Other Issues
Hot Issues
FINRA Conduct Rule IM-2110-1 entitled "Free Riding and Withholding" is designed to protect the integrity of the public offering system by ensuring that members make a bona fide public distribution of "hot issue" securities and do not use the securities for their own benefit or to reward business associates. Hot issues are defined as securities of a public offering that trade at a premium in the secondary market whenever such trading begins. The Rule prohibits members from retaining the securities of hot issues in their own accounts and restricts the sale of hot issues to specific categories of persons otherwise known as "restricted persons." Restricted persons include FINRA members or associated members, other broker/dealers, employees and family members who receive substantial support, and senior officers of banks, savings and loan institutions, insurance companies, investment companies, investment advisory firms, which includes hedge funds.
Limited partnerships and offshore entities were originally ineligible to purchase hot issues if the partnership had a restricted person as a partner. The FINRA currently allows investment partnerships to use "carve out" procedures to prevent restricted persons with an interest in an investment partnership from participating in hot issue allocations. Ordinarily, hot issue security purchases are settled in a separate "hot issue account" and the cash proceeds are then transferred to the regular trading account.
When purchasing hot issues, domestic limited partnerships must meet the following conditions:
- Establish a separate brokerage account for hot issues;
- Prior to initial hot issue transaction, the partnership's legal counsel or independent certified public accountant must provide a written representation stating that the partnership complies with the hot issue rules;
- The hedge fund manager certifies in writing to the independent certified public accountant that hot issues are in a separate account and partners participating are not restricted;
- Annually, the independent certified public accountant must confirm in writing that hot issue allocations were made in accordance with the carve out provisions.
The hedge fund manager should maintain supporting documentation for how it determined whether each partner was restricted (i.e. subscription documents). This information should be kept in the partnership's files for at least three (3) years after the last hot issue purchase and updated on a regular basis. The hedge fund manager may accept investments from other investment companies (e.g. hedge funds, fund of funds) as partners and those other investment companies may participate in hot issues, provided the hedge fund manager obtains documentation stating that restricted persons in these other investment companies will not receive income generated from trading hot issue securities from the partnership.