In a big win for hedge funds and the crypto industry, on November 21, 2024, a Texas federal judge overturned the recent SEC rule that expanded the definition of “dealer” under the Exchange Act. For a review of the final rule see HERE.
The amendments were intended to require certain proprietary or principal traders and liquidity providers to register as either a dealer or government securities dealer as applicable. The rules amended 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.
In a legal challenge, the Crypto Freedom Alliance of Texas and Blockchain Association sued the SEC claiming that the rule amendments radically expanded the definition of a “dealer” in a way that could encompass digital asset industry participants (and hedge funds) that do not engage in any conduct resembling “dealing” as that term has ever been understood. The complaint continued to focus on the SEC attempting to expand the definition of a dealer beyond the traditional entities that have customers, to any entity that provides market liquidity.
The Plaintiff’s argued that the digital assets industry operates through a “novel trading model that allows peer-to-peer trading and direct access to market liquidity” without the need for dealer intermediaries. Digital asset trading operates using the blockchain and smart contracts in which participants can freely inspect, allowing a trader to know in advance exactly how and when a transaction will be executed and at what cost. To assure liquidity the industry created “liquidity pools” that crowdsource digital assets so that any user can trade a digital asset he or she holds for another asset available in the pool.” These liquidity pools utilize “software that automatically adjusts prices as the makeup of assets in the pools shifts.” As a result, users “no longer need to rely on dealers to quote prices, advise on trades, settle transactions, or take custody of assets.” Plaintiffs argued that “[a]lthough the software substitutes for a dealer in performing these functions, it is merely transparent, open-source, automated code, not a dealer itself.”
The Plaintiff’s asked for declaratory judgment finding that the new amendments are arbitrary, capricious and otherwise contrary to law, enjoining the SEC from enforcing the new rules and vacating and setting aside the new dealer rule in its entirety.
In granting summary judgment, the U.S. District Court for the Northern District of Texas, agreed with the Plaintiff’s. The Court found that the new expanded definition of “dealer” is an unlawful expansion of the SEC’s statutory authority and went well beyond the Exchange Act’s text including its definitions of “dealer” and “broker” as well as its trader exception.
In what could be a big win for the current plethora of family office investors being charged with unlicensed dealer activity, the Court found that the historical context and meaning of “dealer” is implicitly limited to the buying and selling of securities to “customers” and that the SEC’s expansion from this core component is fatal to the new rule. The court continued that the “business” of dealing has always included services offered to investors and not merely engaging in trading activities for a person’s own investing or trading objective.
Again, in what can be seen as a win for family office investors, the SEC based its argument on the Almagarby and Keener cases, which are two of the small cap family office investors that have faced enforcement actions by the SEC for unlicensed dealer activity. The SEC had wins in both of those cases, despite, what is clear to me, a misconception of the rules. In the Almagarby and Keener cases the courts found that the nature, volume, regularity and frequency of activity rendered each a “dealer.” Although the Texas court did not go so far as to state that the holdings in the Almagarby and Keener cases was clearly wrong, it did find them unconvincing as support for the new overly expansive dealer definition. The Texas court declined to delve too deep in the Almagarby and Keener cases but the fact that they are mentioned as “losing” arguments from the SEC lends hope for a complete turn of tide in this fight that began in 2017. I note that neither Almagarby nor Keener had customers or provided services to customers.
This is the third “win” for the small cap industry. In June 2024, the U.S. Supreme Court stuck down the Chevron doctrine which for decades had given required judges to defer to federal agencies’ interpretation of the law (see HERE). Chevron v. Natural Resources Defense Council (“Chevron”) held that a government agency must conform to any clear legislative statements when interpreting and applying a law, but courts will give the agency deference in ambiguous situations if its interpretation is reasonable. In Loper Bright Enterprises v. Raimondo and Relentless Inc. v. Department of Commerce (“Loper”) the U.S. Supreme Court overruled Chevron primarily on the grounds that it improperly shifted the balance of power away from the judicial branch. The Court found that deferring to federal agencies’ interpretations of law in rulemaking deprived the courts of its independent judgement.
Then, in August 2024, SEC Commissioner Mark T. Uyeda gave a statement regarding the ongoing SEC attack on the small cap industry through an expansive definition of “dealer” calling the SEC’s position arbitrary, void for vagueness, and discriminatory. Commissioner Uyeda relied on the Chevron demise in support of his position, among other factors (see HERE).
Refresh on SEC Rule Expanding Definition of “Dealer” and Small Cap Enforcement Proceedings
The new rules required any market participants that met specified activity levels to register as a dealer or government securities dealer, depending on the markets in which they trade. Notably, the rule did not encompass the many small-cap investors that are the subject of SEC enforcement proceedings for the failure to register as a dealer. To date, 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 that invest in exchange traded companies, but that do not meet the activity levels in the new rules, with legal uncertainty as to whether they are, or could be, operating as an unlicensed dealer.
The new rules excluded “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 rules. Registered investment companies were also excluded as they are already subject to robust regulations; however, registered investment advisors (RIAs) are not excluded.
Unfortunately for market participants, the SEC was 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 hedged, stating that “the final rules are one way to establish that a person is a dealer or government securities dealer; otherwise applicable court precedent and Commission interpretations will continue to apply.” To drive the point home, the final rule itself contains a provision stating that “no presumption shall arise that a person is not a dealer or government securities dealer solely because that person does not satisfy the standards of the final rules.”
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 amended rule (and the dealer litigation in the small-cap marketplace) focuses on defining a “regular business.” Prior to the rule amendment the Exchange Act did 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 adopted new 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 amended rules set forth qualitative standards designed to more specifically identify activities of certain market participants who assume dealer-like roles. Although the proposed rule also included and amendment to the definition of a “government securities dealer” to include a bright-line quantitative test where a person will be deemed a dealer regardless of whether they meet the qualitative standards, the SEC eliminated that provision from the final rule.
As mentioned above, persons that have or control total assets of less than $50 million are excluded from the new definition as are registered investment companies. 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.
Qualitative Standards
The final rule expanded upon the current definitions to include two types of activities that are considered to have the effect of providing liquidity to other market participants. In particular: (i) regularly 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 (“expressing trading interest factor”); or (ii) 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 (“primary revenue factor”).
“Own Account” Definition
The final rule revised the definition of “own account” to mean an account: (i) held in the name of that person; or (ii) held for the benefit of that person. In addition, to avoid the creation of multiple legal entities or accounts to avoid regulation, the SEC has adopted an anti-evasion provision that prohibits: : (1) engaging in activities indirectly that would satisfy the qualitative factors; or (2) disaggregating accounts.
Exclusion
The following were excluded from the new rules: (i) central banks; (ii) sovereign entities; (iii) international financial institutions; (iv) registered investment companies; and (v) persons that have or control less than $50 million in total assets.
The Author
Laura Anthony, Esq.
Founding Partner
Anthony, Linder & Cacomanolis
A Corporate and Securities Law Firm
Securities attorney Laura Anthony and her experienced legal team provide ongoing corporate counsel to small and mid-size private companies, 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, Linder & Cacomanolis, 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 ALC 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 the American Red Cross for Palm Beach and Martin Counties, 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.
Ms. Anthony is an honors graduate from Florida State University College of Law and has been practicing law since 1993.
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