United States: SEC Proposes Rules To Clarify Dealer-Trader Distinction

In Short

The Situation: The U.S. Securities and Exchange Commission ("SEC" or "Commission") has proposed new rules that would further define the phrase "part of a regular business" contained in the statutory exclusion from the definitions of "dealer" and "government securities dealer" (the "dealer/trader distinction") to help clarify when a person trading securities for its own account is subject to registration under the Securities Exchange Act.

The Issue: Because the proposed rules would define "part of a regular business" for purposes of determining dealer and government securities dealer status as routinely providing liquidity to other market participants through specified qualitative and quantitative activity, the SEC's proposals seek to greatly expand the number and types of entities that will be subject to agency oversight.

Looking Ahead: If the new rules are adopted, entities trading for their own accounts, 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 dealer/trader distinction to avoid registration or whether they will be required to register as a dealer or government securities dealer, as applicable.

The SEC's Proposal

On March 28, 2022, the SEC released a rulemaking proposal (the "Proposal") for new rules to clarify the meaning of certain terms in the statutory definitions of "dealer" and "government securities dealer" under, respectively, Sections 3(a)(5) and 3(a)(44) of the Securities Exchange Act of 1934 ("Exchange Act"). Those statutory provisions essentially define a "dealer" or "government securities dealer" as any person engaged in the business of buying and selling securities or government securities for such person's own account, but exclude "a person that buys or sells securities [or government securities] ... for such person's own account, either individually or in a fiduciary capacity, but not as a part of a regular business." This exclusion is known as the dealer/trader distinction, and many investors, including hedge funds, have relied on this exclusion to avoid registering as dealers.

Over the last several years, the SEC has brought a number of enforcement actions against proprietary trading firms for acting, in the SEC's view, as unregistered dealers. In defending against such allegations, these firms have often asserted that they are merely "traders" and that their transactions are not "part of a regular business," a term that is ambiguous at best. The SEC's proposed new rules would further define the phrase "as a part of a regular business" as used in the statute to make clear that certain entities engaging in "a routine pattern of buying and selling securities that has the effect of providing liquidity to other market participants" will be deemed "dealers" or "government securities dealers."

"Dealer" Status Under Proposed Rule 3a5-4

Proposed Rule 3a5-4 sets forth three different qualitative tests for establishing whether a person's activities are "part of a regular business" of routinely providing liquidity:

• "Routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day;"
• "Routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants;" or
• "Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trade interests."

The SEC considers an entity engaging in any of the above activities to be "providing liquidity" as part of its regular business and that providing such liquidity is not merely incidental to their trading activity. The "same" securities refers to securities of the same class and having the same terms, conditions, and rights (e.g., having the same CUSIP), while determining whether a security is "substantially similar" to another security requires a facts-and-circumstances analysis (although the SEC provides some examples of what would and would not be "substantially similar" securities). Interestingly, instead of referencing "quotations"—market makers typically post quotations simultaneously to both buy and sell the same security—the proposed rules refer to "trading interest," a term the SEC just recently proposed in its ATS Proposing Release to mean an order, as defined in Rule 300(e) of Regulation ATS, or any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price. In addition, the inclusion of "earning revenue" instead of "profit from" in the third bullet is intended to make clear that a person's trading strategies do not have to be profitable for the person to fall under the proposed rule. There is no definition of "primarily" or any bright-line revenue test in the proposed rule, but the SEC explains in the Proposal that "if a person derives the majority of its revenue" from the sources in the rule, it would likely be in a regular business of buying and selling securities or government securities for its own account."

Finally, persons that have or "control" total assets of less than $50 million or which are registered as investment companies under the Investment Company Act of 1940 will be excepted from the new rules. Consequently, if the new rules are adopted, hedge funds that fall within the rules' qualitative or quantitative standards will have a choice to either register as dealers (and allow those of their advisers that are exempt reporting advisers to remain as such) or register as investment companies (and require their investment advisers to become registered under the Investment Advisers Act of 1940 as well).

"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 the exceptions as Proposed Rule 3a5-4, but it also includes a new quantitative, bright-line test for determining government securities dealer status. Under the quantitative test, if, during four of the last six calendar months, the entity "engaged in buying and selling more than $25 billion of trading volume in government securities," it would be considered to be engaged in government securities trading for its own account as "part of a regular business." The SEC believes that such a rule is needed for the U.S. Treasury market due to the large number of significant market participants who are not registered as dealers but which perform dealer-like functions in that market (e.g., unregistered proprietary trading firms account for more than half of the daily volume in the interdealer market) as well as recent disruptions in the U.S. Treasury market into which regulators had limited visibility because many market participants are unregistered.

Closing Potential Loopholes: Definition of "Own Account" and "Control"

As part of each proposed new rule, the SEC also has defined the terms "own account" and "control" to address variations in corporate structure and ownership that could help persons 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 the name of that person; (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 those persons identified in (i) and (ii). "Control" is defined to have the same meaning as prescribed in Rule 13h-1 under the Exchange Act (i.e., the Large Trader reporting rule), which is "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" and for which there is a 25% ownership/capital interest presumption. Therefore, entities will have to aggregate affiliate transactions and holdings with their own to determine if they meet the $50 million threshold for application of the new rules.

Existing Guidance Still Valid

The new rules would operate proscriptively—if a person falls under the proposed rules, it will be considered a dealer or government securities dealer subject to registration unless otherwise exempted. The proposed rules make clear, however, that there is no presumption that a person is not a dealer or government securities dealer if it does not meet the criteria in the proposed rules. In this regard, the Commission makes clear that the proposed rules have no impact on previously issued guidance relating to dealer status. Persons not only will need to take the proposed rules into account when determining dealer status, but also will need to review prior SEC guidance regarding other factors the SEC will consider.

Short Comment Period

These proposed rules are just the latest in a very full complement of proposed new rules and rule amendments proposed by the SEC over the last several months. The SEC has provided for a comment period of least 60 days from issuance (i.e., the comment period ends May 27, 2022, or 30 days after publication in the Federal Register, whichever is later).

Four Key Takeaways

1. The proposed new rules, if adopted, will provide more clarity as to what being engaged in buying and selling securities for one's own account but "not part of a regular business" means for purposes of the exclusions from the definitions of dealer and government securities dealer.
2. If adopted, the proposed rules will require many entities that previously relied on the dealer/trader distinction to avoid registration to become subject to agency oversight.
3. The $25 billion quantitative test for government securities dealers is likely to capture numerous unregistered proprietary trading firms operating in the U.S. Treasury markets no matter the types of trading strategies they employ.
4. Even if they don't fall within the new proposed rules, unregistered trading firms will need to take existing SEC guidance into account to determine whether there is otherwise a sufficient basis for requiring them to register as dealers or government securities dealers.