Each month we publish a roundup of the most important SEC enforcement developments for busy in-house lawyers and compliance professionals. This month, we examine:

• The SEC’s expanded definition of securities dealers;

• An $81 million SEC settlement for recordkeeping failures related to “off-channel” communications;

• A court ruling that proxy advice is not solicitation;

• The SEC’s new amendments to Form PF; and

• A crypto firm’s suit against the SEC for declaratory relief.

1. The SEC’s Dealer Rules Now Cover Proprietary Traders and Private Funds

On February 6, 2024, the SEC adopted two rules that bring proprietary traders and certain private funds under its authority by defining them as securities dealers. The rules will require firms that provide significant liquidity to the markets to register with the SEC, become members of a self-regulatory organization, and comply with federal securities laws and regulations.

Specifically, Rules 3a5-4 and 3a44-2 narrow existing exclusions from the definition of “dealer” in Section 3(a)(5) and the definition of “government securities dealer” in Section 3(a)(44) of the Securities Exchange Act of 1934 (“Exchange Act”) by clarifying the phrase “as a part of a regular business” used therein. In short, the new rules establish qualitative standards to determine if a person is engaged in a regular pattern of buying and selling securities that has the effect of providing liquidity to market participants.

Central banks, registered investment companies, sovereign entities, international financial entities, and pension funds are exempt from the new regulations, as are persons who have or control total assets of less than $50 million. Importantly, there is no carveout for registered investment advisers or private funds, including hedge funds. We expect the SEC to further clarify its registration requirements with interpretation of the rules in the future.

The Commission split over passage of the rules. SEC Chair Gary Gensler voted with Commissioners Caroline Crenshaw and Jaime Lizarraga, asserting that the rules would “protect investors and promote market integrity, resiliency, and transparency.” Commissioners Hester Peirce and Mark Uyeda opposed the rules as a “war on private funds” and “arbitrary and capricious.”

The rules will go into effect on April 29, 2024. Compliance will be required as of April 29, 2025.

2. The SEC Settles with 16 Firms for $81 Million over Charges of Recordkeeping Failures Related to “Off-Channel” Communications

On February 9, 2024, the SEC settled charges of failing to maintain and preserve electronic communications against 16 firms, among them broker-dealers, dually registered broker-dealers and investment advisers, and affiliated investment advisers. This settlement follows several similar settlements with the SEC over the last two years.

In this latest action, the firms admitted that their employees communicated off-channel on unapproved, personal platforms. Specifically, the firms admitted that they had violated Sections 15(B) and 21C of the Exchange Act and/or Sections 203(e) and 203(k) of the Investment Advisers Act of 1940 and related SEC regulations. Culpable employees included supervisors and senior managers.

The firms agreed to refrain from further violations and to hire independent compliance consultants at their own expense to address the violations. They also promised to implement new compliance policies and procedures as a result of the settlement.

Notably, because certain respondents had self-reported and cooperated with the SEC’s investigation, they received a significantly lower civil monetary penalty.

3. D.C. Federal Judge Rules Proxy Advice Is Not Solicitation

On February 26, 2024, Judge Amit Mehta of the United States District Court for the District of Columbia found that the SEC exceeded its lawful authority by subjecting proxy advisory firms to its definition of solicitation. Judge Mehta based his ruling on the ordinary meaning of the terms in the Exchange Act at the time of its enactment. He determined that solicitation did not encompass voting advice delivered by a firm with no interest in the outcome of the vote. An appeal to the United States Court of Appeals for the District of Columbia Circuit remains possible.

4. The SEC Passes New Rules Amending Form PF Requirements

On February 8, 2024, the SEC and CFTC adopted amendments to Form PF requiring additional quarterly disclosures to the regulators on Form PF. These changes apply to registered investment advisers to private funds with assets over $500 million and registered investment advisers operating as commodity pool operators or commodity trading advisors. The disclosures will not be publicly available.

According to the SEC, Form PF will enhance how large private fund advisers report information about their businesses. It will also require large private fund advisers to report certain information about the funds they advise. Notably, the rules will require funds to separate master-feeder arrangements and parallel fund structures. In a master-feeder arrangement, one or more feeder funds invest their assets into a master fund. In a parallel fund structure, one or more funds invest in substantially the same positions as another fund. Firms therefore will have to report on each of the individual funds they invest in, rather than only the master or parallel fund.

The SEC said that the purpose of the amendments is to close information gaps that have persisted since Form PF’s enactment and to improve market stability and transparency. The SEC asserted that the information disclosed on revised Form PF will improve the Financial Stability Oversight Council’s ability to evaluate systemic risk. SEC Commissioners Hester Peirce and Mark Uyeda criticized the new rules, citing concerns about data confidentiality and cost.

The amendments will go into effect on March 12, 2025.

5. A Cryptocurrency Firm Sues the SEC, Seeking Exemption from SEC Authority

On February 21, 2024, a Texas cryptocurrency company, Lejilex, and a cryptocurrency trade association, Crypto Freedom Alliance of Texas, sued the SEC in the United States District Court for the Northern District of Texas, arguing that the SEC has unlawfully extended its authority to digital assets. Seeking to launch a cryptocurrency marketplace called Legit.Exchange, Lejilex asked the court to declare it exempt from SEC registration and enforcement action. The suit comes in the wake of the SEC’s enforcement proceedings against big cryptocurrency firms like Coinbase and Kraken, which Lejilex characterized as “a campaign of gross regulatory overreach.”

Lejilex argued that digital assets are not securities and that the SEC’s “regulatory landgrab” was fatally flawed. This suit represents a novel approach that other companies may follow in light of the regulatory uncertainty in which they operate.

Companies operating in the cryptocurrency space should monitor this case as it progresses, given the SEC’s related enforcement actions and the industry’s unsettled regulatory environment. The SEC is expected to respond to the complaint by April 21, 2024.

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