Publications

On February 6, 2024, the Securities and Exchange Commission (“SEC”) in a 3-2 vote adopted new Rules 3a5‑4 and 3a44‑2 (the “Dealer Rules”) that expand the definition of a “dealer” and a “government securities dealer” under the Securities Exchange Act of 1934 (“Exchange Act”). The new Dealer Rules depart significantly from established precedent distinguishing between “dealer” activity that necessitates registration and “trader” activity that does not, potentially bringing many more entities, including private funds, into the dealer category. According to the SEC, the Dealer Rules are necessary due to the increased number of unregistered market participants engaging in trading and other market-making and liquidity-providing activity that is traditionally performed by registered dealers.

Background

Section 3(a)(5) of the Exchange Act defines the term “dealer” as “any person engaged in the business of buying and selling securities . . . for such person’s own account through a broker or otherwise” but excludes from the “dealer” definition any “person that buys or sells securities . . . for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” (Emphasis added).

New Dealer Rules

The Dealer Rules narrow this exception by establishing the following two activities that would constitute dealing “as part of a regular business”:

• engaging in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants by “[r]egularly 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

• engaging in a regular pattern of buying and selling securities that has the effect of providing liquidity to other market participants by “[e]arning 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.”

Under the Dealer Rules, absent an exemption or exclusion, entities that engage in the above activities must: register with the SEC under Section 15(a) or Section 15C, as applicable; become a member of a self-regulatory organization (“SRO”), generally FINRA; and comply with federal securities laws and regulatory obligations and applicable SRO and Treasury rules and requirements. The Dealer Rules specifically exclude registered investment companies, central banks, sovereign entities, international financial institutions and persons with total assets of less than $50 million. However, the Dealer Rules do not exclude private funds and, as such, any private fund with assets of $50 million or more that engages in one or more of the activities described above may be required to register as a dealer.

Finally, the Dealer Rules state that there will be no presumption that a person is not a “dealer” solely because that person does not engage in any of the activities described above. As a result of this open-ended caveat, even if an entity concludes that it does not fall within this new definition, the SEC could still determine that such entity is nevertheless a dealer under the Exchange Act (although it is not clear what criteria the SEC would use to make this determination).

In the SEC’s press release, Chair Gary Gensler said, “I am pleased to support this adoption because 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…. These measures are common sense. Congress did not intend for registration and regulatory requirements to apply to some dealers and not to others. Absent an exemption or exception, if anyone trades in a manner consistent with de facto market making, it must register with us as a dealer – consistent with Congress’s intent.”

Takeaway

The Dealer Rule represents another effort by the SEC to expand the regulatory oversight of private funds. In particular, hedge funds that pursue high-frequency trading strategies may fall within the scope of the “dealer” and “government securities dealer” definitions, as applicable.^[1] Private funds that fall within the scope of the Dealer Rules will be subject to increased regulatory scrutiny and compliance obligations, including the net capital requirements and risk management controls imposed under the Exchange Act, as well as the self-reporting of rule violations required under FINRA membership rules.

The Dealer Rule will become effective 60 days after the adopting release is published in the Federal Register, with a compliance date one year after the effective date. However, this one-year compliance period is available only for “market participants who are engaging in activities covered by the [Dealer Rules]” and is not a more general exemption from dealer registration for persons whose activities otherwise satisfy the definition of dealer under existing SEC interpretation and federal securities laws.

[1] In its adopting release, the SEC estimated the new rules may affect up to 43 entities, 12 of which were hedge funds. The hedge fund estimation is based on SEC staff analysis of Form PF, and in the release, the SEC noted “since reported HFT [high frequency trading] may apply to a broader set of activities than the final rules’ qualitative factors, the actual number of affected funds may be less than 12.” Securities Exchange Act Release No. 99477 (February 6, 2024), available at: https://www.sec.gov/files/rules/final/2024/34-99477.pdf.

For more information on the topic discussed, contact:

• Wayne H. Davis  |  davis@thsh.com  |  212-508-6705
• Haylie Gordon  |  gordon@thsh.com  |  212-508-6745
• Michele Itri  |  itri@thsh.com  |  212-508-6732
• Mark D. Shaffer  |  mshaffer@thsh.com  |  212-508-6773
• Beth Smigel  |  smigel@thsh.com  |  212-702-3176
• Michael G. Tannenbaum  |  tannenbaum@thsh.com  |  212-508-6701