SEC Proposes New Rules Defining "Dealer" Status: Proposal Seeks to Clarify When Unregistered Firms Engaged in Market-Making and Liquidity-Providing Activities May Need to Register as Dealers1

On March 28, 2022, the Securities and Exchange Commission (SEC) proposed new Rules 3a5-4 and 3a44-2 under the Securities Exchange Act of 1934 (Exchange Act) (collectively, the Proposed Rules). The Proposed Rules seek to clarify certain aspects of the definitions of "dealer" and "government securities dealer."2 In particular, the SEC seeks to further define the phrases "as a part of a regular business" and "own account," as used in the statutory definitions of "dealer" and "government securities dealer."3 As further explained below, the definitions of these phrases have been key for certain market participants in determining that registration as a "dealer" was not required.4

In explaining the basis for the Proposed Rules, the Proposing Release cites the emergence of certain unregistered market participants that "play an increasingly significant liquidity-providing role in overall trading and market activity" in the securities markets and U.S. Treasury securities markets.5 In the SEC's view, because these participants are not registered, "investors and the markets lack important protections."6 Accordingly, the SEC believes that the identification and registration of these market participants as dealers would "provide regulators with a more comprehensive view of the markets through regulatory oversight" and would enhance market stability and investor protection.7

To clarify when certain liquidity-providing and market-making activities could trigger dealer status, the Proposed Rules establish a qualitative standard that would apply to market participants buying and selling any security and a quantitative standard that would apply only to market participants buying and selling government securities. The Proposing Release states that the following market participants, among others, could trigger the new "dealer" definitions in the proposals if they meet the quantitative or qualitative standards: proprietary trading firms (or PTFs), private funds (including hedge funds) and investment advisers.8 Persons who meet the definitions of dealer would be required to register with the SEC as a broker-dealer and become a member of a self-regulatory organization ("SRO") (absent an applicable exemption).

Section I of this client alert provides background on the historic "Dealer/Trader" distinction that many market participants—including PTFs, hedge funds, and investment advisers—have relied on to avoid triggering "dealer" status. Section II, in turn, discusses the SEC's new proposals and standards for determining when market participants may trigger these definitions.

The SEC has requested comments on the Proposed Rules within 60 days following the publication of the Proposing Release on the SEC's website (i.e., May 27, 2022) or 30 days following publication of the Proposing Release in the Federal Register, whichever period is longer.

I. Background on the "Dealer"/"Trader" Distinction, Which Market Participants Have Historically Relied on to Avoid "Dealer" Status When Trading for Their Own Accounts.

Under both the current "dealer" definitions in the Exchange Act, a person acts as a dealer when it "is engaged in the business of buying and selling securities or government securities," respectively, for its own account as part of a "regular business." A person who meets the definition of "dealer" is generally required to register with the SEC absent an available exemption and become a member of an SRO.9

Regulators, courts and market participants have historically distinguished between "dealers" (who are "engaged in the business of buying and selling securities for their own account as part of a regular business") and "traders" (who buy and sell securities but not "as a part of a regular business"). This distinction is commonly known as the "dealer"/"trader" distinction or the "trader exclusion." A trader is not required to register with the SEC or become an SRO member on account of that activity.

Whether a person is a dealer or a trader is highly fact-specific and involves an analysis of the relevant facts and circumstances. Because of the absence of a bright-line test, the exact parameters of the trader exclusion have long existed in a gray area. Over the years, the SEC and courts have identified a number of factors that might indicate a person may be engaged in dealing "as a part of a regular business," including acting as a market maker, a de facto market maker (whereby market professionals or the public look to the firm for liquidity), or a liquidity provider by trading in a manner designed to profit from spreads or liquidity incentives, rather than with a view toward appreciation in value of a security (an indicia of trader status).10

Many PTFs and other market participants that regularly trade for their own accounts rely upon the trader exclusion to support the conclusion that they need not register as a dealer. However, in the Proposing Release, the SEC expressed concern that certain market participants relying on this exclusion may be functioning as dealers. Specifically, the Proposing Release states that with the proliferation of electronic and algorithmic trading over the past several decades, securities and government securities market structure no longer resembles the markets that existed when the trader exclusion was first conceived. The Proposing Release further notes that unregistered firms, such as PTFs, now play a much larger role in providing liquidity in the securities markets and do so in a manner that was historically reserved for registered dealers.11

If adopted, the Proposed Rules would require dealer registration of any firm that engages in liquidity-providing activities "as a part of a regular business," regardless of the firm's label or status, in response to the emergence of unregulated market participants that play an integral role in price discovery and market liquidity.12 The Proposed Rules are intended to resolve the "uneven application of regulatory oversight of significant liquidity providers [that] makes it difficult for regulators and market observers to detect, investigate, understand, or address market events."13

As stated above, the Proposed Rules would not only apply to PTFs but also would apply more broadly to any market participant triggering the quantitative or qualitative standards, including private funds and investment advisers. Moreover, to the extent a digital asset is a security or a government security within the meaning of the Exchange Act, persons trading these instruments that meet the quantitative or qualitative standards also could be deemed dealers under the Proposed Rules.14

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1. Further Definition of "As a Part of a Regular Business" in the Definition of Dealer and Government Securities Dealer, Release No. 34-94524 (the "Proposing Release"). The Proposing Release is available here.

2. 15 U.S.C. § 78c(a)(5); 15 U.S.C. § 78c(a)(44).

3. See id.

4. Unless otherwise indicated, for purposes of this Alert, references to "dealer" activity apply both with respect to "dealers" and "government securities dealers" under Sections 3(a)(5) and 3(a)(44) of the Exchange Act, respectively.

5. Proposing Release at 3.

6. Id. at 4.

7. Id.

8. Id. at 12–14. Registered investment companies would be excluded.

9. 15 U.S.C. § 78o; 15 U.S.C. § 78o–5.

10. See, e.g., Definition of Terms in and Specific Exemption for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, 67 Fed. Reg. 67496, 67498–67500 (Nov. 5, 2002); SEC v. River North Equity LLC, 415 F. Supp. 3d 853, 859 (N.D. Ill. 2019); SEC v. Big Apple Consulting USA, Inc., 783 F.3d 786, 809-10 (11th Cir. 2015); In re Sodorff, 50 S.E.C. 1249, 1992 WL 224082, at *5 (Sep. 2, 1992).

11. Proposing Release at 45.

12. Proposing Release at 46.

13. Proposing Release at 10.

14. Proposing Release at 13.

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