On October 3, 2011, new Securities and Exchange Commission (“SEC”) Rule 13h-1 (the “Rule”) became effective. The SEC enacted the Rule to identify and monitor high volume securities traders. Adopted under Section 13(h) of the Securities Exchange Act of 1934 (the “Exchange Act”), the Rule implements a reporting system and filing obligations for high volume securities traders and their broker-dealers. The Rule requires that “Large Traders” (i) self-register with the SEC by filing and periodically updating new Form 13H and (ii) provide a unique identifier number to their broker-dealers. In turn, registered brokerdealers must (i) maintain specified records relating to Large Traders, (ii) electronically report information relating to Large Trader transactions to the SEC upon SEC request, and (iii) monitor for compliance with the Rule.

“LARGE TRADER” DEFINED

The Rule defines a “Large Trader” as a person that “directly or indirectly, including through other persons controlled by such person, exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any NMS security [1] 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.”

The Rule defines “investment discretion” by reference to Exchange Act Section 3(a)(35), [2] which is the same definition used for purposes of determining Form 13F filing obligations. The term includes both the authority, directly or indirectly, to determine what securities should be purchased or sold by or for an account, and would encompass the discretion to select which NMS securities to purchase even where another person has responsibility for investment decisions. [3] Based on industry comments, the SEC clarified that investment discretion may be exercised on behalf of defined contribution plans differently, depending on how each plan is structured. For example, in some defined contribution plans, participants select their own investments from among the choices offered by their employer. A trustee then effects the transactions pursuant to the instructions it receives from the plan participants. The participants in such plans are the ones who exercise investment discretion over the transactions that are effected on their behalf. Therefore, in such plans, the SEC would not view the trustee as exercising investment discretion over the transactions for purposes of the Rule. Additionally, solely for purposes of determining who is a Large Trader pursuant to the Rule, an employer would not exercise investment discretion merely by establishing investment options for its employees.

The SEC established the “identifying activity level” threshold as either (i) 2 million shares or shares with a fair market value of $20 million in one calendar day, or (ii) 20 million shares or shares with a fair market value of $200 million in one calendar month. Persons that complete aggregate transactions that meet this threshold will generally be required to file Form 13H with the SEC and provide an SEC-assigned Large Trader identifier (“LTID”) to broker-dealers through which such transactions are effect ed. Persons may voluntarily file Form 13H to register as a Large Trader even if their aggregate transactions have not met the “identifying activity level” threshold. Potential Large Traders must include transactions on behalf of all accounts over which they exercise investment discretion, including accounts that they directly or indirectly control. “Control” is defined as the right to vote or direct the vote of at least 25% of a class of voting securities of an entity or the power to sell or direct the sale of at least 25% of a class of voting securities of such entity. The definition of “Large Trader” is purposely designed to focus on the ultimate parent company of an entity or entities that employ or control multiple individuals that exercise investment discretion. Large Traders must aggregate, without offsetting or netting, all of their NMS security transactions with those of their “controlled” entities. The ultimate parent company of an organization with multiple persons or affiliates who would be deemed “Large Traders” may file a single Form 13H covering the entire organization. In these circumstances, the parent company may assign LTID suffixes to the various persons or entities under its control.

ACTIVITY THRESHOLD; EXCLUDED TRANSACTIONS

To calculate a trader’s “identifying activity level,” traders generally must include “all transactions in NMS securities, excluding exercises or assignments of option contracts.” Exercises or assignments of option contracts are excluded from the calculation of the “identifying activity level” because purchases and sales of the options themselves are not. This avoids double-counting options. The volume and value of options purchased or sold is determined by reference to the securities underlying the options.

The Rule also excludes additional securities transactions from the calculation of a trader’s “identifying activity level.” Such excluded transactions include:

• any journal or bookkeeping entry made to an account in order to record or memorialize the receipt or delivery of funds or securities pursuant to the settlement of a transaction;
• any transaction that is part of an offering of securities by or on behalf of an issuer, or by an underwriter on behalf of an issuer, or an agent for an issuer, whether or not such offering is subject to registration under the Securities Act of 1933, other than an offering of securities effected through the facilities of a national securities exchange;
• any transaction that constitutes a gift;
• any transaction effected by a court appointed executor, administrator, or fiduciary pursuant to the distribution of a decedent’s estate;
• any transaction effected pursuant to a court order or judgment;
• any transaction effected pursuant to a rollover of qualified plan or trust assets subject to Section 402(a)(5) of the Internal Revenue Code;
• any transaction between an employer and its employees effected pursuant to the award, allocation, sale, grant, or exercise of an NMS security, option or other right to acquire securities at a pre-established price pursuant to a plan which is primarily for the purpose of an issuer benefit plan or compensatory arrangement; and
• business combination transactions, including reclassifications, mergers, consolidations, or tender offers subject to Section 14(d) of the Exchange Act; issuer tender offers or other stock buybacks by an issuer; or stock loans or equity repurchase agreements.

FORM 13H

Once a trader’s transactions reach the “identifying activity level,” a trader must promptly (within 10 days) file Form 13H. Large Traders must file amendments to Form 13H promptly after the end of a calendar quarter during which any of the information contained in Form 13H becomes inaccurate. Also, Large Traders must file an annual amendment to Form 13H within 45 days of the end of each calendar year. Large Traders that have not completed transactions that meet the “identifying activity level” threshold in the previous calendar year may request to be considered “inactive” and therefore exempt from the Rule’s reporting requirements, until such trader again reaches the “identifying activity level.”

Form 13H requires disclosures relating to six items: (1) the business of the Large Trader and each affiliate that exercises investment discretion over NMS securities (a “Securities Affiliate”); (2) other forms filed with the SEC by the Large Trader or any of its Securities Affiliates; (3) information regarding whether the Large Trader or its Securities Affiliates are regulated by the Commodity Futures Trading Commission or a similar foreign regulator; (4) information regarding each Securities Affiliate, including its relationship to the Large Trader and an organizational chart; (5) the Large Trader’s entity type (e.g., partnership or corporation) and list of executive officers, directors, partners, and/or trustees; and (6) disclosure of broker-dealers with which the Large Trader or any of its Securities Affiliates maintains an account over which it has investment discretion. A controlling person’s Form 13H filing will satisfy the filing obligations of its subsidiaries or other controlled persons if its Form 13H covers the controlled persons’ accounts and otherwise complies with the requirements of the Rule applicable to Large Traders. The SEC will keep the information contained in Form 13H confidential, and the information will be exempt from Freedom of Information Act (“FOIA”) disclosure as well. Transaction information reported by a broker-dealer, pursuant to the broker-dealer reporting obligations discussed below, will also receive confidential treatment and be exempt from FOIA disclosure.

BROKER-DEALER RESPONSIBILITIES

After a Large Trader files Form 13H, it will be required to provide its LTID to each broker-dealer carrying an account on its behalf, which will enable the brokerdealer to associate each identified account with an LTID. Registered broker-dealers must keep detailed records for all transactions effected directly or indirectly by or through (i) any account carried for a Large Trader or an “Unidentified Large Trader,” or (ii) if the broker-dealer is itself a Large Trader, any proprietary or other account over which the broker-dealer exercises investment discretion. An “Unidentified Large Trader” is defined as any person or entity that has not complied with the self-identification requirements of the Rule but that the broker-dealer knows, or has reason to know, is a Large Trader. Although the obligations apply to both executing broker-dealers and to prime brokers and clearing brokers, executing brokerdealers are required to carry out the recordkeeping functions only if the account for which the information is collected is carried by a bank or other non-brokerdealer. If a transaction is cleared by or given up to another registered broker-dealer, retention of the information is the obligation of the clearing broker or prime broker and not of the executing broker.

The records required to be maintained by broker-dealers are set forth in paragraphs (d)(2) and (d)(3) of the Rule, and include:

• the clearing house number or alpha symbol of the broker or dealer submitting the information and the clearing house numbers or alpha symbols of the entities on the opposite side of the transaction;
• the identifying symbol assigned to the security;
• the date the transaction was executed;
• the number of shares or option contracts traded in each specific transaction; whether each transaction was a purchase, sale, or short sale; and, if an option contract, whether the transaction was a call or put option, an opening purchase or sale, a closing purchase or sale, or an exercise or assignment;
• the transaction price;
• the account number associated with the transaction;
• the identity of the exchange or other market center where the transaction was executed;
• a designation of whether the transaction was effected or caused to be effected for the account of a customer of such registered broker-dealer, or was a proprietary transaction effected or caused to be effected for the account of such broker-dealer;
• identification as to whether (i) part or all of an account’s transactions at the registered broker-dealer have been transferred or otherwise forwarded to one or more accounts at another registered brokerdealer or (ii) part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise received from one or more other registered broker-dealers;
• identification as to whether (i) part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise received from another account at the reporting broker-dealer or (ii) part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise forwarded to one or more other accounts at the reporting broker-dealer;
• if a transaction was processed by a depository institution, the identifier assigned to the account by the depository institution;
• the time that the transaction was executed; and
• the LTID number(s) associated with the account, unless the account is for an Unidentified Large Trader.

Broker-dealers will be required to maintain these records for a period of three years.

Under the Rule, broker-dealers must provide to the SEC, upon request, information maintained by the broker-dealer pursuant to their record-keeping obligations for all transactions that are equal to or greater than the “reporting activity level.” The “reporting activity level” is defined as any of the following:

• Each transaction of NMS securities of at least 100 shares effected in one calendar day;
• Any other transaction in NMS securities completed in one calendar day that the broker-dealer deems appropriate to report; and
• Other activity levels that the SEC establishes by order.

Generally, broker-dealers will be required to comply with an SEC information request by the opening of business of the day following the request; in unusual circumstances, however, same day submission may be requested.

Broker-dealers will be required to monitor for Unidentified Large Traders by taking into account transactions in NMS securities completed by or through such brokerdealer. Broker-dealers may determine that they have no reason to know that a person is a Large Trader through two methods. First, the broker-dealer may conclude, based on its knowledge of the customer and its activities, that the customer’s transactions do not meet the “identifying activity level” threshold. Second, broker-dealers may rely on a safe harbor provision under the Rule, whereby a broker-dealer is deemed not to have known or have had reason to know that a person is a Large Trader if it has no actual knowledge that the person is a Large Trader and the broker-dealer has established policies and procedures designed to (i) identify Unidentified Large Traders, (ii) treat such persons as Unidentified Large Traders, and (iii) notify such persons of their reporting obligations under the Rule.

TIMING OF IMPLEMENTATION

Persons meeting or exceeding the “identifying activity level” set forth in the Rule must file Form 13H by December 1, 2011, or within 10 days of meeting the “identifying activity level” threshold after November 22, 2011. Form 13H must be filed electronically using the SEC’s EDGAR system. The compliance date for broker-dealers is April 30, 2012.

COMPLIANCE CHALLENGES

Although the SEC determined that the existing Electronic Blue Sheets (“EBS”) system provides broker-dealers with the infrastructure with which to design their monitoring and record-keeping functions under the Rule, broker-dealers face a challenge to comply with the Rule by April 30, 2012. At a minimum, broker-dealers will have to expand their existing EBS monitoring and record-keeping systems to include additional information required to be maintained under the Rule, such as LTID’s and the time of each transaction. Another challenge facing broker-dealers will be to keep track of which advisers and traders are affiliated, since “Large Trader” status is aggregated across affiliated entities. Monitoring for Unidentified Large Traders may prove especially difficult in this regard in the case of clearing firms, since these firms will also have to aggregate trader activity across all of the correspondent firms for which they clear transactions.

Finally, pursuant to their monitoring and record-keeping obligations, broker-dealers will have to evaluate whether or not traders exercise investment discretion over certain transactions, such as defined contribution plans, and determine how to treat limited exercises of discretion (e.g. Rule 10b5-1 plans).