Chapter 2 Study Notes

Question 1

At the Market Offering Prohibition

Answer 1

If a security is not listed on an exchange, a
broker-dealer is prohibited from representing a security as being offered at-the-market unless an
independent market for the security exists. An independent market is one where no member
dominates or controls the secondary market quotations (and trading) of the securities.

Question 2

IPO Allocation

Free retention

Answer 2

While underwriters will initially receive an allocation, in many cases a large portion
of these shares will have been presold to institutional clients. Free retention is the amount that an
underwriter is allotted for placement to its own clients. Sales to the firm’s retail clients are often filled
from this amount. The profit from the sale of these shares goes to the member who made the sale.

Question 3

IPO Allocation

jump ball basis.

Answer 3

In one allocation method, the syndicate uses an
institutional pot in which shares will be available on a jump ball basis. This process sets aside shares for
institutional clients and allows all members to compete for orders. The profit is allocated based on
each member’s sales. The institutions that receive allocations generally designate which underwriters
are credited with the sale.

Question 4

Information to be Filed The managing underwriter is required to file the following information
with FINRA:

Answer 4

1. estimated maximum offering price
2. estimated maximum underwriting discount, or commission, underwriters’ counsel fees,
   maximum finders’ fees, and a statement of any other type of compensation that may accrue to the
   underwriter
    A statement concerning the affiliation with any member firm of an officer or director of the issuer, or
   a beneficial owner of 5% or more of the issuer’s securities
    A detailed statement explaining any other arrangement entered into during the 180-day period prior
   to the filing date of the offering, where the firm received items of value, warrants, or options from the
   issuer
    A statement demonstrating compliance with any exception to the definition of underwriting
   compensation

Question 5

x

Answer 5

x

Question 6

Exempt Offerings The following offerings are exempt from the Corporate Financing Rule:

Answer 6

 Regulation D (private placements)
 mutual funds
 Variable contracts
 Municipal securities offerings
 Tender offers
 Securities registered with the SEC and issued as a result of a merger or acquisition, spin-off or any
other similar transaction that does not result in public ownership of the member firm

Question 7

Prohibited Arrangements FINRA describes prohibited terms and conditions within the Corporate
Financing Rule. Some of the prohibited arrangements include:

Answer 7

 Reimbursement for miscellaneous expenses
 Reimbursement for salaries of investment banking personnel
 Commissions paid by an issuer to a member firm prior to the commencement of the public sale of
the securities being offered
 The payment of any compensation by the issuer to a member firm in connection with an offering
that was not completed
 The receipt of a security, warrant, or option that has a duration exceeding five years and has more
favorable terms than those that were offered to the public Any non-accountable expense allowance exceeding 3% of the offering proceeds

Question 8

Restrictions on Securities Received by the underwriter

Answer 8

restricted for a period of six months following the effective date of registration.
Options or warrants that are acquired in connection with the offering may be exercised at any time, but the
securities received upon exercise are restricted for the remainder of the initial six-month period.

Question 9

Affiliate

Answer 9

The term affiliate refers to an entity that controls, is controlled by, or isunder common control with the member.

Question 10

Control

Answer 10

Control is defined as having ownership of 10% or more ofthe common or preferred equity or subordinated debt of another entity, or a right to 10% or more of
the profits or losses of a partnership. The term common control means the same person or entity
controls two or more entities.

Question 11

Distribution Restricted period

Answer 11

restricted period generally begins five business days prior to pricing, or whenever the broker-dealer becomes a participant, whichever comes later. The restricted period ends when the broker-dealer’s participation ends or placement is over. the subject security has an average daily trading volume (ADTV) of at least $100,000 and the issuer’s public float value is $25 million or more, the five-business-day standard is reduced to one business day.

Question 12

laddering

Answer 12

it is a violation to allocate IPO shares based on placing prearranged purchase orders in the aftermarket at specified prices. This tie-in arrangement can inflate the aftermarket price of the IPO

Question 13

A passive market maker’s daily purchase limit is

Answer 13

the greater of 30% of its ADTV in the stock (as determined by FINRA) or 200 shares.

Question 14

In a falling market, when the last independent bid drops below that of a passive market maker, the passive market maker may

Answer 14

maintain its bid until its purchases have reached
or exceeded the lesser of two times the minimum quote size for that security (as set by FINRA), or
the passive market maker’s remaining daily limit

Question 15

Initiating Stabilizing When The Principal Market Is Closed

Answer 15

When the principal market for the
security is closed, the price at which stabilization may be initiated is generally limited to the lower of the
price at which stabilizing could have been initiated in the principal market at its previous close, or
the last independent transaction or bid in the market on which stabilizing will be initiated.

Question 16

Spinning

Answer 16

Spinning is defined as a member firm allocating shares of a new issue to certain corporate decision makers.
The rule specifically states that it is a violation to allocate shares of a new issue to those customers if:
 The company is currently an investment banking services client of the member firm or the member
firm has received compensation from the company for investment banking services in the past 12
months
 The person responsible for making the allocation decision knows or has reason to know that the
member firm intends to provide, or expects to be retained by the purchaser for, investment banking
services within the next three months, or
 On behalf of the company they represent, the executive officers or directors make an expressed or
implied condition that their company will use the member firm to provide future investment banking
services

Question 17

Flipping

Answer 17

Flipping is defined as the initial sale of a new issue that occurs within 30 days following its offering date as an IPO.
Flipping creates downward pressure on the price of the security in the secondary market.
Finra prohibits a member firm and any person associated with a member firm from directly or indirectly recovering, or attempting to recover, any portion of a commission or credit that was paid or awarded to an associated person who originally sold shares of a new issuethat were flipped by a customer. An exception to this prohibition is available if the managing
underwriter has assessed a penalty bid on the entire syndicate.

Question 18

Stabilization Records

Answer 18

Typically, the syndicate manager places a stabilizing bid or conducts the syndicate’s short covering transactions. However, if a syndicate member (not the manager) executes a transaction, the firm is required to notify the manager within three business days of execution. The
manager must maintain these records as part of its recordkeeping responsibilities.

Question 19

Material

support

Answer 19

is defined as providing more than 25% of the person’s income or living in the same
household as the person associated with the member firm.