On February 6, 2024, a divided U.S. Securities and Exchange Commission (“SEC”) adopted two new rules — Rules 3a5-4 and 3a44-2 (“Final Rules”) of the Securities Exchange Act of 1934 (“Exchange Act”) — to further define the phrase “as part of a regular business” as used in the statutory definitions of “dealer” and “government securities dealer.” Under Section 3(a)(5) of the Exchange Act, firms that buy and sell securities for their own accounts, but not as part of a regular business, are excluded from the definition of a dealer for purposes of the Exchange Act. Section 3(a)(44) operates similarly with respect to government securities dealers and government securities. Instead of clarifying what the “as part of a regular business” standard in Section 3(a)(5) and Section 3(a)(44) means, however, the Final Rules only add more confusion, especially in light of the definition’s legislative history and subsequent judicial decisions.  

Further Defining “As Part of a Regular Business”

Under the Final Rules, a person that is engaged in buying and selling securities or government securities for its “own account” is engaged in such activity “as a part of a regular business” and consequently must register as a dealer or government securities dealer if that person engages in a regular pattern of buying and selling securities or government securities that has the effect of providing liquidity to other market participants by:

• 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; 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 interest.

The adopting release refers to the above as the “qualitative factors” it will look to in evaluating potential dealer activity. Regarding the first qualitative factor, “expressing trading interest” does not hinge on a particular method of communication and representation; rather, it depends on the totality of the trading activity. Whether or not a market participant has customers is irrelevant to the Final Rules analysis because, as the SEC noted, the statutory text never included the word “customers.” In addition, a market participant neither needs to be continuously expressing trading interest nor profitable to be engaging in a “regular” business.

As to the second qualitative factor, the SEC seeks to identify activity that “has the effect of providing liquidity to other market participants.” The term “trading interest” in the second qualitative factor is defined as: (i) an “order” as the term is defined under Exchange Act Rule 3b-16(c); or (ii) any non-firm indication of a willingness to buy or sell a security that identifies the security and at least one of the following: quantity, direction (buy or sell), or price. Also, trading interest does not have to be expressed simultaneously on both sides of the market, which could have implications for those that employ trading strategies where a person posts resting offers and bids on a central limit order book. Rather, visibility of the bid/ask to the market is an essential element as the second qualitative factor only applies when the expressed trading interests are “communicated and represented in a way that makes them accessible to other market participants.”

In its adopting release, the SEC highlighted that a particular venue used for trading matters less than the fact that a market participant provides liquidity on it. Thus, the SEC emphasized that market participants acting similarly to traditional dealers that are buying and selling U.S. Treasuries as part of a regular business may still meet the definition of government securities dealer — even absent the activity identified in the qualitative standard.

The Final Rules also include an anti-evasion provision that prohibits persons from evading the registration requirements by: (i) engaging in activities indirectly that would satisfy the qualitative factors; or (ii) disaggregating accounts. The SEC will surveil market participants and monitor whether persons divide or structure their activity to evade application of the Final Rules, including by switching between legal entities to evade the “regular” requirement of the qualitative factors.

Exclusions to the Final Rules

The Final Rules contain three significant exclusions: (1) a person that has or controls total assets of less than $50 million; (2) an investment company registered under the Investment Company Act of 1940; and (3) a central bank, sovereign entity, or a specified international financial institution. Importantly, the SEC forewent other exclusions proposed by commenters, including for private funds and registered investment advisers, because a private fund or an investment adviser “could be acting as a dealer depending upon the particular activities in which it is engaged.” Similarly, the SEC also declined requests to exclude trading activity for certain types of securities, including crypto assets noting that “the dealer framework is a functional analysis based on the securities trading activities undertaken by a firm, not the type of securities being traded.”

Implications

The Final Rules raise two important issues. First, they raise the issue of whether the SEC has exceeded its authority in promulgating the Final Rules.  Although the SEC has in recent years pushed the envelope of what is a dealer through enforcements actions, as we discussed here: https://www.law.com/newyorklawjournal/2023/04/03/the-secs-stacked-deck-is-news-to-unsuspecting-dealers/, those enforcement decisions appear inconsistent with the legislative history of Sections 3(a)(5) and 3(a)(44), as well as judicial interpretations, including In re ScriptsAmerica, Inc., a case from the U.S. Bankruptcy Court in Delaware.1 We foresee ensuing litigation over the Final Rules that will likely address these issues.   

Second, they raise the issue of which market participants will be swept into the new regulatory regime, not to mention the actual, versus estimated, cost of complying with the legal status of dealer or governmental securities dealer. The Final Rules are relatively broad and could have a substantial impact on the market, as noted below. Market participants that engage in activities that meet the criteria must decide if they want to register or alter their trading activities to avoid registration. This analysis applies not simply to hedge funds but to mutual funds, pension funds, foundations, large corporations with a surplus of investing capital, investment advisers, and money/asset managers.   

If market participants choose to register, various requirements will apply to these new registrants. Compliance with these rules may prove challenging for some market participants based on their current business model. New registrants will be subject to, among other things, minimum net capital and related financial responsibility requirements under SEC rules. In addition, a broker-dealer must abide by the one-year capital withdrawal restriction that requires a broker-dealer to treat any capital to be withdrawn within one year of its contribution as a liability. A broker-dealer also is required to file financial reports with the SEC on a continuing basis.

Further, each dealer and government securities dealer registered with the SEC as a broker-dealer is subject to the recordkeeping requirements under the SEC. For example, the firm must maintain an extensive set of records relating to the registrant’s business as a broker-dealer for prescribed periods of time and capture any electronic communications, including text messages, related to its securities business.

The SEC forecasts that hedge funds are more likely to meet the Final Rules’ definition of dealer, although private equity funds and liquidity funds are less likely. Critically, the Final Rules emphasize there is no presumption that a person is not a “dealer” solely because they do not satisfy the requirements of the Final Rules. As a result, even if a market maker reasonably believes in good faith that it does not fall within the interpretation of engaging in activity as a part of a regular business, the SEC could decide that the entity is nonetheless a dealer/government securities dealer requiring to be registered under sections 15 and 15C of the Exchange Act, respectively.

Conclusion

The Final Rules will become effective sixty days after the date of publication of the Final Rules’ adopting release in the Federal Register. The compliance date for the Final Rules will be one year after the effective date.

Given the dramatic impact of the expanding definitions of Rules 3a5-4 and 3a44-2, market participants will be well-served to seek guidance from counsel to determine whether their current or contemplated activities meet the new criteria under the Final Rules.

A copy of the adopting release of the Final Rules can be found here: https://www.sec.gov/files/rules/final/2024/34-99477.pdf

For More Information

This Client Alert has been prepared by the following Partners of the international law firm of Sullivan & Worcester LLP:

• Meghan Rohan is a Partner in the Regulatory Compliance Group. Ms. Rohan may be reached in our New York office by calling 212-660-3040 or by email mrohan@sullivanlaw.com.
• Michael T. Dyson is a Partner in the Regulatory Compliance Group. Mr. Dyson may be reached in our Washington, D.C. office by calling 202-775-1217 or by email mdyson@sullivanlaw.com.
• John Hunt is a Partner in the Investment Management Group. Mr. Hunt may be reached in our Boston office by calling +1 (617) 338-2961 or our London office by calling +44 (0)20 7448 1000, or by email at jhunt@sullivanlaw.com.