Legal development

US SEC Refines and Broadens  The Scope of The Dealer Definition

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    On 6 February, the US Securities and Exchange Commission (SEC) adopted rules that will force certain firms that engage in de facto market-making activities to register as dealers and be subject to the statutes, rules and regulations applicable to dealers.  What follows is a brief summary of those changes. 

    1. The SEC did not actually change the statutory definition of "dealer"  

    Section 3(a)(5) of the Exchange Act defines the term "dealer" to mean "any person engaged in the business of buying and selling securities …for such person's own account through a broker or otherwise."  

    Section 3(a)(5) excludes from the definition "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 SEC has the authority to define by rule terms used in a statutory definition, thereby essentially accomplishing indirectly what it can't accomplish directly.  

    2. The SEC has adopted two new rules (Rule 3a 5-4 and Rule 3a 44-2)1  that are meant to clarify the phrase "as a part of a regular business" in the context of market-making

    The Commission has historically determined that market-making is one of the activities that requires a firm to register and operate as a dealer.  

    According to the new rules, a person is a de facto market-maker (and therefore a dealer) if that person "engages in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants."  There are two factors that determine whether a person is providing liquidity as a part of a regular business: 

    (a) The expressing trading interest factor.  Regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants.  A trading interest is (i) an order, or (ii) any other non-firm indication of a willingness to buy or sell that identifies the security and at least one of:  quantity, direction (buy/sell) or price.  The trading interests do not necessarily have to be expressed simultaneously to be considered "on both sides of the market" or

    (b) The primary revenue factor.  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.

    3. The SEC has established three exclusions to the meaning of "dealer" under limited circumstances

    The following are excluded even if they provide liquidity (i.e., are de facto market makers):

    (a)  a person that has or controls totals assets of less than $50 million;

    (b)  an investment company registered under the Investment Company Act; and

    (c)  a central bank, sovereign entity, or international financial institution.

    It is important to note that these exclusions apply only in the context of acting as a liquidity provider; they do not apply to other dealer activities such as underwriting.  Thus, for example, an underwriter with less than $50 million in assets would not be excluded. 

    4. The SEC declined to create exclusions for private funds and registered investment advisers

    This does not mean that all Registered Investment Advisers (RIAs) and private funds must register.  It simply means that, if they meet the standards in one of the two factors, then they are dealers for purposes of the federal securities laws.  The determination must be made based on an entity's activities, not its status under other statutory or regulatory regimes. 

    5. The SEC adopted a "no presumption" clause

    Using a triple negative, the rules state explicitly that no presumption is established that a person is not a dealer as defined in Section 3(a)(5) solely because that person does not satisfy either of the two factors. The rules do not provide examples of when this would be the case.  

    6. The SEC adopted an anti-evasion clause

    Pursuant to this clause, a person will not successfully evade the requirement to register as a dealer by engaging in de facto market making activities indirectly (e.g. through a third party), or by disaggregating accounts.  This means that although the SEC usually analyzes these sorts of questions on an entity-by-entity basis, it will aggregate accounts if a structure was established for the purpose of avoiding registering and operating as a dealer.  

    7. Some key additional take-aways

    • The rules only affect unregistered firms that engage in market-making as a part of a regular business (as now defined).  All other aspects of the "dealer" definition remain the same.
    • Registering and doing business as a dealer is a significant undertaking and may be difficult to accomplish operationally.  For example, the SEC's Net Capital Rule requires dealers to maintain a minimum level of capital based on their activities.  In addition, registered dealers must become members of FINRA (a self-regulatory organization), thereby becoming subject to its rules as well as the rules, oversight and enforcement authority of the SEC. 
    • The SEC does not appear to have embarked on this task to target private funds and RIAs specifically; it merely declined to create an exclusion from the registration requirements for those entities as specifically requested by persons commenting on the rules proposal.  The SEC did so on the basis that, unlike mutual funds (which are excluded), private funds and RIAs are not otherwise subject to a regulatory regime with similar investor protection obligations to those applicable to dealers.  Some of the other features of the rules, such as the definition of "own account" (see below) and the nature of the "as part of a regular business" tests (see above) make it less likely that garden-variety private funds and RIAs will be required to register as dealers.
    • The new rules define a person's "own account" to mean any account held in the person's name or held for that person's benefit.  This will generally exclude an investment adviser's client accounts over which it has discretion.
    • The Compliance Date for the rules will be one year after the Effective Date, which in turn will be 60 days after the rules are published in the Federal Register.

      1  The rules are identical except that Rule 3a5-4 deals with all securities and Rule 3a44-2 deals with government securities.

    The information provided is not intended to be a comprehensive review of all developments in the law and practice, or to cover all aspects of those referred to.
    Readers should take legal advice before applying it to specific issues or transactions.


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