restricted persons: member firms, their associated persons and certain immediate family members, portfolio managers buying for their own accounts, and finders or fiduciaries of the managing underwriter. Before selling, a firm obtains a representation that the account is eligible, refreshed at least annually, and an account may still buy if restricted persons hold no more than a de minimis 10 percent beneficial interest. Rule 5131 attacks spinning, the allocation of hot IPO shares to executive officers and directors of current or prospective investment banking clients as an inducement for business, and it also prohibits quid pro quo allocations tied to excessive compensation and regulates how flipping penalties are imposed on reps. Regulation M prevents participants in a distribution from propping up the price. Rule 101 bars underwriters and other distribution participants from bidding for or purchasing the covered security during a restricted period that begins one or five business days before pricing depending on the security's trading volume and public float, with the most actively traded securities exempt. Rule 102 applies similar restrictions to issuers and selling shareholders. Rule 103 permits passive market making in Nasdaq securities within strict price and volume limits. Rule 104 governs stabilization, allowing one stabilizing bid at no higher than the offering price, disclosed in the prospectus. Rule 105 prohibits purchasing offered shares in a firm commitment offering by anyone who sold the security short during the five business days before pricing. Principals maintain restricted lists tied to each deal calendar and certify allocation eligibility before shares move.
Research, Fairness Opinions, and Tender Offers
FINRA Rule 2241 walls equity research off from investment banking. Research analysts may not be supervised by investment banking personnel, their compensation may not be tied to specific banking transactions and must be reviewed by a committee, firms may not promise favorable research to win mandates, and prepublication review of research by the subject company or banking staff is tightly limited to fact checking. Quiet periods restrict participating underwriters from publishing research for ten days after an IPO, and managers and co-managers for three days after a follow-on offering. Reports and public appearances require conflict disclosures, including financial interests and banking relationships, and firms restrict analysts from trading against their own recommendations. Rule 2242 applies a parallel regime to debt research, with an institutional carve-out for sophisticated recipients who consent. Regulation AC requires each report to include the analyst's certification that the views expressed are genuinely held and disclosure of whether any compensation is tied to the specific recommendations. FINRA Rule 5150 addresses fairness opinions issued in mergers and acquisitions: firms must disclose whether they acted as advisor in the transaction, whether compensation is contingent on the deal closing, whether material relationships exist with the parties, whether information was independently verified, and whether a fairness committee approved the opinion. Tender offer mechanics come from the Williams Act: an offer stays open at least 20 business days and at least 10 business days after any change in price or the number of shares sought, all holders must be treated equally at the best price paid, Rule 14e-3 prohibits trading on material nonpublic information about a tender offer once substantial steps are taken, and a person may tender only shares they are net long. Example: analysts at Kestrel Partners learn the firm is advising on an unannounced tender offer; the name goes on the watch list and their trading is surveilled.
Key terms
- Registration statement
- — The disclosure document filed with the SEC under the Securities Act of 1933 before a public offering; sales are prohibited until it becomes effective.
- Red herring
- — The preliminary prospectus circulated during the waiting period to solicit non-binding indications of interest; it lacks the final price and carries a red legend.
- Access equals delivery
- — The standard under which filing a final prospectus with the SEC generally satisfies prospectus delivery obligations for offering participants.
- Accredited investor
- — An investor eligible for private placements, including institutions, issuer insiders, individuals meeting income tests of 200,000 dollars single or 300,000 joint, net worth above one million dollars excluding the primary residence, or certain license holders.
- Rule 144
- — The safe harbor for reselling restricted and control securities, imposing holding periods of six or twelve months and, for affiliates, volume limits of the greater of one percent of shares outstanding or four-week average weekly volume.
- Qualified institutional buyer (QIB)
- — An institution managing at least 100 million dollars in securities of unaffiliated issuers, 10 million for broker-dealers, eligible to buy unregistered securities under Rule 144A.
- Firm commitment underwriting
- — An underwriting in which the syndicate purchases the entire issue from the issuer as principal and bears the risk of any unsold securities.
- Corporate financing rule (5110)
- — The FINRA rule requiring filing of offering terms, reviewing underwriting compensation for fairness, locking up securities received as compensation for 180 days, and banning unreasonable arrangements.
- Restricted person (5130)
- — A person barred from buying equity IPO new issues, including member firms, associated persons and certain family members, portfolio managers buying for themselves, and fiduciaries of the managing underwriter.
- Spinning
- — Allocating new issue shares to executives or directors of current or prospective investment banking clients to win business, prohibited by FINRA Rule 5131.
- Stabilizing bid
- — The single bid a syndicate manager may enter under Reg M Rule 104 to support a new issue, placed no higher than the offering price and disclosed in the prospectus.
- Fairness opinion
- — A firm's opinion on the financial fairness of an M&A transaction, subject to Rule 5150 disclosures about contingent compensation, relationships, verification, and fairness committee approval.
Exam tips
- Timeline questions are the staple: know what is permitted in the pre-filing, waiting, and post-effective periods, and remember that indications of interest are never binding.
- Keep 5130 and 5131 separate: 5130 defines who may not buy new issues at all, while 5131 targets spinning and allocation abuses aimed at winning banking business.
- For Regulation M, tie each rule number to its job: 101 and 102 restricted periods, 103 passive market making, 104 stabilization at or below the offering price, and 105's five-business-day short sale restriction.
- Research quiet periods after the 2015 rule changes are 10 days post-IPO for participants and 3 days post-follow-on for managers and co-managers; Reg AC certification appears in every research report.
- Tender offer arithmetic recurs: open at least 20 business days, extended at least 10 business days after a change in terms, and investors may tender only shares they are net long.