The SEC has recently adopted new rules amending the definition of a “dealer” under the Exchange Act. While these changes come after years of litigation targeting small-cap and penny stock convertible debt lenders, the new rules notably fail to clarify regulations for this sector.

Amendments and Their Implications

The amendments require certain proprietary traders and liquidity providers to register as dealers or government securities dealers. Specifically, Exchange Act Rules 5a5-4 and 3a44-2 have been updated to enhance the definition of “as part of a regular business” under Sections 3(a)(5) and 3(a)(44) of the Exchange Act. However, these changes primarily target large proprietary traders and government securities dealers, leaving small-cap traders to navigate ongoing legal ambiguity.

Focus on U.S. Treasury Markets

Although the rules are not limited to U.S. Treasury markets, it is evident that the proliferation of electronic trading mechanisms in these markets has been a driving factor. Automated, algorithmic systems now account for half of daily trading volume, positioning themselves as market makers that the public relies on for liquidity.

The new rules mandate that market participants meeting specific activity thresholds must register as dealers or government securities dealers. This requirement is expected to primarily affect principal trading firms and proprietary trading firms (PTFs), and potentially some private funds.

Small-Cap Market Impact

The rules do not address the small-cap investors currently embroiled in SEC enforcement actions for unlicensed dealer activity, particularly those using convertible notes in penny stock issuers. Despite successful SEC actions in this area, market participants in exchange-traded companies that do not meet the new activity levels remain uncertain about their regulatory status.

Exclusions and Clarifications

The rules exclude “smaller participants” controlling less than $50 million in total assets, as they are deemed unlikely to significantly impact liquidity. Registered investment companies are also excluded due to existing regulations, but registered investment advisors (RIAs) are not.

Definition of “Dealer” and “Government Securities Dealer”

Sections 3(a)(5) and 3(a)(44) of the Exchange Act define dealers and government securities dealers as those engaged in buying and selling securities or government securities for their own account as part of a regular business. The SEC’s amendments aim to clarify what constitutes a “regular business” by considering factors such as activity frequency, market making roles, and holding out as a buyer or seller at a regular place of business.

New Qualitative Standards

The amended rules introduce qualitative standards to better identify dealer-like activities. These include:

1. Regularly expressing trading interest at or near the best available prices on both sides of the market.

2. Earning revenue primarily from capturing bid-ask spreads or incentives from trading venues.

### “Own Account” Definition

The final rule defines “own account” to include accounts held in a person’s name or for their benefit. An anti-evasion provision prevents indirect engagement in dealer activities or disaggregation of accounts to avoid regulation.

Exclusions and Compliance Timeline

Exclusions from the new rules include central banks, sovereign entities, international financial institutions, registered investment companies, and entities controlling less than $50 million in assets. Those required to register under the new rules must comply by April 29, 2025, one year from the effective date.

Conclusion

The new SEC rules provide clearer regulatory frameworks for large proprietary traders and liquidity providers but leave small-cap lenders in a state of legal uncertainty. The SEC’s stance remains firm, with ongoing judicial precedents and Commission interpretations continuing to guide this sector. Market participants affected by the new rules should promptly begin the registration process to ensure compliance by the effective date.