SEC Expands the Definition of "Broker-Dealer" under the SEA

Steven Lofchie Commentary by Steven Lofchie

The SEC adopted two new rules under the Securities Exchange Act to further define the term "as a part of a regular business." The new rules expand the scope of firms that are required to register as broker-dealers and as government securities broker-dealers.

Under SEA Rule 3a5-4 the definition of "broker-dealer" and under SEA Rule 3a44-2 the definition of "government securities broker-dealer" apply to firms that are engaged in the buying and selling of securities and of government securities, respectively, "as a part of a regular business." By changing the definition of the phrase, "as a part of a regular business," the SEC amended the SEA to expand the activities that are deemed to be dealer activities and thereby the scope of firms that are required to be registered with the SEC.

As newly interpreted by the SEC, for purposes of Rule 3a5-4, the term "as a part of a regular business" means a firm "engaged in buying and selling securities that has the effect of providing liquidity to other[s]" by either:

  • quoting "at or near the best available prices on both sides of the market for the same security" if the quotes are "accessible to other market participants"; or
  • "earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer," or "capturing any incentives offered by trading venues to liquidity-supplying trading interest."

Rule 3a44-2 is identical except that the word "government" is added, so that a regular business refers to "buying and selling government securities . . . "

In the new rules, the SEC carved out from its expanded definitions the following categories of entities:

  • persons with less than $50 million in assets;
  • SEC-registered investment companies; and
  • central banks, sovereign entities and International financial institutions.

The new rules also contain an "anti-evasion principle," which states that no person shall "evade" registration by either:

  • engaging in activities that would "indirectly" result in registration; or
  • "disaggregating accounts."

The adopted rules dropped provisions contained in the original proposal, including provisions that would have required firms to register based on (i) the fact that they went flat in a security at the end of the day after trading or (ii) where firms exceeded certain volume limits with respect to transactions in government securities. The SEC also dropped from the proposal, requirements that would have required aggregation of trading activities conducted in affiliated entities that were acting wholly independently (e.g., investment funds with the same legal entity as investment adviser but with different owners of the funds, different portfolio managers and different trading strategies).

The effective date is 60 days after publication in the Federal Register. The compliance date is one year from the effective date.

The Commissioners adopted the Rules by a 3-2 margin. Commissioners Mark Uyeda and Hester M. Peirce dissented.


The version of these rules that was originally proposed by the SEC (i) extended the definition of "dealer" in ways that could not plausibly be justified (as the SEC admitted in the adopting release) and (ii) contained provisions for the aggregation of legally separate entities with different owners that were acting independently, which could not possibly be aggregated for purposes of registering as a dealer.  

The final rules are a substantial improvement.  Had these final rules been put forth as part of a proposal, and combined with a fulsome and convincing cost-benefit analysis, one might have said that the proposal was worthy of discussion, even if one was not ultimately persuaded by the justifications put forth by the SEC.  

Instead, given that the rules have been adopted, as has been the case with quite a number of the SEC's recent rule adoptions, this one seems materially vulnerable to judicial challenge for reasons of both statutory interpretation and under the Administrative Procedure Act. Here's why:

  • Given that the relevant provisions of the "dealer" definition have been in the SEA for 90 years, since 1934, one can be reasonably skeptical of the SEC reinterpreting that definition on the basis of a 3-2 vote; particularly where the SEC made arguments for an even greater expansion in the proposing release, claiming that it was well supported by precedent, but which it has since abandoned.  
  • The downsized version of the rules is materially different from the proposed versions, which means, among other things, that the original cost-benefit analysis is meaningless. 
  • Neither in the original proposal nor in the adopting release does the SEC's cost-benefit analysis take account of the costs of compliance with the net capital rule. This is a nearly astonishing omission; the cost of maintaining permanent capital is almost certainly, by far, the greatest cost of the requirement. The SEC's failure to take account of that cost simply vitiates the entire analysis.  
  • The scope of the revised rules is wholly ambiguous. For example, what does it mean to say that an entity may be a dealer by virtue of "buying at the bid and selling at the offer"? Shouldn't every purchase be at the bid and shouldn't every sale be at the offer? That is the whole purpose of the National Market System; that all trades take place at the best available bid and offer. If one does not buy at the bid and sell at the offer, that means that one is getting a worse price than is otherwise available in the market.  
  • For further detailed analysis of the benefits that the SEC argues will result from the rules, one should go to Commissioner Mark T. Uyeda's dissent or to that of Commissioner Hester M. Peirce.

It is also worth noting that the SEC's statement that firms engaged in cryptocurrency trading activities are potentially within the scope of the rules seems simply one more attempt to prohibit trading in cryptocurrencies through regulation by anxiety.  

Finally, the time given for the dealer registration requirement seems materially too short. It is not just a matter of firms having to register with the SEC. Assuming the firms do not reduce the scope of their business in order to avoid subjecting themselves to the new requirements, many firms will have to restructure their business substantially. For example, "non-dealer" activities should be located in a legal entity that is separate from dealer activities; non-U.S. activities should be located in a legal entity separate from U.S. activities; and funds that do not have permanent capital will have to completely revise their capital structure. Assuming it takes FINRA six months to review a completed broker-dealer application (which is optimistic given the volume of applications that would be required), this leaves firms very little time to restructure themselves and prepare an application for registration as a broker-dealer. And that does not even account for the significant lesser tasks that would be required (e.g., establishing clearing agreements, hiring additional personnel, having existing personnel take required examinations and so on).

More analysis of these rules will be coming soon. 

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