SEC Proposes To Expand 15a-6 Registration Exemption For Foreign Broker-Dealers

The Securities and Exchange Commission (the "SEC") has proposed to expand the conditional exemptions from registration that are provided to foreign broker-dealers under rule 15a-6 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The proposal to amend Exchange Act rule 15a-6 (the "Proposed Rule") would ease the conditions required to qualify for the exemptions, enable foreign broker-dealers to reach a broader class of US investors, and impose fewer restrictions. The SEC published the proposing release ("Proposing Release") on its website on June 27, 2008 and in the Federal Register on July 8, 2008. Comments are due on September 8, 2008.

Categories of Exemptions - Overview

The Proposed Rule consists of five categories of exemptions, each containing specific conditions and requirements with which foreign broker-dealers must comply in order to be exempt from registration. We briefly introduce them here and revisit each of them later discussing key proposed revisions to each exemption. The five categories are:

(a)(1) Unsolicited trades
(a)(2) Research reports
(a)(3) Solicited trades
(a)(4) Counterparties and specific customers
(a)(5) Familiarization with foreign options exchanges

The exemption for unsolicited trades in subsection (a)(1) would remain unchanged from the current rule. The exemptions in subsections (a)(2) and (a)(3) would be revised substantially to allow foreign broker-dealers to operate more easily when they solicit and effect securities transactions with US investors. The exemption in subsection (a)(4) would be expanded by allowing foreign broker-dealers to conduct business with US fiduciaries of non-US resident entities and persons. The exemption in subsection (a)(5) is newly-proposed. It would allow foreign broker-dealers and foreign options exchanges to interact with US investors to provide information on, and mechanisms to transact in, options on foreign securities.

Some Important Definitions

Some definitions in the Proposed Rule are integral to understanding the scope of the exemptions provided for foreign broker-dealers. We introduce these definitions below.

(1) Qualified Investors

The exemptions in the Proposed Rule apply to "Qualified Investors," a class of investors defined in Exchange Act rule 3(a)(54). This is a much broader class of investors than the class of investors reached by the exemptions in the current rule. The exemptions in the current rule apply to "Major Institutional Investors" and "Institutional Investors." Major Institutional Investors generally include US institutions or registered investment advisors that have in excess of $100 million in assets under management. Institutional Investors generally include registered investment companies, banks, insurance companies, employee benefits plans, private business development companies, and trusts. Qualified Investors, on the other hand, have a substantially lower threshold of assets under management. They include institutions, partnerships and natural persons with $25 million in investments on a discretionary basis, and certain government entities with $50 million in investments on a discretionary basis. Qualified Investors also include a broader range of entities, including registered and exempt investment companies, banks, insurance companies, broker-dealers, employee benefit plans, business development companies, small business investment companies, trusts of certain Qualified Investors, exempt market intermediaries, foreign banks, foreign governments, and multinational or supranational entities.

(2) Foreign Resident Clients

The Proposed Rule defines "Foreign Resident Clients" to include: (1) natural persons who are non-US residents or considered non-US residents for purposes of federal income tax; (2) entities that are not incorporated in the US and are not engaged in a trade or business in the US for purposes of federal income tax; and (3) entities that are not organized or incorporated in the US and that are "predominantly" (85%) owned by persons or entities meeting the definition of Foreign Resident Client.

The proposed exemptions in subsections (a)(3) and (a)(4)(vi) apply to Foreign Resident Clients. Pursuant to the (a)(3) exemption, foreign broker-dealers would be permitted to custody customer accounts and retain books and records if they conduct "Foreign Business," which includes securities business conducted with Foreign Resident Clients. Pursuant to the
(a)(4)(vi) exemption, foreign broker-dealers that conduct Foreign Business would be permitted to solicit and effect transactions with US persons that act in a fiduciary capacity on behalf of Foreign Resident Clients. In both cases, foreign broker-dealers would be required to determine that such persons or entities qualify as Foreign Resident Clients.

(3) Foreign Business

The definition of "Foreign Business" is important to the proposed exemptions in subsections (a)(3) and (a)(4). As discussed above, a foreign broker-dealer that conducts a Foreign Business would be permitted to custody customer accounts and retain books and records pursuant to the (a)(3) exemption. Pursuant to the (a)(4)(vi) exemption, a foreign broker-dealer would be permitted to solicit and effect transactions with the US fiduciaries of Foreign Resident Clients if they conduct a Foreign Business.

To be considered to be conducting a Foreign Business, a foreign broker-dealer must derive at least 85% of the aggregate value of its securities business from transactions in Foreign Securities with Qualified Investors and Foreign Resident Clients. Foreign Securities include the equity and debt securities of a foreign private issuer, debt securities distributed pursuant to Regulation S, notes, bonds, debentures or similar evidence of indebtedness issued or guaranteed by certain eligible foreign governments, and derivative instruments on any of the foregoing securities. The 85% threshold is calculated on a rolling two-year basis. The calculation should be made each year for the previous two years to determine the aggregate value of securities transacted and the percentage of the value from Foreign Securities. Each year, a foreign broker-dealer must make the calculation within the first 60 days of the new calendar year, within which time it can rely on the prior calculation.

(4) Foreign Broker-Dealers

The Proposed Rule would retain the existing definition of a foreign broker-dealer, but carves out special categories of foreign broker-dealers for specific exemptions. Generally, a foreign broker-dealer is a non-US resident person that is not a branch office or associated person of a US registered broker-dealer. US persons conducting a broker-dealer business entirely outside of the US are also considered foreign broker-dealers. For purposes of the (a)(3) exemption, however, a foreign broker-dealer must also be regulated by a foreign securities authority and, in order to custody customer funds and securities, be conducting a Foreign Business. For certain exemptions under subsection (a)(4), a foreign broker-dealer must also be conducting a Foreign Business. These varying definitions of foreign broker-dealer are found in subsections (b)(2)(i) and (ii) of the Proposed Rule.

Exemption (a)(1): Unsolicited Trades

Consistent with the current rule, the Proposed Rule allows foreign broker-dealers to effect unsolicited transactions with US investors. The (a)(1) exemption in the Proposed Rule allows foreign broker-dealers to effect trades from US investors without violating registration requirements when the US investors have initiated contact with the foreign broker-dealer. It is not limited to transactions with Qualified Investors or Foreign Resident Clients.

The (a)(1) exemption is, however, narrower than it may appear because the SEC construes solicitation broadly. According to the SEC, "solicitation" can be any affirmative effort by a broker or dealer intended to induce transactional business for the broker-dealer or its affiliates. Participation in seminars with US investors (whether or not hosted by a US registered broker-dealer), and providing free research reports to US investors are examples of activities that have been construed as solicitation. Transactions resulting from such activities must be effected pursuant to exemptions in other subsections of the rule. Foreign broker-dealers must continue to exercise caution in assessing whether their activities may be considered solicitation.

For purposes of the (a)(1) exemption, the SEC would not consider the distribution of quotations by foreign broker-dealers in the US as solicitation, provided that the foreign broker-dealer uses qualified third-party systems. According to the SEC:

US distribution of foreign broker-dealers' quotations by a third-party system (which [does] not allow securities transactions to be executed between the foreign broker-dealer and persons in the US through the system) would not be viewed as a form of solicitation in the absence of other contacts with US investors initiated by the third-party system or the foreign broker-dealer.

The proposed interpretation formally adopts the SEC's longstanding no-action position allowing foreign broker-dealers to distribute quotations through third party systems that distribute quotations outside or inside the US. Prior to the no-action position, the exemption was limited to systems that distribute quotations primarily outside the US. The Proposing Release also clarifies that the SEC's no-action position is limited to systems that do not allow foreign broker-dealers to effect securities transactions with US investors through the system. In such instances, the distribution of quotations through the system may be construed as a form of solicitation. The SEC seeks comments on the proposed interpretation.

Exemption (a)(2): Research Reports

The Proposed Rule would continue to allow foreign broker-dealers to distribute research reports in the US and effect transactions in the securities discussed in the research reports without being registered, provided that such foreign broker-dealers satisfy the conditions in the (a)(2) exemption. The SEC has proposed, however, two important revisions. First, foreign broker-dealers would be able to distribute research reports to Qualified Investors, a broader class of investors. (Under the current rule, foreign broker-dealers can distribute research reports only to "Major US Institutional Investors.") Second, foreign broker-dealers would be able to effect transactions in securities discussed in the research reports directly with Qualified Investors if the foreign broker-dealer has a relationship with a US registered broker-dealer to satisfy the conditions under the (a)(3) exemption for solicited trades (discussed below). The Proposed Rule would eliminate the requirement that the transaction be effected only through a US registered broker-dealer.

Exemption (a)(3): Solicited Trades

Under the current (a)(3) exemption, a foreign broker-dealer may solicit securities business from "Major US Institutional Investors" and "US Institutional Investors" without being registered if it has an arrangement with a US registered broker-dealer that would take on substantial responsibilities in connection with the resulting securities transactions. The Proposed Rule would significantly revise the (a)(3) exemption by expanding the class of investors that can be solicited by foreign broker-dealers and by streamlining (or, in some instances, eliminating) the involvement of the US registered broker-dealer in transactions between foreign broker-dealers and US investors. The Proposed Rule would require foreign broker-dealers to take on more direct responsibilities with respect to transactions effected on behalf of US investors.

(1) Expanded Class of Investors: Qualified Investors

The proposed (a)(3) exemption would allow foreign broker-dealers to solicit transactions from Qualified Investors. The revised exemption would eliminate all references to "Major US Institutional Investors" and "US Institutional Investors." A foreign broker-dealer's ability to solicit transactions in the US would be expanded to institutions, partnerships, and individuals with $25 million in investments on a discretionary basis and certain government entities with $50 million in investments on a discretionary basis. Foreign broker-dealers would be able to reach out to, among others, registered and exempt investment companies, banks, insurance companies, broker-dealers, employee benefit plans, trusts of certain Qualified Investors, and exempt market intermediaries without any investment threshold because these investors are deemed to be sufficiently sophisticated. Foreign broker-dealers would also be able to solicit business from foreign banks, foreign governments, and multinational or supranational entities, presumably when the representatives or offices of such entities are present in the United States.

(2) "Chaperoning" Requirements

US registered broker-dealers would no longer have the burden of "chaperoning" transactions solicited by foreign broker-dealers. The Proposed Rule would eliminate the requirements found in current subsections (a)(3)(ii)(A) and (iii)(B), which mandate that a US associated person participate in a foreign associated person's oral communications with US investors and accompany a foreign associated person visiting the US. A foreign associated person may visit Qualified Investors in the US to solicit and discuss securities business, as long as the foreign broker-dealer effects the resulting transactions in compliance with all other conditions under subsection (a)(3). The Proposed Rule does not define the term "visit," but the SEC proposes to interpret a "visit" as one or more trips to the US over a calendar year that do not last more than 180 days in the aggregate. The elimination of the "chaperoning" requirement allows foreign broker-dealers to communicate and interact with US investors more freely. US registered broker-dealers would no longer be required to interpose themselves in communications between foreign broker-dealers and US investors.

(3) Effecting Transactions in Solicited Securities

Under the current (a)(3) exemption, transactions in securities that are solicited by foreign broker-dealers must be effected through US registered broker-dealers. The Proposed Rule would allow foreign broker-dealers to effect solicited transactions directly with Qualified Investors, provided that the foreign broker-dealers satisfy all of the other conditions under subsection (a)(3). The US registered broker-dealer would no longer be required to issue confirmations or account statements, or take net-capital charges under Exchange Act rule
15c3-1 for the transactions. This means that foreign broker-dealers could effect solicited transactions on an RVP/DVP basis with Qualified Investors without the involvement of a US registered broker-dealer.

In foreign broker-dealer transactions that involve a US registered broker-dealer, however, the US registered broker-dealer must comply with all applicable US laws and rules relating to the transactions. Transactions effected on a US national securities exchange through US alternative trading systems or through US over-the-counter market makers are examples of such transactions.

(4) Custody and Recordkeeping Requirements

The Proposed Rule would eliminate custody and recordkeeping requirements for solicited transactions effected by foreign broker-dealers that conduct a Foreign Business. This is a significant development. Custody is a core protection under federal securities laws and allowing foreign broker-dealers to act as the custodian of the funds and securities of US investors is a major change. The custody and recordkeeping requirements appear in two separate subsections: (a)(3)(iii)(A)(1) and (a)(3)(iii)(A)(2).

Under subsection (a)(3)(iii)(A)(1), a foreign broker-dealer that conducts a Foreign Business would be allowed to custody customer funds and securities, and retain books and records, relating to solicited US transactions according to the rules of the foreign jurisdictions in which it operates. A US registered broker-dealer, however, would have the responsibility to make a "reasonable determination" that the foreign broker-dealer can provide books and records to the SEC promptly upon request. This "reasonable determination" would involve examining the foreign jurisdiction's laws and rules to determine whether the foreign jurisdiction restricts the foreign broker-dealer from providing the SEC with books and records or information relating to the transactions with Qualified Investors.

Under subsection (a)(3)(iii)(A)(2), a US registered broker-dealer would be required to custody funds and securities, and retain books and records, related to solicited US transactions on behalf of a foreign broker-dealer that does not conduct Foreign Business. Subsection
(a)(3)(iii)(A)(2) would allow the foreign broker-dealer to solicit and effect securities transactions with Qualified Investors that have accounts with US registered broker-dealers. In such instances, the US registered broker-dealer would be responsible for: (1) receiving, delivering, and safeguarding funds and securities in compliance with Exchange Act rule 15c3-3;
and (2) retaining books and records.

(5) Responsibilities of Foreign Broker-Dealers

Under the Proposed Rule, foreign broker-dealers would be directly responsible for some of the requirements that are currently imposed on US registered broker-dealers. Foreign broker-dealers would have the following responsibilities:

• upon request, foreign broker-dealers would be required to provide the SEC with information and documents related to transactions effected pursuant to the (a)(3) exemption;
  
  
• foreign broker-dealers would be required to make a determination that foreign associated persons who effect transactions with Qualified Investors are not subject to disqualification;
  
  
• foreign broker-dealers would be required to disclose to Qualified Investors that they are regulated by a foreign securities authority and not by the SEC; and
  
  
• foreign broker-dealers that conduct Foreign Business would be required to retain records pursuant to Exchange Act rule 15a-6(a)(3)(iii)(A)(1) and to disclose to Qualified Investors that US segregation requirements and bankruptcy protections will not apply, and that the Securities Investor Protection Corporation ("SIPC") will not protect funds or securities.
  
  

It should also be noted that, for purposes of subsection (a)(3), the Proposed Rule would specifically require that the foreign broker-dealer is regulated by a foreign securities authority for conducting securities business with Qualified Investors. Foreign broker-dealers would also have the responsibility to determine that they satisfy the 85% Foreign Business threshold each year if they seek to custody customer funds and securities pursuant to Exchange Act rule
15a-6(a)(3)(iii)(A)(1).

(6) Responsibilities of US Registered Broker-Dealers

As described above, the Proposed Rule would eliminate some of the more burdensome and challenging responsibilities that were previously imposed on US registered broker-dealers under Exchange Act rule 15a-6. Those that remain are more narrowly tailored to allow the SEC to obtain information relating to transactions effected between foreign broker-dealers and Qualified Investors, when needed. Under the Proposed Rule, the US registered broker-dealer would be required to:

• make a "reasonable determination" that the foreign broker-dealer can provide books and records to the SEC promptly upon request when the foreign broker-dealer retains books and records pursuant to Proposed Rule 15a-6(a)(3)(iii)(A)(1);
  
  
• retain records relating to transactions between the foreign broker-dealer and Qualified Investors (including, among other things, confirmations) and receive, deliver and safeguard funds and securities in connection with such transactions in compliance with Exchange Act rule 15c3-3 pursuant to the Proposed Rule 15a-6(a)(3)(iii)(A)(2) when the foreign broker-dealer does not conduct a Foreign Business;
  
  
• obtain written consents to service of process from the foreign broker-dealer and each of its associated persons for civil actions and/or regulatory proceedings; and
  
  
• obtain a representation that the foreign broker-dealer has determined that each of its associated persons effecting transactions with Qualified Investors is not subject to disqualification.
  
  

Exemption (a)(4):Counterparties and Specific Customers

Under the current rule, a foreign broker-dealer may solicit and effect transactions in securities with the specific counterparties and customers listed in the exemption. Foreign broker-dealers are not required to satisfy any additional conditions to be exempt from registration.

The Proposed Rule would add "any US person that acts in a fiduciary capacity for a Foreign Resident Client" to the list of counterparties and customers in subsection (a)(4). Foreign broker-dealers would be permitted to solicit and effect securities transactions with any US fiduciary of a Foreign Resident Client. To qualify for this exemption, the foreign broker-dealer must conduct a Foreign Business. In addition, the foreign broker-dealer must obtain a representation from the US fiduciary that the account for which the foreign broker-dealer is effecting securities transactions is an account that is managed for a Foreign Resident Client. The foreign broker-dealer must also ensure that the US fiduciary is acting as a fiduciary for a Foreign Resident Client when soliciting and effecting transactions with the US fiduciary.

Exemption (a)(5): Familiarization with Foreign Options Exchanges

Subsection (a)(5) is a newly proposed addition to Exchange Act rule 15a-6. It would provide an exemption for a foreign broker-dealer that effects unsolicited transactions with Qualified Investors in options on Foreign Securities ("Foreign Options"). A foreign broker-dealer would be able to effect transactions in Foreign Options that are listed on a foreign options exchange of which it is a member without being registered. Because this exemption is restricted to unsolicited transactions, a foreign broker-dealer's ability to establish an ongoing relationship with Qualified Investors that seek to trade in Foreign Options is limited.

The Proposed Rule is intended to provide US investors with broader access to foreign options markets. Consistent with such intent, the Proposed Rule would not consider certain direct contact with Qualified Investors to be solicitation. Representatives of a foreign options exchange would be permitted: (1) to communicate with Qualified Investors or participate in seminars in the US regarding a foreign options exchange, Foreign Options, or a foreign options exchange's OTC options processing service; (2) to provide Qualified Investors with disclosure documents describing a foreign options exchange; and (3) to make available to Qualified Investors, solely upon request, a list of participants on the foreign options exchange permitted to take orders and any registered broker-dealer affiliates of such participants. Foreign broker-dealers would be permitted to make available to Qualified Investors an OTC options processing service of a foreign options exchange, and to provide Qualified Investors with disclosure documents describing foreign options exchanges, but only in response to unsolicited inquiries.

The Proposed Rule would significantly reduce the current restrictions on foreign broker-dealers that engage in activities involving US investors. Perhaps most significantly, the Proposed Rule vastly expands the class of investors that may receive research reports from foreign broker-dealers, and that may engage in solicited transactions with foreign broker-dealers. The Proposed Rule also eliminates many of the burdens that were previously imposed on US registered broker-dealers in connection with solicited transactions (chaperoning, effecting transactions on behalf of foreign broker-dealers and, in some instances, custody and recordkeeping). These are major steps forward. If adopted, the Proposed Rule would go a long way toward increasing access to foreign markets for US investors. The end result is more US investors having better access to foreign markets with fewer impediments.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.