Two years after proposing rule changes, the SEC has finalized new rules amending the definition of a “dealer” under the Exchange Act. Despite ongoing litigation against small-cap and penny stock convertible debt lenders, these new rules do not provide regulatory clarity for this sector.

Key Amendments

The amendments aim to require certain proprietary or principal traders and liquidity providers to register as either a dealer or government securities dealer. The rules modify Exchange Act Rules 5a5-4 and 3a44-2 to better define “as part of a regular business” in Sections 3(a)(5) and 3(a)(44) of the Exchange Act, primarily focusing on large proprietary traders and government securities dealers. Unfortunately, small-cap traders are left to navigate these rules through judicial precedence.

BACKGROUND

While the amended rules are not limited to U.S. Treasury market participants, this area is a primary focus due to the rise in electronic trading mechanisms, including automated, algorithmic systems that now account for a significant portion of daily trading volume. These systems typically act as market makers, providing liquidity that the public relies on.

The new rules stipulate that market participants meeting specific activity levels must register as a dealer or government securities dealer, particularly affecting principal trading firms and proprietary trading firms (PTFs). Some private funds may also fall within this scope.

Importantly, the rule changes do not address the small-cap investors currently facing SEC enforcement for failing to register as dealers, particularly those investing in convertible notes in penny stock issuers. The SEC has not limited broker-dealer registration requirements based on the type of security or the issuer's size. While the SEC has succeeded in several litigations, small-cap market participants remain uncertain about their status as unlicensed dealers.

EXCLUSIONS AND SCOPE

The new rules exclude participants with less than $50 million in total assets and registered investment companies, although registered investment advisors (RIAs) are not excluded. The SEC’s stance is clear that its final rules are one way to establish dealer status, and existing court precedents and Commission interpretations still apply. The rules also emphasize that meeting the new standards does not imply exemption from dealer registration.

DEFINITIONS

Section 3(a)(5) of the Exchange Act defines a “dealer” as anyone engaged in buying and selling securities for their account as part of a regular business but excludes those who trade for their account not as part of a regular business. This exclusion is known as the “trader” exception. Section 15(a)(1) makes it unlawful for a dealer to transact without SEC registration per Section 15(b).

Similarly, Section 3(a)(44) defines a “government securities dealer” and includes a trader exception. The rule amendments seek to clarify what constitutes a “regular business” of buying and selling securities, considering factors like activity frequency, trading nature, acting as a market maker, and providing liquidity.

Dealers are those who buy and sell quickly to minimize risk, while traders invest for extended periods, exempting them from dealer registration. The SEC states that someone investing for short durations cannot be considered an investor.

NEW RULES

The SEC has adopted new Rules 3a5-4 and 3a44-2 to further define a “dealer” and “government securities dealer,” identifying activities that require registration as a dealer or government securities dealer.

Qualitative Standards

The final rule includes qualitative standards to identify market participants acting as dealers. These standards focus on: (i) regularly expressing trading interest near the best available prices on both market sides (“expressing trading interest factor”) and (ii) earning revenue mainly from capturing bid-ask spreads or liquidity-supplying incentives (“primary revenue factor”).

“Own Account” Definition

The rule revises “own account” to mean an account held in the person’s name or for their benefit. It includes an anti-evasion provision to prevent circumventing regulations by creating multiple entities or accounts.

Exclusions

Exclusions from the new rules include central banks, sovereign entities, international financial institutions, registered investment companies, and persons controlling less than $50 million in assets.

COMPLIANCE

Affected parties must register as a dealer or government securities dealer by April 29, 2024. Compliance involves SEC registration (Form BD) and SRO membership (FINRA), so starting the process promptly is advised.