SEC proposes rules to clarify broker-dealer distinction | Jones Day

In short

The situation: The United States Securities and Exchange Commission (“SEC” or “Commission”) has proposed new rules that would more precisely define the term “part of a regular business” contained in the statutory exclusion from the definitions of “dealer”. and “government securities broker” (the “broker/dealer distinction”) to help clarify when a person trading securities on their own account is subject to registration under the Securities Exchange Act.

the Publish: Since the proposed rules would define “part of a regular business” for purposes of determining brokerage and state securities dealer status as regularly providing liquidity to other market participants through Qualitative and quantitative activities specified, the SEC’s proposals seek to significantly expand the number and types of entities that will be subject to the agency’s oversight.

Look forward: If the new rules are adopted, entities that trade on their own account, such as certain hedge funds and proprietary trading firms, will need to review the new standards to determine whether they can still rely on the broker/dealer distinction to avoid registration or whether they will have to register as a stockbroker or state securities dealer, as the case may be.

The SEC Proposal

On March 28, 2022, the SEC issued a regulatory proposal (the “Proposal”) for new rules to clarify the meaning of certain terms in the statutory definitions of “dealer” and “dealer in government securities” by under, respectively, Sections 3(a)(5) and 3(a)(44) of the Securities Exchange Act of 1934 (“Exchange Act”). These statutory provisions essentially define a “dealer” or “dealer in government securities” as any person engaged in the business of buying and selling securities or government securities for his own account, but excludes ” a person who buys or sells securities [or government securities] … for that person’s own account, either individually or in a fiduciary capacity, but not in the course of a regular business. This exclusion is known as the reseller/dealer distinction, and many investors, including hedge funds, have relied on this exclusion to avoid registering as resellers.

In recent years, the SEC has filed a number of lawsuits against proprietary trading firms for acting, according to the SEC, as unregistered brokers. To defend themselves against such claims, these companies have often claimed that they are only “traders” and that their transactions are not “part of a regular business”, a term that is ambiguous at best. The new rules proposed by the SEC would more precisely define the term “in the course of a regular business” as it is used in the law to clarify that certain entities engaging in “a common pattern of buying and selling securities that has the effect of providing liquidity to other market participants” will be considered “dealers” or “dealers in government securities”.

“Concessionaire” Status Under Proposed Rule 3a5-4

Proposed Rule 3a5-4 sets out three different qualitative tests for determining whether a person’s activities are “part of a regular business” of regularly providing liquidity:

  • “Regularly make roughly comparable purchases and sales of identical or substantially similar securities in one day;”
  • “Regularly express business interests that are at or near the best available prices on both sides of the market and that are communicated and represented in such a way as to make them accessible to other market participants;” Where
  • “Earn income primarily by capturing bid-ask spreads, buying on the bid and selling on the bid, or capturing any incentives offered by trading platforms to trading interests providing liquidity.”

The SEC considers an entity engaged in any of the above activities to “provide liquidity” as part of its regular business and that the provision of such liquidity is not merely incidental to its trading activity. The “same” securities refer to securities of the same category and having the same terms, conditions and rights (for example, having the same CUSIP), while determining whether a security is “substantially similar” to another security requires a factual analysis and analysis of the circumstances (although the SEC provides some examples of what would and would not be “substantially similar” securities). Interestingly, instead of referring to “quotes” – market makers typically post quotes simultaneously to buy and sell the same security – the proposed rules refer to “trading interests”, a term the SEC recently proposed in its ATS Proposal Release to designate an Order, as defined in Rule 300(e) of the ATS Rules, or any non-firm indication of a willingness to buy or sell a security that at least identifies the security and quantity, direction (buy or sell) or price. Additionally, the inclusion of “earning income” instead of “benefiting from” in the third bullet is intended to clarify that a person’s trading strategies do not need to be profitable for the person to fall under. the stroke of the proposed rule. There is no definition of “primarily” or a clear income test in the proposed rule, but the SEC explains in the proposal that “if a person derives the majority of his or her income” from the sources of the rule, it would be probably in a regular activity of buying and selling securities or public securities for its own account.”

Finally, people who have or “control” total assets of less than $50 million or who are registered as investment companies under the Investment Company Act of 1940 will be excluded from the new rules. Therefore, if the new rules are passed, hedge funds that fall under the qualitative or quantitative standards of the rules will have the option of either registering as dealers (and allowing those of their advisers who are exempt reporting advisers to remain) or to register as investment firms (and require their investment advisers to also be registered under the Investment Advisers Act 1940).

“Government Securities Dealer” Status Under Proposed Rule 3a44-2

Proposed Rule 3a44-2 not only includes the same three qualitative tests for determining dealer status and exceptions as Proposed Rule 3a5-4, but it also includes a clear new quantitative test for determining securities dealer status. of state. Under the quantitative test, if in four of the last six calendar months the entity “has engaged in the buying and selling of more than $25 billion in trading volume of government securities” , it would be considered to be trading government securities on its own account. counts as “part of a regular business”. The SEC believes that such a rule is necessary for the US Treasury market because of the large number of significant market participants who are not registered as broker-dealers but perform broker-like functions in this market. market (e.g. unregistered proprietary trading firms account for more than half of the daily volume in the middleman market) as well as the recent disruptions in the US Treasury market on which regulators had limited visibility as many players of the market are not recorded.

Eliminate potential loopholes: definition of “own account” and “control”

As part of each proposed new rule, the SEC has also defined the terms “own account” and “control” to address variations in corporate structure and ownership that could help people circumvent the new rules. The Proposed Rules would define a person’s “own account” to mean, subject to certain exceptions, any account: (i) held in that person’s name; (ii) held in the name of a person over whom that person exercises control or with whom that person is under common control; or (iii) held for the benefit of persons identified in (i) and (ii). “Control” is defined to have the same meaning as prescribed in Rule 13h-1 of the Foreign Exchange Act (i.e. the Large Trader Reporting Rule), which is “the possession, direct or indirect, power to direct or cause the direction of the management and policies of a person, whether by ownership of securities, by contract or otherwise” and for which there is a presumption of ownership/interest 25% capital, so entities will need to aggregate affiliates’ transactions and holdings with their own to determine if they meet the $50 million threshold for the new rules.

Existing guidance still valid

The new rules would apply proscriptively – if a person falls under the proposed rules, they will be considered a dealer or state securities dealer subject to registration, unless otherwise exempt. The proposed rules clarify, however, that there is no presumption that a person is do not a broker or state securities dealer if it does not meet the criteria of the proposed rules. In this respect, the Commission clarifies that the proposed rules have no impact on the previously published guidance on the status of concessionaire. Individuals will not only need to consider the proposed rules when determining broker status, but will also need to review previous SEC guidance regarding other factors that the SEC will consider.

Short comment period

These proposed rules are just the latest in a very comprehensive series of proposed new rules and rule changes proposed by the SEC over the past several months. The SEC has provided a comment period of at least 60 days from publication (i.e., the comment period ends May 27, 2022 or 30 days after publication in the Federal Register, depending on the latest date).

Four takeaway meals

  1. The proposed new rules, if passed, will clarify what it means to be engaged in the buying and selling of securities on one’s own account but “not part of a regular business” for the purposes of the exclusions from the dealer definitions and state securities dealer. .
  2. If passed, the proposed rules will require many entities that previously relied on the dealer/dealer distinction to avoid registration to be subject to agency oversight.
  3. The $25 billion quantitative test for government stockbrokers is likely to capture many unregistered proprietary trading firms operating in US Treasury markets, regardless of the types of trading strategies they employ.
  4. Even if they do not fall under the proposed new rules, unregistered trading firms will need to consider existing SEC guidance to determine whether there is otherwise a sufficient basis to require them to register as brokers or dealers in government securities.

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