Series 7 New Issue Rules: IPOs, Freeriding, and Restricted Persons

New issue rules represent a discrete regulatory area on the Series 7 that candidates can master with focused preparation. The underlying principle is straightforward — protect public investors by ensuring they get fair access to IPO shares — but the specific rules under FINRA Rules 5130 and 5131, and SEC Regulation M, have important technical details that are tested precisely.

The IPO Process

Understanding the mechanics of a public offering provides the context for the compliance rules.

Registration — Before securities can be offered to the public, the issuer must file a registration statement with the SEC under the Securities Act of 1933. The registration statement includes a preliminary prospectus (the red herring) — named for the bold red text on the cover that identifies it as preliminary and incomplete.

The red herring can be distributed to potential investors during the waiting period (after filing but before SEC effectiveness), but it cannot include the final offering price, proceeds amount, or effective date. Oral solicitations of investor interest are permitted during this period; written offers are not (except the red herring).

Road Show — During the registration period, the lead underwriter and company management conduct a road show — a series of presentations to institutional investors to gauge demand and build the order book. Indications of interest are collected but are not binding commitments.

Pricing and Effectiveness — Once the SEC declares the registration effective, the final prospectus is issued with the offering price. The effective date is when the securities can actually be sold.

The Underwriting Syndicate

The lead underwriter and syndicate members are bound by the terms of the underwriting agreement. The key structures are:

Firm commitment underwriting — The underwriter buys the entire offering from the issuer and resells to the public, bearing the risk that the offering does not fully sell.

Best efforts underwriting — The underwriter agrees only to use its best efforts to sell the securities, without purchasing them for its own account. The issuer bears the risk of an incomplete offering.

Green Shoe Option (Overallotment Option)

The green shoe option — named after the Green Shoe Manufacturing Company, the first issuer to use it — gives the underwriter the right to sell up to 15% more shares than the original offering size. This provides a price stabilization mechanism:

• If demand is strong and the stock rises above the offering price, the underwriter exercises the green shoe and purchases the additional shares from the issuer, covering the overallotment
• If demand is weak and the stock falls below the offering price, the underwriter buys shares in the open market for stabilization (using the short position created by the overallotment) rather than exercising the green shoe

Candidates should know that the green shoe is an overallotment option — it allows the underwriter to sell more shares, not just to stabilize. The maximum overallotment is 15%.

Stabilization Bids and Regulation M

Stabilization is the underwriter's practice of bidding for shares in the secondary market after the IPO to prevent the price from falling below the offering price. Stabilization is legal, but it is a form of price manipulation authorized by SEC Regulation M.

Under Regulation M, participants in a distribution — including underwriters, issuer, selling shareholders, and their affiliates — are generally prohibited from purchasing the offered security during the distribution period. Stabilization by the lead underwriter is an exception, subject to specific conditions and required disclosure.

Penalty bids are assessed by the lead underwriter against syndicate members whose customers flip (immediately sell) IPO shares after the offering. The syndicate member's selling concession is taken back. Penalty bids discourage flipping and support post-IPO price stability.

FINRA Rule 5130: Free-Riding and Withholding

FINRA Rule 5130 prohibits FINRA members from selling shares of a new equity issue (a "hot issue" — one that trades at a premium to the offering price) to accounts in which restricted persons have a beneficial interest.

Who Are Restricted Persons?

Restricted persons include:

• Broker-dealer employees and their immediate family members
• Portfolio managers and their immediate family members (if the portfolio manager has significant authority over investment decisions at a registered investment company or investment adviser)
• Finder's and fiduciary service providers who provide ongoing services to broker-dealers
• Any person who is associated with a FINRA member firm

The policy rationale: broker-dealer employees should not be able to take allocations of oversubscribed IPOs that the public cannot access.

The "Immediate Family" Definition

Immediate family for purposes of Rule 5130 includes parents, mother-in-law and father-in-law, spouse, children (natural or adopted), and siblings — if they live in the same household or if the person provides material support to them.

FINRA Rule 5131: New Issue Allocations and Distributions

FINRA Rule 5131 prohibits spinning — the practice of allocating new issue shares to executives and directors of current or prospective investment banking clients as an inducement for their company's investment banking business.

Rule 5131 also prohibits quid pro quo allocations — conditioning IPO allocations on a customer's promise to purchase additional securities in the aftermarket or to direct other business to the underwriter.

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Practice Series 7 new issue compliance questions at advisorexams.com/exams/series-7.