SEC defines the phrase “as part of a regular business” to capture private funds and other market participants that take on liquidity-providing roles.

The Securities and Exchange Commission (SEC) adopted new rules that expand the definition of “dealer” and “government securities dealer” under the Securities Exchange Act of 1934 (Exchange Act), requiring registration by market participants that take on significant liquidity-providing roles. The February 6, 2024, SEC Release (Adopting Release) adopting Rules 3a5-4 and 3a44-2 under the Exchange Act (New Rules) noted that the SEC was principally concerned with market participants, such as certain proprietary trading funds (PTFs) and private funds, that behave as de facto dealers without registration. The New Rules and the Adopting Release, however, could have significant implications for all market participants, including hedge funds, lenders, and crypto asset securities.

The New Rules effectively turn certain traders or customers into securities dealers. The concern over the expanded breadth of the concept of “dealer” is particularly acute when evaluated in light of the SEC’s adoption of rules related to private fund advisers, short position and short activity reporting, and securities lending disclosure.

New Rules 3a5-4 and 3a44-2 define the phrase “as a part of regular business” used in Sections of 3(a)(5) and 3(a)(44) of the Exchange Act to identify, but not limit, certain activities that would cause persons engaging in such activities to be “dealers” or “government securities dealers” and, thus, subject to the registration requirements of Section 15 and 15C of the Exchange Act. The New Rules require that covered market participants: (1) register with the SEC, (2) become members of a self-regulatory organization (SRO), such as the Financial Industry Regulatory Authority (FINRA), and (3) comply with federal securities laws and regulations.

Background

Congress defined “dealer” in the Exchange Act as “any person engaged in the business of buying and selling securities [. . .] for such person’s own account through a broker or otherwise.” Absent an exception or an exemption, Section 15(a)(1) of the Exchange Act prohibits a “dealer” from effecting any transactions in, or inducing or attempting to induce the purchase or sale of, any security unless registered with the SEC. For the last 90 years, the Exchange Act has limited the definition of “dealer” by excluding “traders” or any person that “buys and sells securities [. . .] for such person’s own account, but not as a part of a regular business.”[1] While the economic analysis in the adopting release identifies only a handful of persons that would become subject to the New Rules (i.e., 13 to 22 PTFs and up to four hedge funds),[2] the New Rules could catch many other market participants under the definition of “dealer” that, due to advancements in electronic trading, are now able to play a significant role as liquidity providers. According to the SEC, the expanded registration requirements will provide regulators with a more comprehensive view of the markets, support market stability and resiliency, and protect investors.

Key Considerations

The SEC’s further defining of the phrase “as a part of regular business,” as used in Sections of 3(a)(5) and 3(a)(44) of the Exchange Act, places increased emphasis on the regularity of buying and selling securities as a core component of a business. Under the New Rules, any person that engages in any of the following activities as part of a regular business would be a “dealer” or a “government securities dealer”:

• Regularly[3] 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 (the “expressing trading interest 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 interest (the “primary revenue factor”)

The test is designed to capture persons operating as dealers through their “expression of trading interest” on both sides of the market for the same security, who otherwise may have been able to avail themselves of the trader exception. Notably, the term “trading interest” captures firm orders as well as non-firm indications of willingness to buy or sell a security, where the communication identifies the security and at least one of the following: quantity, direction (buy or sell), or price.

Market participants deemed “dealers” or “government securities dealers” under the New Rules are required to:

• register with the SEC under either Section 15(a) or Section 15C;
• become a member of an SRO, like FINRA; and
• comply with federal securities laws, regulatory obligations, and applicable SRO and Treasury rules and requirements.

The New Rules prohibit persons from evading the registration requirements by: (1) engaging in activities indirectly that would require registration, or (2) disaggregating accounts.

Exceptions

In the Adopting Release, the SEC excluded the following persons from its expanded definitions:

• Persons that have or control total assets valued below $50 million
• Investment companies registered under the Investment Company Act of 1940
• Central banks, sovereign entities, or international financial institutions

The New Rules do not exclude any particular type of securities, such as crypto asset securities.

Effective and Compliance Dates

The New Rules become effective 60 days following the date of publication of the Adopting Release in the Federal Register. The compliance date for the New Rules will be one year after the effective date.

Key Differences from the Proposed Rule

There are several key differences from the March 28, 2022, proposed rules (for more information, see this Latham blog post), including the removal of the quantitative standard, the modification of the qualitative standard, the revision of the “own account” definition, and the addition of an anti-evasion provision.

The proposed rules included a quantitative standard bright line test under which persons engaged in certain levels of activity in the securities markets would be found to be buying and selling securities “as part of a regular business” regardless of the quantitative factors. In the New Rules, this bright line test has been removed.

The New Rules also eliminate a qualitative factor that would have captured persons engaging in liquidity provision by routinely making roughly comparable purchases and sales of the same or substantially similar securities in a day.

The proposed rules defined “own account” to include accounts “held in the name of a person over whom that person exercises control or with whom that person is under common control.” However, the New Rules revised this definition of “own account” to mean accounts held in the name of that person or held for the benefit of that person.

Statements by Members of the Commission

The Commission adopted the rules by a 3-2 margin.

• Chairman Gary Gensler supported the adoption, stating that “it requires that firms that act like dealers register with the Commission as dealers, thereby protecting investors as well as promoting market integrity, resiliency, and transparency.”
• Commissioner Caroline A. Crenshaw supported the adoption, stating that the rule would “level the playing field by subjecting market participants that perform similar dealer functions to a common regulatory regime.”
• Commissioner Jaime Lizárraga supported the adoption, stating that the Rules will “provide for a standard that is more protective of investors and our markets.”
• Commissioner Hester M. Peirce dissented, stating that “the rule defines dealer in a way that is inconsistent with the statutory framework within which it sits and will distort market behavior and degrade market quality.”
• Commissioner Mark T. Uyeda dissented, stating that the New Rules “classify nearly any person who buys and sells securities as a ‘dealer’ […] extend[ing] beyond its statutory authority.” Further, Commissioner Uyeda expressed concern that the New Rules “may reduce liquidity in the Treasury Markets, make them more volatile, reduce the number of liquidity providers, and increase debt costs to taxpayers.” Finally, Commissioner Uyeda noted that complying with the New Rules provides no assurance on dealer status; rather, the Adopting Release notes that “no presumption shall arise that a person is not a dealer within the meaning of [the Exchange Act] solely because that person does not satisfy [the standards set forth in the New Rules].”

Endnotes

[1] Exchange Act § 3(a)(5)(A)-(B) (emphasis added).

[2] In speaking with the Financial Times, Chair Gensler noted that the affected market participants would be “up to” 16 private funds (including hedge funds). See Financial Times, SEC’s Gensler plays down hedge fund fears over Treasury dealer rule (February 18, 2024). Note that the analysis does not account for crypto asset platforms, as the SEC considers that such market participants already may be “dealers” under current law. See Adopting Release at p. 122.

[3] The SEC replaced the term used in the Proposing Release — “routinely” — with the term “regularly.” The term “regularly” “distinguishes persons engaging in isolated or sporadic expressions of trading interest from persons whose regularity of expression of trading interest demonstrates that they are acting as dealers.” Adopting Release at p. 35.