On July 27, 2011, the Securities and Exchange Commission (the "SEC") adopted Rule 13h-1 ("Rule 13h-1" or the "Large Trader Rule") and related Form 13H as directed by Section 13(h) of the Securities Exchange Act of 1934 ("Exchange Act").1 Rule 13h-1 requires each "Large Trader" (as defined in the Large Trader Rule) (i) to identify itself by filing and periodically updating Form 13H with the SEC and (ii) to disclose to each SEC-registered broker-dealer, through which it trades its large trader identification number ("LTID") and all accounts to which that LTID applies. Rule 13h-1 also requires registered broker-dealers to (i) monitor accounts for the purpose of identifying "Unidentified Large Traders," (ii) capture certain information relating to all transactions on behalf of Large Traders and Unidentified Large Traders that are effected directly or indirectly by or through it, and (iii) make such information available to the SEC through the already-established trade-reporting infrastructure, commonly referred to as the electronic blue sheets ("EBS").
Rule 13h-1 will become technically effective on October 3, 2011, but (i) Large Traders will have until December 1, 2011 to comply with the requirements of the Large Trader Rule2 and (ii) brokerdealers will have until April 30, 2012 to comply with the requirements under the Large Trader Rule to maintain records, report transaction data when requested, and monitor Large Trader activity.
The Large Trader Rule is intended to enhance the SEC's ability to collect information on the trading activities of the most significant participants in the U.S. equities and options markets.3 The SEC believes this information will greatly "influence" its ability to analyze market movements, investigate the causes of market events and conduct investigations of regulated entities, and prosecute enforcement matters.4
Notwithstanding approval of the Large Trader Rule, the SEC has indicated that it continues to consider adoption of a consolidated audit trail for equities and options.5 Indeed, the SEC characterizes the requirements of the Large Trader Rule as "much more limited in terms of their scope, objectives, and implementation burden. . . ."6 Nevertheless, unlike the proposed consolidated audit trail, which the SEC seems to recognize would be a very significant undertaking requiring a significant implementation period, the SEC believes that the requirements of Rule 13h-1 requires "relatively modest steps" and can be "implemented more expeditiously and at less cost. . "7
Part I below discusses the application of Rule 13h-1 and Form 13H to Large Traders; Part II discusses the application of Rule 13h-1 to registered broker-dealers. At the end of each Part, we have also set forth suggested steps that entities should take as part of their compliance with Rule 13h-1. Note that a registered broker-dealer can also be a Large Trader and, therefore, may have to comply with both sets of requirements.
I. Large Traders
A. Large Trader Status
For purposes of Rule 13h-1, a Large Trader is (i) any "person" that voluntarily registers as a Large Trader; 8 (ii) any person that directly exercises "investment discretion" over one or more accounts through which transactions in national market system securities ("NMS securities" and each such security an "NMS security")9 are effected through one or more registered broker-dealers in amounts that, in the aggregate, satisfy the "identifying activity level;" (iii) any person that "controls" another person that is a Large Trader; and (iv) any person that would be a Large Trader if such person's transactions were aggregated with the transactions of all other entities controlled by such person.
1. Definition of Person, Control and Investment Decision
The term "person" means "a natural person, company, government, or political subdivision, agency, or instrumentality of a government."10 Unlike Section 13(f) of the Exchange Act, Section 13(h) does not provide an exemption for natural persons.
Rule 13h-1(a)(3) defines "control" as "the 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." For purposes of Rule 13h-1, any person that directly or indirectly has the right to vote or direct the vote of 25% or more of a class of voting securities of an entity or has the power to sell or direct the sale of 25% or more of a class of voting securities of such entity or, in the case of a partnership, has the right to receive, upon dissolution, or has contributed, 25% or more of the capital, is presumed to control that entity.
Rule 13h-1 adopts the definition of "investment discretion" set forth at Section 3(a)(35) of the Exchange Act.11 As defined at Section 3(a)(35), the exercise of "investment discretion" includes both the authority to determine what securities to purchase or sell as well as the making of decisions as to purchases or sales even though another person may have responsibility for investment decisions. (The term "investment discretion" is used in Section 28(e) of the Exchange Act – the exemption for "soft dollars" – and a number of no-action letters issued under that Section discusses the meaning of the term.) An employee that exercises "investment discretion" within the scope of employment is deemed to do so on behalf of the employer.
Because a person is deemed to exercise "investment discretion" for purposes of Section 3(a)(35) merely by having "authority" it would appear that, for purposes of the Large Trader definition, a person would be deemed to exercise investment discretion over an account regardless of whether that person in fact exercised such discretion.
2. Identifying Activity Level
a. General Rule
Rule 13h-1(a)(7) defines the term "identifying activity level" as aggregate "transactions" in NMS securities that are effected by or through one or more registered broker-dealers equal to or greater than: (1) during a calendar day, either two million shares or shares with a fair market value of $20 million; or (2) during a calendar month, either twenty million shares or shares with a fair market value of $200 million.
i. Registered Broker-Dealers
Significantly, transactions "count" only towards the identifying activity level if they are conducted through a "registered broker-dealer": i.e., an SEC-registered broker-dealer. Accordingly, while the Large Trader provisions of Rule 13h-1 apply equally to all U.S. and foreign persons (as discussed further at section B(1) of this Part I), transactions effected by or through a foreign broker-dealer (i.e., a non-SEC-registered broker-dealer) would not count towards identifying activity level.
b. Transactions
The term "transaction" is defined to mean all transactions in NMS securities, excluding exercises or assignments of option contracts and certain specifically enumerated transactions, as discussed further at subsections (i) and (ii) below.
i. Options
For purposes of calculating the "identifying activity level," the volume and fair market value of options on equity securities, other than options on indexes, purchased or sold is determined by reference to the equity securities underlying the option purchased or sold.12 For example, an option to purchase 10,000 shares of equity XYZ, which then trades at $10 per share, would constitute 10,000 shares of XYZ and have a fair market value of $100,000 (10,000 times $10).13 Transactions in index options are not required to be "burst" into share equivalents for each of the underlying component equities."14 Instead, one looks only to the notional value of the index underlying the option and does not count such options towards the volume limit.15
Moreover, as noted above, only purchases and sales of the options themselves, and not transactions in the underlying securities pursuant to exercises or assignments of such options, need to be counted. By excluding purchases and sales pursuant to exercises or assignments, the Large Trader Rule avoids double-counting towards the applicable identification threshold.
ii. Exclusions
Rule 13h-1(a)(6) provides an enumerated list of exclusions from the definition of "transaction" for the purposes of determining whether one meets the identifying activity level threshold.16 The SEC stated that such exceptions are not effected with an intent that is commonly associated with the arm's-length trading of securities in the secondary market and therefore do not fall within the types of transactions that are characterized by the exercise of investment discretion and thus excluded such transactions from the identifying activity level calculation.17
c. No Offsets in Calculating Volume and Market Value
For purposes of calculating the "identifying activity level," each qualifying transaction must be separately accounted for without taking into account offsetting transactions, whether in the same account or in different accounts.18 For example, a purchase of 100 shares of XYZ at $10 a share in one account and a sale of 100 shares of XYZ at $10 in another account would aggregate to 200 shares (100 shares purchased plus 100 shares sold) with a market value of $2,000 (200 shares times $10). Similarly, transactions that make up complex option strategies or stock/option strategies should be added for purposes of calculating volume and market value.
B. Requirements Applicable to Large Traders
1. Applicability to Foreign Persons
Rule 13h-1 does not contain any jurisdictional carve outs that would limit its applicability to U.S. persons. Nevertheless, it should be noted that the definition will apply only where transactions meeting the identifying activity level are conducted through SEC-registered broker-dealers.19 Accordingly, the Large Trader provisions of Rule 13h-1 will apply only to persons that either trade though SEC-registered broker-dealers or control persons who do so. This raises the question of whether non-U.S. persons will be incentivized to trade through foreign non-SEC-registered brokerdealers to avoid becoming Large Traders. However, assuming that the foreign non- SECregistered broker-dealer itself executed trades in NMS securities through a SEC-registered brokerdealer, that foreign non- SEC-registered broker-dealer could be required to report as a Large Trader.20
The SEC does, however, acknowledge the possibility that the laws of certain foreign jurisdictions may prevent a non-U.S. Large Trader (whether itself a broker-dealer or adviser) from disclosing certain personal identifying information of an underlying principal. In such event, foreign Large Traders or representatives of foreign Large Traders may request an exemption from the SEC pursuant to Section 36 of the Exchange Act and subsection (g) of Rule 13h-1.21
2. Form 13H
Rule 13h-1(b)(1) requires each Large Trader to identify itself to the SEC by filing a Form 13H but also allows this obligation to be pushed up to a parent or pushed down to a subsidiary so long as the parent or subsidiary (i.e, the filing Large Trader), can comply with all of the requirements otherwise applicable to the non-filing Large Trader.22
In practice, a parent can always satisfy the Form 13H filing requirement of its subsidiaries. Pushing down the Form 13H filing requirement is more problematic, however, and requires that every person under common control that exercises discretion directly or indirectly over an account with an SEC registered broker-dealer through which covered transactions in NMS securities occur either itself files a Form 13H or is under the control, directly or indirectly, of a person that both files a Form 13H and is itself under the same common control.
As the foregoing suggests, the correct utilization of the push down option, and, therefore, whether a particular person needs to file a Form 13H, or can rely upon a filing by another person, is likely to require careful consideration. This is particularly true the more complex the structure of ownership and control becomes. For this reason, a number of examples illustrating the applicability of the push up and push down options in a variety of structures are set forth on Exhibit A attached hereto.
Where a Large Trader files on behalf of itself and one or more parent entities, it would still be required to identify the parent entity on its Form 13H filing, and where an affiliate of such Large Trader also files a Form 13H, both filing entities must identify the other in Item 4(c) of Form 13H as an affiliate filing separately. This enables the SEC to tell what entities are under common control of a parent company and allows the SEC to assign LTIDs that references such common parent.
As discussed further below, Form 13H provides for an initial filing as well as annual filings and filings related to amendments, inactive status, reactivation of active status and termination of status as a Large Trader.
a. Initial Filing
A Large Trader must file its initial Form 13H ("Initial Filing") with the SEC "promptly" upon satisfaction of the identifying activity level. The SEC has indicated that under "normal" circumstances it would be appropriate for a Large Trader to make its Initial Filing (as discussed further at subsection (e)) within 10 days after the Large Trader effects aggregate transactions at least equal to the identifying activity level.23 The SEC declined giving further guidance for circumstances that are not "normal," stating that "promptly" is an appropriate standard because it emphasizes the need for filings to be submitted without delay to ensure their timeliness while affording filers a limited degree of flexibility.
i. Content
- Introduction: Background Information About the Large Trader and its Authorized Person. The introductory section of Form 13H requires the Large Trader to provide its mailing address. Additionally, the introductory section requires that the following information be provided about the natural person authorized to submit the Form 13H on behalf of the Large Trader ("Authorized Person"): business address, telephone number, facsimile number, and e-mail address.
- Item 1: Businesses of the Large Trader. In Item 1(a) of the Form, the Large Trader must indicate by checking off the appropriate boxes the types of businesses in which it or any of its affiliates engage.24 Item 1(b) of the Form requires that the Large Trader provide the following for itself and its Securities Affiliates:25 a description of the nature of its operations, including a general description of its trading strategies.26 The SEC has stated that collection of this descriptive information will allow itself to better understand each Large Trader and will allow the SEC to more carefully tailor requests both to registered broker-dealers for Large Trader transaction data and, if necessary, to Large Traders for additional information pursuant to Rule 13h-1(b)(4).
- Item 2: Securities and Exchange Commission Filings. Item 2 requires the Large Trader to indicate whether it or any of its Securities Affiliates files any other forms with the SEC. If the Large Trader or any of its Securities Affiliates file other forms with the SEC, Item 2 requires the disclosure of each filing entity, the form(s) filed, and the CIK number.
- Item 3: CFTC Registration and Foreign Regulators. The Large Trader must disclose on Item 3(a) whether it or any of its affiliates are registered with the Commodity Futures Trading Commission ("CFTC"). Item 3(b) is less expansive and requires only the Large Trader to disclose whether it or any of its Securities Affiliates are regulated by a foreign regulator. If so, the Large Trader is required to identify each entity and the CFTC registration number or primary foreign regulator, as applicable.
- Item 4: Organization Information. Item 4(a) requires the Large Trader to attach an organizational chart.27 As part of Item 4(b), the Large Trader is required to list a narrative description of the relationship between the Large Trader and each Securities Affiliate and each entity identified in Item 3(a). Large Traders should anticipate that they may be questioned by the SEC not only about common ownership but also about shared employees and common or as coordinated trading or investment strategies. Additionally, the Large Trader must describe the business and disclose the market participation identification numbe (if any) for each of those entities. Item 4(c) requires the provision of the LTIDs, including LTID suffixes, for all entities within the Large Trader that file a separate Form 13H (if any). Finally, Item 4(d) allows the Large Trader to assign suffixes to its affiliates, that is, to append additional characters (a suffix)28 to sub-identify particular units that directly control any of the Large Trader's accounts.
- Item 5: Legal Form of the Large Trader. The Large Trader must choose one or more of the following statuses under Item 5(a): individual, partnership, limited liability partnership, limited partnership, corporation, trustee or limited liability company.29 Partnerships must identify each of its partners and each partner in partnership status (i.e., general partner or limited partner) under Item 5(b), while corporations and trustees must identify each of its executive officers, directors or trustees.
- Item 6: List of Broker-Dealers at which the Large Trader or its Securities Affiliates Has an Account. Item 6 requires the Large Trader to identify broker-dealers at which it or any of its Securities Affiliates has an account and disclose whether each such brokerdealer provides prime broker, executing broker and/or clearing broker services. Note that the firms through which a Large Trader transacts is likely to change or be expanded periodically. Large Traders should be mindful to apprise new broker-dealers of their status and also to update their own Forms 13H at least quarterly.
- Instructions for Form 13H. Further information regarding each of the items listed above can be found at the back of the Adopting Release under "Instructions for Form 13H."
ii. Confidentiality
Addressing a number of commenters concerned about the sensitive nature of the information collected on Form 13H, the SEC stated in the Adopting Release that it is committed to protecting the confidentiality of such information to the fullest extent permitted by applicable law (that is, in a manner consistent with Section 13(h)(7) of the Exchange Act).
Section 13(h)(7) specifies that the SEC shall not be compelled to disclose information collected from Large Traders and registered broker-dealers under a Large Trader reporting system, such as the Large Trader Rule, subject to limited exceptions. On the other hand, the statute provides that nothing in Section 13(h)(7) shall authorize the SEC to withhold information from Congress or prevent the SEC from complying with a request for information from any other Federal department or agency requesting information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the SEC. (The recent news stories as to the release by Congress of supposedly private information of futures traders is likely to give further concern to non-U.S. Large-Traders that may potentially be able to avoid disclosure of their information to U.S. regulators or Congress.)
b. Amended Filings
If any of the information contained in a Form 13H filing becomes inaccurate for any reason, a Large Trader must file an amended filing ("Amended Filing") no later than the end of the calendar quarter in which the information becomes stale.30 While not required by the Large Trader Rule, a Large Trader may voluntarily file an Amended Filing more frequently than quarterly at its discretion. A Large Trader on "Inactive Status" (as discussed further at subsection (d)) is not required to file any Amended Filings while it is on Inactive Status.
c. Annual Filings
All Large Traders (other than those on Inactive Status) must submit an annual filing ("Annual Filing") within 45 days after the end of each full calendar year.
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