On March 28, 2022, the Securities and Exchange Commission (the “SEC”) issued a proposal to broaden the definitions of “dealer” and “government securities dealer” (the “Proposed Rules”) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Under the Proposed Rules, market participants that provide significant liquidity in the securities or government securities markets would need to register with the SEC as dealers or government securities dealers, become members of self-regulatory organizations, such as the Financial Industry Regulatory Authority (“FINRA”) or stock exchanges (“SROs”), and comply with various regulatory requirements associated with SEC registration and SRO membership. Comments on the Proposed Rules are due 30 days after publication in the Federal Register or May 27, 2022, whichever is later.

Dealers and Government Securities Dealers Under the Exchange Act

“Dealers” and “Government Securities Dealers,” which are defined in Sections 3(a)(5) and 3(a)(44) of the Exchange Act, respectively, are required to register with the SEC, become members of an SRO, and comply with ongoing regulatory requirements. Section 3(a)(5) defines a dealer as “any person engaged in the business of buying and selling securities . . . for such person’s own account through a broker or otherwise . . . [but] does not include a person that buys or sells securities . . . for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” The definition of “government securities dealer” in Section 3(a)(44) is comparable but applies to the buying and selling of government securities. A principal distinction between dealers or government securities dealers, who are required to register with the SEC, and “traders,” who are exempt from registration, is whether the buying and selling are a part of such person’s regular business.

Proposed Rules Expand Definition of “As a Part of a Regular Business”

In light of the significant role that proprietary trading funds (“PTFs”), private funds, and investment advisers have played in providing liquidity in the marketplace for securities and government securities, especially in the U.S. Treasury market, the Proposed Rules provide that the buying and selling of securities or government securities for one’s own account will be deemed “a part of a regular business” and thus require registration with the SEC if such person “[e]ngages in a routine pattern of buying and selling [securities/government securities] that has the effect of providing liquidity to other market participants . . . .”

The Proposed Rules add new Rules 3a5-4 and 3a44-2 under the Exchange Act, which further define “as a part of a regular business” for purposes of trading in securities and government securities, respectively. Both Rules 3a5-4 and 3a44-2 have three qualitative standards to determine whether the provision of liquidity in the marketplace is significant enough to be part of a regular business and require registration. In addition, given the substantial participation of unregistered persons in the U.S. Treasury market, Rule 3a44-2 includes an additional quantitative standard with respect to the buying and selling of “U.S. Treasury Securities,” which include Treasury bills, notes, floating rate notes, bonds, Treasury Inflation-Protected Securities (TIPS) and Separate Trading of Registered Interest and Principal Securities (STRIPS), but would exclude auction awards and repurchase or reverse repurchase transactions in U.S. Treasury Securities.

Three Qualitative Standards under Rules 3a5-4 and 3a44-2

Proposed Rules 3a5-4 and 3a44-2 provide that a person buying and selling securities or government securities, as the case may be, for its own account is engaged in an activity “as a part of a regular business” if such person engages in a routine pattern of buying and selling securities or government securities, as the case may be, that has the effect of providing liquidity to other market participants by:

• routinely making roughly comparable purchases and sales of the same or substantially similar securities or government securities, as the case may be, in a day; or
• 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 trading interests.

In its release relating to the Proposed Rules (the “Proposing Release”), the SEC emphasizes that the person would be buying and selling securities or government securities, not just accumulating for investment purposes, and doing this in a given day. Moreover, the securities or government securities being bought and sold would need to be the same or substantially the same security. In the Proposing Release, the SEC noted the following nonexclusive examples of purchases and sales of “substantially similar” securities: selling a Treasury security and buying another Treasury security in the same maturity range; buying an exchange traded fund and selling the underlying securities that make up the basket of securities held by the exchange traded fund; buying a European call option on a stock and selling a European put option on the same stock with the same strike price and maturity; and buying an OTC call option on a stock and selling a listed option on the same stock with the same strike price and maturity. The Proposing Release noted that the following transactions would be examples of purchases and sales that are not substantially similar: buying stock in one company and selling stock in another company; buying stock and selling bonds issued by the same company; and buying cash Treasury securities and selling Treasury futures.

The Proposing Release notes that “routinely” means more frequently than occasionally, but not necessarily continuously. According to the Proposing Release, “‘routinely’ relates to the frequency of the activity both intraday and across time, and means both repeatedly within a day and on a regular basis over time.”

The SEC also believes that being compensated for trades based on spreads rather than the appreciation of securities or government securities held for investment is more akin to dealer compensation and should require the person trading to register as a dealer. Although the Proposed Rules do not define “primarily” with respect to revenue generation, the SEC notes in the Proposing Release that if a person derives a majority of its revenues from the sources noted in bullet three above, “it would likely be in a regular business of buying and selling securities or government securities for its own account.”

Quantitative Standard under Rule 3a44-2

Rule 3a44-2 has an additional quantitative standard for determining whether a person buying and selling government securities for its own account is engaged in such activity “as a part of a regular business.” The SEC added a quantitative standard for government securities because of the sheer volume of activity by unregistered persons in the U.S. Treasury market. According to the Proposing Release, market participants that were not members of FINRA accounted for approximately 19% of the aggregate Treasury trading volume in July 2021, with PTFs representing the highest volumes of trading among the participants. Under Rule 3a44-2, engaging in buying and selling more than $25 billion of trading volume in U.S. Treasury Securities in each of four out of the last six calendar months would be deemed “a part of a regular business.”

Definition of “Own Account”

The Proposed Rules also clarify the definition of a person’s “own account” for purposes of Rules 3a5-4 and 3a44-2. A person’s own account would mean any account:

• held in the name of that person; or
• held in the name of a person over whom that person exercises control or with whom that person is under common control, but not including:
  • an account in the name of a registered broker, dealer, or government securities dealer, or an investment company registered under the Investment Company Act of 1940, as amended (the “Investment Company Act”); or
  • with respect to an investment adviser registered under the Investment Advisers Act of 1940, as amended (the “Investment Advisers Act”), an account held in the name of a client of the adviser unless the adviser controls the client as a result of the adviser’s right to vote or direct the vote of voting securities of the client, the adviser’s right to sell or direct the sale of voting securities of the client, or the adviser’s capital contributions to or rights to amounts upon dissolution of the client; or
  • with respect to any person, an account in the name of another person that is under common control with that person solely because both persons are clients of an investment adviser registered under the Investment Advisers Act unless those accounts constitute a parallel account structure; or
• held for the benefit of those persons identified above.

The Proposed Rules define a “parallel account structure” as “a structure in which one or more private funds (each a ‘parallel fund’), accounts, or other pools of assets (each a ‘parallel managed account’) managed by the same investment adviser pursue substantially the same investment objective and strategy and invest side by side in substantially the same positions as another parallel fund or parallel managed account.” By referencing parallel account structures, the SEC is anticipating persons who try to avoid registration as dealers or government securities dealers through the structuring of funds.

Excluded Persons

Rules 3a5-4 and 3a44-2 would not apply to: (i) persons who have or control total assets of less than $50 million, or (ii) investment companies registered under the Investment Company Act. Excluding smaller companies from regulatory requirements is consistent with SEC practice, and the SEC believes there are sufficient regulatory safeguards for companies registered under the Investment Company Act.

No Safe Harbor

Rules 3a5-4 and 3a44-2 state that no presumption shall arise that a person is not a dealer or government securities dealer, as the case may be, solely because that person’s activities are not covered by the Proposed Rules.

Compliance Period

The Proposing Release provides for a one-year compliance period from the effective date of any final rules adopted by the SEC.

For additional information related to anything contained in this Client Alert, please contact one of the authors listed, or any member of our Securities Law Practice Group.

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