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.
FINRA 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.
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.
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:
| Investor | Capital Balance | New Issue Classification |
|---|---|---|
| Bob Apple | 200,000 | 10% |
| James Kevelch | 300,000 | 10% |
| Tony DiPoni | 400,000 | 25% |
| Sally Cowok | 100,000 | 25% |
| Gerry Gihest | 50,000 | Restricted |
| Laurie Hapsburg | 500,000 | Unrestricted |
| Diamond Phelps | 100,000 | Unrestricted |
By using their capital balance as a basis within the various classes, the following participation percentages are determined:
| Investor | Capital | Class | New Issue % | New Issue P/L |
|---|---|---|---|---|
| Bob Apple | 200,000 | 10% | 4% | 8.000 |
| James Kevelch | 300,000 | 10% | 6% | 12,000 |
| Total for 10% | 10% | 20,000 | ||
| Tony DiPoni | 400,000 | 25% | 20% | 40,000 |
| Sally Cowok | 100,000 | 25% | 5% | 10,000 |
| Total for 25% | 25% | 50,000 | ||
| Gerry Gihest | 50,000 | Restricted | 0% | 0 |
| Restricted Total | 10% | 20,000 | ||
| Laurie Hapsburg | 500,000 | Unrestricted | 54% | 108,333 |
| Diamond Phelps | 100,000 | Unrestricted | 11% | 21,667 |
| Unrestricted total | 65% | 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:
| Investor | Capital Balance | New Issue Classification |
|---|---|---|
| Bob Apple | 5,000 | 10% |
| Tony DiPoni | 400,000 | 25% |
| Sally Cowok | 100,000 | 25% |
| Gerry Gihest | 500,000 | Restricted |
| Laurie Hapsburg | 500,000 | Unrestricted |
| Diamond Phelps | 100,000 | Unrestricted |
If we used the above methodology, then the investor Bob Apple would actually receive more new issue income than his capital balance would warrant:
| Investor | Capital | Class | New Issue % | Capital % |
|---|---|---|---|---|
| Bob Apple | 5,000 | 10% | 10% | 0.4% |
| Total for 10% | 10% | |||
| Tony DiPoni | 400,000 | 25% | 20% | 34.6% |
| Sally Cowok | 100,000 | 25% | 5% | 8.7% |
| Total for 25% | 25% | |||
| Gerry Gihest | 50,000 | Restricted | 0% | 4.3% |
| Unrestricted total | 0% | |||
| Laurie Hapsburg | 500,000 | Unrestricted | 54% | 43.3% |
| Diamond Phelps | 100,000 | Unrestricted | 11% | 8.7% |
| Unrestricted total | 65% | |||
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:
| Investor | Capital | Class | Initial % | Capital % | Over- allocation % | New Issue % |
|---|---|---|---|---|---|---|
| Bob Apple | 5,000 | 10% | 10% | 0.4% | -9.6% | 0.4% |
| Total for 10% | 10% | 0.4% | ||||
| Tony DiPoni | 400,000 | 25% | 20% | 34.6% | 20% | |
| Sally Cowok | 100,000 | 25% | 5% | 8.7% | 5% | |
| Total for 25% | 25% | 25% | ||||
| Gerry Gihest | 50,000 | Restricted | 0 | 4.3% | ||
| Restricted total | 0% | 0% | ||||
| Laurie Hapsburg | 500,000 | Unrestricted | 54% | 43.3% | 8.0% | 62% |
| Diamond Phelps | 100,000 | Unrestricted | 11% | 8.7% | 1.6% | 12.6% |
| Unrestricted total | 65% | 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.
