Can you say de minimis?

With the latest rules from the SEC and FINRA (rule 5130 and 5131) funds now have more options to handle income from new public offerings. Previously, investors were classified into 2 buckets: the ‘haves’ (eligible investors that can get income from new issues) and the ‘have not’ (ineligible investors that get nothing). This made life simple – either you participate in new issues or you don’t.

Good things come in small packages

Buried deep in the small print of these new rulings is a big benefit for investors.

Itsy Bitsy SpiderFINRA rule 5130 included language that certain restricted investors could receive up to 10% of the fund’s new issue income, and FINRA rule 5131 defined another class of investors who could receive up to 25% of the fund’s new issue income.

Seal holding a bucket

Ok, it’s a non sequitur, but we did mention buckets, seals are cute, and the upcoming tables of investor accounting data are very boring… Speaking of tables, bonus points if you can name the two new elements added to the periodic table. Scientists vote on their names. Like they did in de-planetizing Pluto – grr.

These situations are known as “de minimis exceptions”.

De minimus exceptions create four buckets of investors:

  • Completely ineligible
  • Participate up to 10%
  • Participate up to 25%
  • Completely unrestricted

Carving out before Thanksgiving

If a fund creates procedures to classify investors into the appropriate bucket and then limit their allocation of new issue income to only their authorized limit, then the fund can freely participate in new issues. This is also known as a “carve-out” as the new issue income is being removed from the other trading income.

Below is an example of such a “carve-out” and the calculation of the new issue participation percentages:

New issue income: 200,000
InvestorCapital BalanceNew Issue Classification
Bob Apple200,00010%
James Kevelch300,00010%
Tony DiPoni400,00025%
Sally Cowok100,00025%
Gerry Gihest50,000Restricted
Laurie Hapsburg500,000Unrestricted
Diamond Phelps100,000Unrestricted

By using their capital balance as a basis within the various classes, the following participation percentages are determined:

Simple Calculation
InvestorCapitalClassNew Issue %New Issue P/L
Bob Apple200,00010%4%8.000
James Kevelch300,00010%6%12,000
Total for 10%10%20,000
Tony DiPoni400,00025%20%40,000
Sally Cowok100,00025%5%10,000
Total for 25%25%50,000
Gerry Gihest50,000Restricted0%0
Restricted Total10%20,000
Laurie Hapsburg500,000Unrestricted54%108,333
Diamond Phelps100,000Unrestricted11%21,667
Unrestricted total65%130,000

Although the simple methodology illustrated above might get a fund into compliance, the allocation may result in unfair treatment. For example, say there is only one investor in a particular category and they have a small capital balance:

Small Capital Balance
InvestorCapital BalanceNew Issue Classification
Bob Apple5,00010%
Tony DiPoni400,00025%
Sally Cowok100,00025%
Gerry Gihest500,000Restricted
Laurie Hapsburg500,000Unrestricted
Diamond Phelps100,000Unrestricted

If we used the above methodology, then the investor Bob Apple would actually receive more new issue income than his capital balance would warrant:

Over-allocated Small Capital Calculation
InvestorCapitalClassNew Issue %Capital %
Bob Apple5,00010%10%0.4%
Total for 10%10%
Tony DiPoni400,00025%20%34.6%
Sally Cowok100,00025%5%8.7%
Total for 25%25%
Gerry Gihest50,000Restricted0%4.3%
Unrestricted total0%
Laurie Hapsburg500,000Unrestricted54%43.3%
Diamond Phelps100,000Unrestricted11%8.7%
Unrestricted total65%

By performing an additional step of limiting the new issue percentage to the investor’s capital percentage, the issue of small investor over-allocation can be avoided. The percentage that is limited in this step can be applied to the unrestricted investors:

Improved Small Capital Calculation
InvestorCapitalClassInitial %Capital %Over- allocation %New Issue %
Bob Apple5,00010%10%0.4%-9.6%0.4%
Total for 10%10%0.4%
Tony DiPoni400,00025%20%34.6%20%
Sally Cowok100,00025%5%8.7%5%
Total for 25%25%25%
Gerry Gihest50,000Restricted04.3%
Restricted total0%0%
Laurie Hapsburg500,000Unrestricted54%43.3%8.0%62%
Diamond Phelps100,000Unrestricted11%8.7%1.6%12.6%
Unrestricted total65%74.6%

Penny can help

A while back we talked about spreadsheets that were convoluted enought to make even the most dedicated fund accountants become professional chia farmers. Penny – It Works® is designed to be flexible in the new issue classifications so that when the regulations change, the categories and their related percentages can be easily updated.

Rumor has it Dee Snider was an accountant

With these new SEC rules, you can either use a system like Penny to automate the complex record-keeping and calculations, or try to manually maintain these classifications on spreadsheets and somehow avoid traps like small investor over-allocations.

If you choose the latter course, be prepared to hear a lot of Twisted Sister from the accounting office suite.