Following a continuous stream of litigation against small-cap and penny stock convertible debt lenders, the SEC has proposed some statutory changes to the definition of a “dealer” under the Exchange Act. The SEC’s enforcement attack on convertible debt lenders began in 2017 and has been decried by industry participants as regulation by enforcement which, unfortunately, is not resulting in judicial orders or settlements offering clear guidance (see HERE). Also, unfortunately, the proposed new rules, which were published in March 2022 and are likely to reach final rule stage this year, still do not help small-cap investors navigate the regulatory highway.
The rule is intended to require certain proprietary or principal traders and liquidity providers to register as either a dealer or government securities dealer as applicable. The proposed rules would amend Exchange Act Rules 5a5-4 and 3a44-2 to enhance the definition of “as part of a regular business” in Sections 3(a)(5) and 3(a)(44) of the Exchange Act.
Although the proposed rules are not limited to participants in the U.S. Treasury markets, it is clear that is the focus and impetus for the change. The expansion in the Treasury markets has primarily been as a result of the proliferation of electronic trading mechanisms including automated, algorithmic systems that now account for half of the daily trading volume. As a result of the liquidity generated, these trading systems generally fall within the historical definition of a “market maker” in that they are market professionals that the public looks to for liquidity.
The proposed rule would require any market participants that meet specified activity levels to register as a dealer or government securities dealer, depending on the markets in which they trade. As such, the proposed rule will primarily require the registration of principal trading firms and proprietary trading firms (PTFs) though some private funds may be within the scope as well.
Notably, the proposed rule does not encompass the many small-cap investors that are the subject of SEC enforcement proceedings for the failure to register as a dealer. In particular, the SEC has only filed actions for unlicensed dealer activity against investors that invest specifically using convertible notes in penny stock issuers. There is nothing in the broker-dealer regulatory regime or guidance that limits broker-dealer registration requirements based on the form of the security being bought, sold or traded or the size of the issuer. The SEC has had a series of wins in the pending litigations, but at the end of the day, it leaves market participants with the uncomfortable, purely enforcement-driven conclusion that they are only acting within the legal boundaries if they limit lending activity to exchange traded companies.
In fact, the new proposed rules exclude “smaller participants” that “control less than $50 million in total assets” as these participants “are unlikely to be able to engage in the significant liquidity provision that is the focus of the Proposed Rules.” Registered investment companies are also excluded as they are already subject to robust regulations; however, registered investment advisors (RIAs) are not excluded.
Again, unfortunately for market participants, the SEC is unapologetic concerning its failure to provide guidance to the myriad of small-cap lenders/investors that are now engaged in litigation or under investigation. The SEC hedges, referring to the litigation in a footnote and explaining that the new proposed rules “are not the exclusive means of establishing that a person is a dealer or government securities dealer.” Rather, quoting directly from one of the current litigation matters, the SEC indicates it may consider “underwriting, as well as buying and selling directly to securities customers together with conducting any of an assortment of professional market activities such as providing investment recommendations, extending credit, and lending securities in connection with transactions in securities, and carrying a securities account.” The SEC concludes that “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.”
Definition of “Dealer” and “Government Securities Dealer”
Section 3(a)(5) of the Exchange Act defines the term “dealer” to mean “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise,” but excludes “a 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.” The statutory exclusion from the definition of “dealer” is often referred to as the “trader” exception. Absent an exception or an exemption, Section 15(a)(1) of the Exchange Act makes it unlawful for a “dealer” to affect any transactions in any security unless registered with the SEC in accordance with Section 15(b) of the Exchange Act.
Similarly, Section 3(a)(44) of the Exchange Act provides, in relevant part, that the term “government securities dealer” means “any person engaged in the business of buying and selling government securities for his own account, through a broker or otherwise,” but “does not include any person insofar as he buys or sells such securities for his own account, either individually or in some fiduciary capacity, but not as part of a regular business.”
The current rule proposal (and the dealer litigation in the small-cap marketplace) focuses on defining a “regular business.” Currently the Exchange Act does not define the term. In determining whether a trader is engaged in a “regular business” of buying and selling securities, the courts and SEC consider: (i) the frequency of activity; (ii) nature of tracing activity; (iii) acting as a market maker or specialist on an organized exchange or trading system; (iv) acting as a de facto market maker or liquidity provider; and (v) holding oneself out as buying or selling securities at a regular place of business.
Further, the SEC states that dealers include those who are willing to buy and sell contemporaneously and often quickly enter into offsetting transactions to minimize the risk associated with a position. In contrast, traders are “market participants who provide capital investment and are willing to accept the risk of ownership in listed companies for an extended period of time.” Such an investor is generally just considered a “trader” and is exempt from dealer registration. The SEC has also stated that “it makes little sense to refer to someone as ‘investing’ in a company for a few seconds, minutes, or hours.”
The SEC is proposing two rules, proposed Rules 3a5-4 and 3a44-2, to further define a “dealer” and “government securities dealer” to identify certain activities that would constitute a “regular business” requiring a person engaged in those activities to register as a “dealer” or a “government securities dealer,” absent an exception or exemption.
The Proposed Rules set forth three qualitative standards designed to more specifically identify activities of certain market participants who assume dealer-like roles, specifically, persons whose trading activity in the market “has the effect of providing liquidity” to other market participants. In addition, the definition of a “government securities dealer” would include a bright-line quantitative test where a person would be deemed a dealer regardless of whether they meet the qualitative standards. Like other securities regulations, a “person” could be any form of individual or entity.
As mentioned above, persons that have or control total assets of less than $50 million are excluded from the new proposed definition as are registered investment companies. As mentioned above, RIAs are not excluded, although the rules do include provisions for determining when an RIA is acting for their own account as opposed to for the account of clients.
The proposed rule would expand upon the current definitions to include three types of activities that would be considered to have the effect of providing liquidity to other market participants. In particular: (i) routinely making roughly comparable purchases and sales of the same or substantially similar securities (or government securities) in a day; or (ii) routinely expressing trading interests that are at or near the best available prices on both sides of the market and that are communicated and represented in a way that makes them accessible to other market participants; or (iii) earning 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 interests.
In addition to the qualitative standards, proposed Rule 3a44-2 would also include a quantitative standard that would establish a bright-line test under which persons engaging in certain specified levels of activity in the U.S. Treasury market would be defined to be buying and selling securities “as a part of a regular business,” regardless of whether they meet any of the qualitative standards. Specifically, proposed Rule 3a44-2(a)(2) would provide that a person that is engaged buying and selling government securities for its own account is engaged in such activity “as a part of a regular business” if that person in each of four out of the last six calendar months, engaged in buying and selling more than $25 billion of trading volume in government securities.
A person that is required to register as a dealer or government securities dealer under the new rules, would have one year from the effective date to comply. As compliance will involve both the registration with the SEC (Form BD) and membership with an SRO (FINRA), when the rule is effective, those affected should begin the process quickly.
Laura Anthony, Esq.
Anthony L.G., PLLC
A Corporate Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded public companies as well as private companies going public on the Nasdaq, NYSE American or over-the-counter market, such as the OTCQB and OTCQX. For more than two decades Anthony L.G., PLLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker-dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions, securities token offerings and initial coin offerings, Regulation A/A+ offerings, as well as registration statements on Forms S-1, S-3, S-8 and merger registrations on Form S-4; compliance with the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers; applications to and compliance with the corporate governance requirements of securities exchanges including Nasdaq and NYSE American; general corporate; and general contract and business transactions. Ms. Anthony and her firm represent both target and acquiring companies in merger and acquisition transactions, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. The ALG legal team assists Pubcos in complying with the requirements of federal and state securities laws and SROs such as FINRA for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the small-cap and middle market’s top source for industry news, and the producer and host of LawCast.com, Corporate Finance in Focus. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.
Ms. Anthony is a member of various professional organizations including the Crowdfunding Professional Association (CfPA), Palm Beach County Bar Association, the Florida Bar Association, the American Bar Association and the ABA committees on Federal Securities Regulations and Private Equity and Venture Capital. She is a supporter of several community charities including siting on the board of directors of the American Red Cross for Palm Beach and Martin Counties, and providing financial support to the Susan Komen Foundation, Opportunity, Inc., New Hope Charities, the Society of the Four Arts, the Norton Museum of Art, Palm Beach County Zoo Society, the Kravis Center for the Performing Arts and several others. She is also a financial and hands-on supporter of Palm Beach Day Academy, one of Palm Beach’s oldest and most respected educational institutions. She currently resides in Palm Beach with her husband and daughter.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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