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Unveiling the SEC's Redefined Concept of a "Dealer"

In the wake of relentless legal battles involving small-cap and penny stock convertible debt lenders, the SEC has put forth changes aimed at modifying the concept of a “dealer” as per the Exchange Act. Starting from 2017, a series of enforcement actions against convertible debt lenders initiated by the SEC has been met with strong criticism from industry insiders, who describe it as regulation by enforcement. Regrettably, these actions have not resulted in clear guidance through court orders or settlements. Disappointingly, the revised rules, proposed in March 2022 and expected to be finalized this year, do not seem to clarify the regulatory landscape for small-cap investors.

The purpose of the rule change is to make it mandatory for specific proprietary or principal traders, as well as liquidity providers, to register as either a dealer or a government securities dealer, depending on their respective market. The suggested amendments would modify Exchange Act Rules 5a5-4 and 3a44-2, to give more clarity to the phrase “as part of a regular business” in Sections 3(a)(5) and 3(a)(44) of the Exchange Act.

Overview of the Proposed Amendments

While these proposed changes apply to all market participants, they are evidently intended to address issues in the U.S. Treasury markets. The growth in Treasury markets has been largely due to the surge in electronic trading platforms, including automated algorithmic systems which currently account for half of the daily trading volume. These trading systems typically meet the historical definition of a “market maker”, as they are market professionals relied upon by the public for liquidity provision.

The proposed amendment would mandate that market participants who reach certain activity levels register as a dealer or a government securities dealer, depending on the markets they operate in. Principal trading firms and proprietary trading firms (PTFs) would primarily be required to register, though some private funds might also fall within the scope.

Interestingly, the proposed amendment does not include numerous small-cap investors who are presently under SEC enforcement proceedings for failing to register as dealers. Specifically, the SEC has primarily pursued enforcement actions against investors who use convertible notes to invest in penny stock issuers. There are no existing regulations or guidance that restrict broker-dealer registration requirements based on the type of security being bought, sold, or traded, or the size of the issuer. Although the SEC has claimed victories in ongoing litigations, the conclusion drawn from this enforcement-led approach is disconcerting for market participants, suggesting that they can only legally operate by restricting lending activities to exchange-traded companies.

The new proposals intentionally exclude “smaller participants” that “control less than $50 million in total assets”, as these participants “are unlikely to engage in the significant liquidity provision that is the focus of the Proposed Rules.” While registered investment companies are also exempted due to their existing robust regulatory obligations, registered investment advisors (RIAs) are not.

Regrettably, the SEC continues to disregard its obligation to provide guidance to numerous small-cap lenders/investors currently involved in litigation or under investigation. The SEC equivocates, noting the litigation in a footnote and stating that the new proposed rules “are not the exclusive means of establishing that a person is a dealer or government securities dealer.” Echoing sentiments from one of the ongoing litigations, the SEC maintains it may consider various professional market activities such as “underwriting, buying and selling directly to securities customers, providing investment recommendations, extending credit, and lending securities in connection with transactions in securities, and carrying a securities account.” According to the SEC, “a person may still be acting as a dealer even if they do not, under the Proposed Rules, engage in a routine pattern of buying and selling securities that has the effect of providing liquidity to other market participants.”

Clarifying “Dealer” and “Government Securities Dealer”

Section 3(a)(5) of the Exchange Act defines a “dealer” as “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise.” However, it excludes a person who trades securities for personal or fiduciary interests, but not as a part of a regular business, a provision often called the “trader” exception. Without an exemption or exception, Section 15(a)(1) of the Exchange Act forbids a “dealer” from engaging in any security transactions unless they are registered with the SEC according to Section 15(b) of the Exchange Act.

Likewise, Section 3(a)(44) of the Exchange Act, in part, defines a “government securities dealer” as “any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise,” but excludes individuals buying or selling such securities for their own account outside the scope of a regular business.

The present proposal (and the dealer litigation in the small-cap marketplace) zeroes in on the interpretation of a “regular business.” The Exchange Act does not currently define this term. To assess if a trader is conducting a “regular business” of trading securities, the SEC and courts look at the frequency of activity, nature of trading activity, whether they act as a market maker or specialist on an organized exchange or trading system, whether they act as a de facto market maker or liquidity provider, and whether they represent themselves as a regular business for buying or selling securities.

Additionally, the SEC specifies that dealers include those who frequently engage in simultaneous buying and selling transactions to reduce position-associated risk. Conversely, traders are "market participants who invest capital and are ready to take on the risk of ownership in listed companies for a significant period." These participants are generally deemed as "traders" and are not required to register as dealers. The SEC also posits that it is not appropriate to refer to someone as 'investing' in a company for a few seconds, minutes, or hours.”

The SEC is suggesting two rules, proposed Rules 3a5-4 and 3a44-2, to refine the definitions of “dealer” and “government securities dealer.” These rules identify certain activities that would be considered a “regular business”, requiring the individual engaged in such activities to register as a “dealer” or a “government securities dealer,” barring an exception or exemption.

The Proposed Rules lay out three qualitative standards to identify specific activities of certain market participants who play dealer-like roles, namely, those whose trading activity “has the effect of providing liquidity” to other market participants. Also, the definition of a “government securities dealer” would introduce a bright-line quantitative test where a person would be deemed a dealer irrespective of whether they meet the qualitative standards. Like other securities regulations, a “person” can refer to any individual or entity.

It’s important to note that entities that possess or control total assets under $50 million are exempted from the new proposed definition, as are registered investment companies. However, RIAs are not excluded, though the rules do include stipulations for determining when an RIA is acting for their own account versus their clients'.

Qualitative Standards

The suggested rule expands the current definitions to include three types of activities that would be seen as providing liquidity to other market participants. Specifically, these are: (i) frequently making roughly similar purchases and sales of the same or almost identical securities (or government securities) in a day; (ii) frequently expressing trading interests that are close to the best available prices on both sides of the market, and that are communicated in a way that makes them accessible to other market participants; or (iii) generating revenue mainly from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing incentives offered by trading venues to liquidity-supplying trading interests.

Quantitative Standards

Besides the qualitative standards, proposed Rule 3a44-2 also includes a quantitative standard. This standard would establish a clear-cut test where persons engaged in specific levels of activity in the U.S. Treasury market would be defined as conducting securities transactions "as a part of a regular business," regardless of whether they meet any of the qualitative standards. Specifically, proposed Rule 3a44-2(a)(2) states that a person buying and selling government securities for its own account is conducting such activity "as a part of a regular business" if that person in each of four out of the last six calendar months, was engaged in buying and selling more than $25 billion of trading volume in government securities.

Compliance

A person required to register as a dealer or government securities dealer under the new rules would have one year from the effective date to comply. Compliance will involve both the registration with the SEC (Form BD) and membership with a Self-Regulatory Organization (SRO), such as FINRA. Therefore, those impacted should initiate the process promptly once the rule comes into effect.