United States: SEC Adopts New Rule On Large Trader Reporting System

I. Introduction

On July 26, 2011, the Securities and Exchange Commission (the "SEC") adopted Rule 13h-1 under the Securities Exchange Act of 1934 (the "Exchange Act") to require large trader registration and reporting.¹

The rule requires persons who directly or indirectly exercise investment discretion and purchase or sell more than a specified amount of U.S.-listed stocks and options through a registered broker-dealer ("NMS securities")², to register with the SEC as large traders. The SEC will use the large trader identification numbers ("LTID") to collect information about the orders and transactions of large traders across broker-dealers, analyze their activity, and monitor the impact of their trades on the markets. This information also will be used for enforcement purposes and to reconstruct trading activity following periods of unusual market volatility.

Under the new rule, registered broker-dealers must comply with recordkeeping, reporting and monitoring requirements with respect to registered large traders and persons who such broker-dealers know or have "reason to know" are large traders. The information that the broker-dealers submit to the SEC under these requirements is confidential and not subject to public reporting. Registered broker-dealers are also required to enhance their recordkeeping and reporting capabilities (using the existing Electronic Blue Sheets ("EBS") system) regarding large trader activity in accounts they carry, and to develop systems to identify accountholders who may be "Unidentified Large Traders."

Below are the key aspects of the new SEC rules and discussions on some of the practical considerations they raise.

II. The Rule

Rule 13h-1 applies to large traders who use the U.S. jurisdictional means to effect transactions in NMS securities, subject to a limited set of exceptions, as well as to broker-dealers who effect such traders' securities transactions.

III. Large Traders

A. Large Trader Status

1. Who Should Register as a Large Trader?

The rule requires that any persons who engage in substantial levels of trading activity, "large traders," register with the SEC by filing Form 13H with the SEC and updating it at least annually. Form 13H provides the SEC with general information concerning the large trader's name, address, business, regulatory status, affiliates, governance and broker-dealers. Rule 13h-1(a)(1) defines a large trader as any person that:

• "directly or indirectly, including through other persons controlled by such person, exercises investment discretion³ over one or more accounts and effects transactions for the purchase or sale of NMS securities for or on behalf of such accounts, by or through one or more registered broker-dealers in an aggregate amount equal to or greater than the identifying activity level; or
• voluntarily registers as a large trader by filing electronically [on Form 13H]."

The definition of a large trader is designed to focus on the ultimate parent company of an entity or entities that employ or otherwise control the individuals that exercise investment discretion. Accordingly, the definition of larger trader, in conjunction with the provision that allows the parent company to comply with the self-identification requirement on behalf of its subsidiaries,⁴ is intended to allow the SEC to gather information about the primary institutions that conduct a large trading business, while at the same time mitigating the burden of the new rule by focusing the filing requirement on persons or entities that control large traders.

2. Parent-Company-Level Registration

The definition of large trader is designed to focus on the ultimate parent company of an entity that employs or otherwise controls the individuals that exercise investment discretion. While the rule's broader focus on identification at the parent-company level may provide less detailed information on the activity of individual traders within a large trader complex, it nevertheless will facilitate the SEC's ability to collect data on the full extent of trading by persons and entities under common control. The large trader reporting requirements are also intended to facilitate the reconstruction of market events using transaction data. To that end, parent-company-level aggregation should enhance the SEC's ability to reconstruct trading by significant market participants by providing the SEC with access to a broad set of useful data. In conclusion, corporate parents will need to ensure themselves that all large trader subsidiaries under their control have registered with the SEC. As a practical matter, this type of parent-level monitoring and reporting may be an entirely new practice for many firms.

3. Identifying Activity Level

Rule 13h-1(a)(7) defines the term "identifying activity level" as aggregate transactions in NMS securities that are equal to or greater than:

The SEC believes that the identifying trading activity level is appropriate because it will identify large traders that engage in a substantial amount of trading activity relative to overall market volume— specifically, approximately 0.01 percent of the daily volume and market value of trading in NMS securities. Inactive Status is available for large traders whose trading activity reaches the identifying activity level infrequently.

Purchases and sales of NMS securities will be aggregated, without offsetting or netting transactions among or within accounts, including for hedged positions.⁶ A potential large trader must aggregate the value of all transactions in NMS securities for or on behalf of accounts over which it and its controlled persons exercise investment discretion in order to determine if it meets the identifying activity level.⁷

The rule includes eight narrow exclusions from the definition of "transaction" that remove specific limited activities from the identifying activity level and from the reporting requirements for large traders. These limited activities are:

• Journal or bookkeeping entries memorializing the settlement of transactions
• Offerings by or on behalf of an issuer
• Gifts
• Distributions of estates
• Transactions ordered by a court
• Rollovers of a retirement plan
• Transactions pursuant to an issuer benefit plan
• Transactions to effect a business combination, including a reclassification, merger, consolidation or tender offer; an issuer tender offer or other stock buyback by an issuer; or a stock loan or equity repurchase agreement

The SEC will count toward the identifying activity level trading activity in the secondary market that relates to the acquisition or disposition of securities in connection with, for example, the creation or redemption of ETF shares, but not the transfer of such securities between an authorized participant and an ETF.⁸

B. Large Trader Obligations

As a general rule, every person who is a large trader must register with the SEC. However, a large trader is not required to register with the SEC if (i) a person that controls the large trader complies with all of the large trader requirements, or (ii) one or more persons controlled by such large trader collectively comply with the large trader requirements. In the latter case, one or more control persons must aggregate all of the collective activities of the group, even if the other members of the group do not individually reach the identifying activity level. It is also possible to voluntarily register as a large trader even if the trading activity threshold is not met.

Large traders are required to register "promptly"⁹ after the aggregate daily or monthly trading volumes of the trader and its controlled persons equal or exceed the identifying activity threshold. To register, a large trader must file Form 13H with the SEC, and thereafter must update its Form 13H at least annually (within 45 days after the end of each full calendar year), and on a quarterly basis if necessary to correct information that becomes inaccurate. The large trader must also promptly provide, on request, additional descriptive or clarifying information that would allow the SEC to further identify the large trader and all accounts through which the large trader effects transactions. Large traders on Inactive Status are not required to file Form 13H (or amend a previously filed form) while they are on Inactive Status.¹⁰ Further, the SEC requires that any such person that elects to voluntarily file, indicate on its initial filing such voluntary registration.

Upon receipt of the Form 13H, the SEC will issue the large trader a unique LTID. The LTID is used for all accounts over which the large trader controls or exercises investment discretion, across broker-dealers, thereby providing the SEC with a full picture of each large trader's activity in NMS securities.

Each large trader is also required to disclose its LTID to registered broker-dealers effecting transactions on its behalf, identify each account to which it applies. The rule prohibits persons from disaggregating accounts for the purpose of avoiding identification as a large trader.

Large traders who are registered with the SEC must promptly respond to requests from the SEC for additional identifying or clarifying information that would allow the SEC to further identify the large trader and all accounts through which the large trader effects transactions.

A large trader may assign suffixes to the large trader ID to sub-identify persons, affiliates, departments or units that directly control an account. The SEC could then request information directly from the person or area identified by the suffix.

Form 13H requires the following information, among other things, to be disclosed:

• Description of the business of the large trader, such as broker or dealer, bank holding company, securities broker, etc. and the nature of operations, including a general description of trading strategies;
• Whether any of the large trader's affiliates that exercise discretion over NMS securities file forms with the SEC;
• " Whether the large trader or any of its affiliates is registered with the CFTC in any capacity, including as a "registered trader," and whether the large trader or any of its affiliates is regulated by a foreign regulator;
• " An organizational chart that depicts the organization of the large trader with the parent company (if applicable), affiliates and entities identified, as well as descriptions of the businesses of the affiliates and their relationship to the large trader;
• " Governance of the large trader (i.e., type of organization and, if applicable, list of general partners and, if a limited partnership, partners that own more than 10 percent of the partnership interests); and
• " The names of each broker-dealer at which the large trader and any affiliates hold an account¹¹, and whether each broker-dealer provides execution, clearing or prime brokerage services.

IV. Broker-Dealer Responsibilities

The new rule places broad recordkeeping, reporting and monitoring responsibilities on broker-dealers with respect to large traders who maintain accounts with them. The recordkeeping and reporting requirements are based substantially on existing Exchange Act Rule 17a-25 and the EBS system, which the SEC currently uses to collect transaction data from broker-dealers. However, the rule requires recordkeeping and reporting of two new data fields: the LTID and the execution time of the transaction. As a result, registered broker-dealers will need to enhance their existing Electronic Blue Sheets infrastructure and adopt new policies and procedures. In addition, broker-dealers will have to develop monitoring capabilities to detect potential "Unidentified Large Traders" across multiple accounts.

New Rule 13h-1(a)(9) defines an "Unidentified Large Trader" as a person who has not complied with the large trader registration and self-identification requirements, and that a registered broker-dealer knows or has reason to know is a large trader based on such person's transactions in NMS securities effected by or through such broker-dealer. If a registered broker-dealer effects transactions for an intermediary who carries an omnibus account that exceeds the identifying activity level, the broker-dealer must treat the intermediary as an Unidentified Large Trader, unless the intermediary represents that the individual subaccounts that are part of the omnibus account do not exceed the identifying activity level. The registered broker-dealer does not need to seek information about the holders of the sub-accounts, even if the broker-dealer suspects that the holder is a large trader.

A. Recordkeeping

The SEC requires under Rule 13h-1(d) that every registered broker-dealer maintain records of information of the LTID and trade execution times, in addition to all of the information currently required to be collected by the EBS system.¹² A registered broker-dealer also must maintain records of an Unidentified Large Trader's name, address, tax identification number(s) and the date its account was opened, in addition to the other information required to be recorded about large traders. All records regarding large traders and Unidentified Large Traders must be available on the morning after the day the transactions were effected (including Saturdays and holidays).

B. Reporting

Under Rule 13h-1(e), if requested by the SEC, a broker-dealer who itself is a large trader or carries an account for a large trader or an Unidentified Large Trader, will have to provide the required information for all transactions effected directly or indirectly by or through accounts carried by such broker-dealer for large traders and Unidentified Large Traders, equal to or greater than the reporting activity level. Additionally, where a non-broker-dealer carries an account for a large trader or an Unidentified Large Trader, the broker-dealer effecting such transactions directly or indirectly for a large trader shall electronically report such information. The broker-dealer must report the requested information to the SEC via the EBS system. Broker-dealers must have the information available no later than the day and time specified in the request for transaction information, which shall be no earlier than the opening of business of the day following such request, unless in unusual circumstances the same-day submission of information is requested.

C. Monitoring

Under the new rule, registered broker-dealers have a responsibility to monitor their customers' accounts for compliance with the large trader registration requirement. The rule provides registered broker-dealers with a safe harbor for the monitoring requirement if the registered broker-dealer has no "reason to know" that a person is a large trader.¹³ The rule also establishes policies and procedures reasonably designed to detect and identify Unidentified Large Traders, treat any persons identified as Unidentified Large Traders as such, and inform Unidentified Large Traders of their potential obligations under Rule 13h-1.

A broker-dealer may determine that it has no "reason to know" that a person is a large trader through two methods. First, the broker-dealer may simply conclude, based on its knowledge of the nature of its customers and their trading activity with the broker-dealer, that it has no reason to expect that any of these customers' transactions is approaching the identifying activity level.¹⁴ Second, the broker-dealer may rely on the safe harbor provision in paragraph (f) of the rule. Under this safe harbor, a registered broker-dealer would be deemed not to know or have reason to know that a person is a large trader if it does not have actual knowledge that a person is a large trader, and it establishes policies and procedures reasonably designed to identify customers whose transactions at the broker-dealer equal or exceed the identifying activity level and, if so, to treat such persons as Unidentified Large Traders and notify them of their potential reporting obligations under this rule.

Under either approach, a broker-dealer's obligation with respect to an Unidentified Large Trader is limited to compliance with the requirements of paragraphs (d) and (e) of the rule, and the broker-dealer would not be required to cease trading or take other action with respect to that Unidentified Large Trader.¹⁵ The SEC notes that, pursuant to the reporting requirements of the Rule, it may periodically request reports from broker-dealers regarding all customers they may be treating as Unidentified Large Traders.

V. Foreign Entities

Any person, including a foreign entity, that uses the U.S. jurisdictional means to effect transactions in NMS securities through registered broker-dealers and exceeds the identifying activity level, must register as a large trader.¹⁶ Only registered broker-dealers are subject to the rule's recordkeeping and reporting requirements.

Any foreign entity that cannot register as a large trader because of foreign privacy laws could seek an exemption pursuant to section 36 of the Exchange Act, though the SEC notes that it believes it is unlikely that a foreign jurisdiction's laws would preclude the large trader from completing Form 13H. If a foreign entity, or a domestic entity, obtains an exemption from registration, registered broker-dealers would still need to tag these entities as Unidentified Large Traders, and record and report their trades.

Only SEC-registered broker-dealers are subject to the rule's monitoring, recordkeeping and reporting requirements. Foreign intermediaries who carry accounts for foreign entities do not have a duty to obtain or disclose the identity of their ultimate customers to registered broker-dealers, nor do registered broker-dealers have a duty to identify the ultimate customers of such foreign intermediaries.

VI. Implementation

The rule's effective date was October 3, 2011. Large traders must register with the SEC by December 1, 2011, and registered broker-dealers must comply with the recordkeeping, reporting and monitoring requirements by April 30, 2012. These accelerated time schedules are based on the SEC's determination that the EBS system provides the infrastructure to allow for an efficient transition.

Footnotes

1. Securities Exchange Act Release No. 64976 (July 27, 2011), 76 FR 46960 (August 3, 2011) (File No. S7-10-10 ("Final Release"). The rule was proposed in April 2010. See Securities Exchange Act release No. 61908 (April 14, 2010), 75 FR 21456 (April 23, 2010) (File No. S7-10-10) ("Proposing Release").

2. An "NMS security" is "any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options." 17 CFR 242.600(b)(46). "The term refers generally to exchange-listed securities, including equities and options." See Final Release at FN 61.

3. Rule 13h-1(a)(4) provides that the term "investment discretion" has the same meaning as in Section 3(a)(35) of the Securities Exchange Act of 1934. That definition states that a person exercises 'investment discretion' with respect to an account if, directly or indirectly, such person (A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the Commission, by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this chapter and the rules and regulations thereunder." 15 U.S.C. § 78c(a)(35). Rule 13h-1(a)(4) further specifies that a "person's employees who exercise investment discretion within the scope of their employment are deemed to do so on behalf of such person." To the extent that an entity employs a natural person that individually, or collectively with others, meets the definition of a "large trader," then for purposes of Rule 13h-1, the entity that controls that person or those persons would be a large trader.

4. The rule, however, also permits compliance by a controlled person, as evidenced in new Rule 13h-1(b)(3)(ii). In determining whether a person is a large trader, such person must aggregate all of the qualifying NMS securities activities of persons controlled by it. The term "control" is defined as "possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of securities, by contract, or otherwise." In spite of comments to the SEC that the control threshold in the proposed rule was too low and could pose challenges for minority (25 percent or more) owners that do not have full access to information about their affiliates, the SEC did not alter the definition of control. This means that a minority investor who owns 25 percent or more of a large trader must ensure that such large trader complies with the Rule 13h-1, or, if it is unable to ensure this, the minority investor must register itself as a large trader.

5. Listed options, as NMS securities, would be covered by the rule. Over-the-counter options would be outside the scope of the rule, though purchases or sales of NMS securities upon exercise of an option probably would be covered. Separately, the SEC staff is developing, for SEC consideration, a proposal to establish a consolidated audit trail for equities and options that would collect and consolidate detailed information about orders entered and trades executed on any exchange or in the over-the-counter market. See Securities Exchange Act Release No. 62174 (May 26, 2010), 75 FR 32556 (June 8, 2010) (proposed Consolidated Audit Trail) (File No. S7-11-10).

6. With respect to U.S.-listed options transactions, only purchases and sales of the options themselves, and not purchases and sales pursuant to exercises or assignments, must be counted. Purchases and sales of equity and equity index options must be converted into share equivalents.

7. Where two separate entities engage in a coordinated investment trading strategy that results in the joint exercise of investment discretion over their individual accounts, each entity must count the transactions in NMS securities effected through such "joint" accounts toward its own identifying activity level.

8. "Specifically, then, in connection with creation or redemption: (1) purchases of securities by an authorized participant for the purpose of assembling a basket would count toward an authorized participant's identifying activity level; (2) transfers of those securities by an authorized participant to the ETF would not be counted toward the ETF's identifying activity level; (3) acquisitions of securities by an authorized participant from the ETF would not count toward the authorized participant's identifying activity level; and (4) sales of securities by an authorized participant into the secondary market would count toward the authorized participant's identifying activity level. No transactions effected would be counted toward an ETF's identifying activity level because the ETF would not be exercising investment discretion by creating or redeeming ETF shares." See Final Release at FN 77.

9. The SEC states in the Final Release that under normal circumstances, it would be appropriate for such filing to occur within 10 days after the large trader effects aggregate transactions equal to or greater than the identifying activity level. See Final Release at FN 93.

10. Rule 13h-1(b)(3)(iii) permits a large trader who has not effected aggregate transactions at any time during the previous full calendar year in an amount equal to or greater than the identifying activity level to obtain inactive status by filing for "Inactive Status" through a Form 13H submission. Inactive Status is effective upon such filing. A person on Inactive Status who effects aggregate transactions that are equal to or greater than the identifying activity threshold must file a "Reactivated Status" Form 13H promptly after effecting such transactions. Upon filing for Reactivated Status, the person once again would be subject to the filing requirements of 13h-1 and must inform its broker-dealers of its reactivated status.

11. The rule does not define the term "account," but the context in which it is used implies that the term refers to an account established at a broker-dealer for the purposes of trading NMS securities.

12. The information currently required to be supplied on the EBS includes, among other items: date the transaction was executed; account number; identifying symbol assigned to the security; transaction price; number of shares or option contracts traded in each specific transaction designation of whether the transactions was proprietary or for a customer; the identity of the execution market; and a prime broker identifier.

13. Rule 13h-1(a)(9) states that in considering whether the broker-dealer has "reason to know" that a person is a large trader, however, the broker-dealer need take into account only transactions in NMS securities effected by or through such broker-dealer (i.e., it need not seek out information on transactions effected by that person through another broker-dealer).

14. For example, the broker-dealer may know, or learn from its customer, that the transactions over the identifying activity level were effected in connection with a tender offer, which are excluded under the Rule for purposes of determining whether a person is a Large Trader. Alternatively, the broker-dealer may know, or learn from its customer, that the account in question is an omnibus account and that the individual subaccounts do not exceed the identifying activity level.

15. The SEC reiterates that the monitoring requirements are intended to be a "limited" duty that serves as "a necessary backstop to encourage compliance and fulfill the objectives of Section 13(h) of the Exchange Act." Proposing Release, supra note 3, 75 FR at 21470. The SEC believes that requiring limited monitoring by broker-dealers will help assure that the objectives of the Rule are met and are consistent with the statutory intent of section 13(h) of the Exchange Act.

16. The rule would apply to all transactions in NMS securities effected through registered broker-dealers, including those that involve trades in foreign over-the-counter markets or exchanges. Persons otherwise using any "means or instrumentality of interstate commerce or of the mails, or any facility of a national securities exchange" (the "U.S. jurisdictional means") to trade NMS securities on a foreign exchange, to the extent their trades reach the identifying activity level, would be required to register as large traders. Trades in NMS securities in foreign markets that are effected without the participation, direct or indirect, of registered broker-dealers or other use of the U.S. jurisdictional means, would be outside the rule.

This article is presented for informational purposes only and is not intended to constitute legal advice.