February 14, 2024

Regulatory Intelligence Commentary: SEC Expands Broker-Dealer Registration Requirement: The Rule, The Consequences, The Legal Questions

The Securities and Exchange Commission adopted two new rules (the "Rules") requiring certain market participants that, in the words of the SEC, "play an increasingly significant liquidity providing role," to register with the SEC as broker-dealers pursuant to SEA Section 15 or as government securities broker-dealers pursuant to SEA Section 15C.[1] The Rules were adopted by a 3-2 vote of the Commissioners, with the two dissenting Commissioners, Mr. Uyeda and Ms. Peirce, each issuing a statement that the Rules exceeded the SEC’s authority under the SEA.[2]

Section I of this memorandum describes the plain language of the Rules; Section II provides a review of the SEC’s explanation of key terms in the Rules, along with commentary on those explanations. Section III highlights a number of the issues that will be most pressing for market participants who determine that they are required to register as either a dealer or a government securities dealer. Section IV, discusses the potential for a legal challenge to the Rules based on either (i) the Rules being beyond the SEC’s authority under the SEA , or (ii) the SEC’s process for adopting the Rules not complying with the requirements of the Administrative Procedures Act (the "APA"). Section V considers the SEC’s timetable for the Rules becoming effective.

I. The Rules

A. The Words

SEA Section 15 requires registration with the SEC of "dealers" as such term is defined in SEA Section 3(a)(5); SEA Section 15C requires registration of "government securities dealers" as such term is defined in SEA Section 3(a)(44). The new Rules expand the Section 15 and Section 15C registration requirements by purporting to expand the scope of the statutory definitions of the defined terms "dealer" and "government securities dealer."[3]

SEA Section 3(a)(5) 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 . . . but not as a part of a regular business." Newly adopted SEA Rule 3a5-4 defines the phrase "part of a regular business" to mean a firm "engage[d] in a regular pattern of buying and selling securities that has the effect of providing liquidity to other[s]" by the conduct of one of the following two activities:

"[r]egularly expressing trading interest that is 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
"[e]arning 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 as to the definition of "government securities dealer" refers to "buying and selling government securities . . . "

One question that has arisen is how the two types of activities differ. On the plain language, the first activity relates to transactions that result from persons expressing "trading interest"; i.e., "quoting" as very broadly defined by the SEC, and the second activity relates to entering into transactions. That is, an entity that only hit the bids and offers of others would seem to be outside of the first activity, but captured by the second.

B. Exclusions

The Rules exclude from their application the following entities:

any person that has or controls total assets of less than $50 million;
investment companies registered under the Investment Company Act of 1940; and
central banks, sovereign entities and an enumerated list of international financial institutions such as the World Bank.

C. Anti-Evasion

The Rules prohibit "evasion" of the dealer registration requirements by either:

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

The Release explains that evasive activity may include coordinating trading across commonly controlled entities to avoid falling within the scope of the rule. The Release provides the following examples of evasive action:

(i) a person conducts purchases in one entity and sales in another entity so that no one entity is expressing trading interest on both sides of the market; or

(ii) a person rotates purchases and sales of securities across several entities so that none of the entities trades frequently enough to constitute a "regular pattern of buying and selling securities."

The Release states that in determining whether trading activity may be considered evasive, the SEC may consider:

(a) whether a firm implements information barriers to prevent sharing of information between trading entities;

(b) whether a firm employs overlapping personnel across trading entities;

(d) whether personnel with supervisory authority over multiple accounts have authority to execute trades or approve trading decisions for those accounts; or

(e) whether there is a business purpose that shows that there is no coordinated buying and selling between accounts.

For multi-strategy firms, a question arises as to whether these factors can be used to demonstrate that trading in one legal entity (rather than in separate entities) by two different desks or legal strategies are also genuinely independent. Although the Release does not address this situation specifically, in our view there is no reason why the SEC should distinguish between two trading strategies conducted in different but affiliated entities and the same strategies conducted in the same entity. In either case, there will be a burden on the relevant entity or affiliated entities to prove that the two strategies are, in fact, distinct.

We also note that the Release does recognize the fact that legal entities may need to be restructured (which we agree is likely) if they would become subject to the Rules. The Rules recognize that such a restructuring would not constitute evasion.

II. SEC’s Explanation of the Rules and Some Comments

The heart of the SEC’s explanation of its interpretation of the dealer definitions is that "the frequency and nature of a person’s trading" means that the person is "liquidity-providing," and that such liquidity providing constitutes "market-making," which is understood to be a dealer activity. According to the SEC, if a firm engages in either of the two activities set out in the Rule, the firm would be "liquidity-providing," and thus a dealer.

As to the two activities, the Release provides some explanation of the following key terms: "regularly"; "trading interest"; "accessible"; and "earning revenue primarily".

A. Regularly.

The Release speaks at some length as to the term "regularly" expressing trading interest. According to the SEC, the term "regularly" implies having a greater frequency than "isolated or sporadic," but it does not require that the activity be carried on "continuously." On the positive side, "one-off" activities are not considered to be regular.

The SEC then goes on identify firms that employ "automated, algorithmic trading strategies... rely[ing] on "high frequency trading strategies to generate a large volume of orders and transactions . . ." Such trading strategies include firms that submit "non-marketable resting orders."

But the SEC also says "regular" means expressing trading interest "on both sides of the market both intraday and across days . . ." For example, the Release states "if the market for a security is less liquid, and it is difficult to execute orders in that security or large orders can dramatically affect the price of the security, the term 'regular' would account for the possibility or more interruptions or wider spreads for the best available prices." Expressing trading interest on both sides of the market across trading days, and with interruptions, seems quite a distance from a "high frequency trading strategy." In short, the term "regular" is open to considerable interpretation, particularly as it may vary based upon the type of security and could change over time based upon the changing trading characteristics of the security. At least as to illiquid securities, the Release seems to set no clear standard at all as to what it means for an activity to be regular. [4]

B. Trading Interest.

According to the Release, the term "trading interest" is broader than the term "quotation." The Release defines "trading interest" as including (i) an "order" as defined in SEA Rule 3b-16(c), meaning "any firm indication of a willingness to buy or sell a security, as either principal or agent, including any bid or offer quotation, market order, limit order, or other priced order," and (ii) "any non-firm indication of a willingness to buy or sell a security that identifies the security and at least one of the following: quantity, direction (buy or sell), or price." The SEC also says that the term "trading interest" refers to "standing ready to trade on both sides of the market on the same security on a regular ongoing basis." In short, the explanation is a bit of a mess. "Trading interest" may be firm or not firm; it may be one side of the market or both.

If one takes the SEC at its word that the term "trading interest" includes any indication of a willingness to trade a security that identifies the security and at least one of the "quantity, direction or price" of the statement, it would result in conclusions that seem surprising. Compare these two examples:

(i) "I am open to trading in Security X," would not be expressing trading interest because there is not a firm order and none of quantity, direction or price has been indicated, even though the phrasing suggests that the speaker could be on either side of the market; but

(ii) "I am interested in buying Security X; what price will you give me" would be expressing trading interest that could render the speaker a dealer, even though the speaker is only on side of the market, and has not indicated either price or quantity.

Then the Release goes on to say that requesting quotes on both sides of the market as to a security would not be an expression of trading interest because that trading interest would not be "at or near the best available price." This example is inconsistent with the Releases statement that expressing direction brings a firm within the scope of the term "trading interest." The Release then attempts to narrow the definition of "trading interest" by making clear that, at least over some time period, the expression of interest must be on both sides of the market and must be "at or near the best available price." [5]

The lack of clarity in the Release as to the first activity has resulted in an understandable concern that the SEC is trying to reach any strategy that involves both buying and selling during the same day. Without attempting to defend the language or the explanation of the Release, both of which are problematic given how ambiguous they are, we do not think that the SEC is trying to reach strategies that may involve both buying and selling in the same day. For example, in discussing the concept of evasion, the Release says that a firm would be acting in an evasive manner if it were to "express trading interest to buy and sell in alternate moments in time . . ." [Emphasis added.] At least for liquid securities, this language implies that the first activity would only be in scope if the bids and offers were, if not simultaneous, at least near to simultaneous.

C. Accessible to Other Market Participants.

The Release says that the means by which "trading interest" is expressed is not relevant: "trading interest" may be expressed through the "use of streaming quotes, requests of quotes ("RFQs"), or order books." An offer to trade to a single person seems not to be "accessible"; however, a offer made to multiple persons (even if made to each of them individually) could be deemed accessible.

D. Primary Revenue.

The fourth term concerns an entity’s primary revenue: it must be derived from some combination of (i) trading at the bid-offer spread and (ii) capturing any incentives offered by trading venues to liquidity-supplying trading interest.

Before going on to discuss the determination of revenue, we also note that any trading must be by "buying at the bid and selling at the offer." It is not obvious that this supposedly limiting phrase as any substantive content, as presumably any purchase is at the bid and any sale is at the offer.

The calculation is a "revenue" test, not a profit test. It is not clear what this means in the context of buying and selling a security. Does it mean the total amount that the firm made in selling securities? It doesn’t seem what the SEC intended; if it was what the SEC intended then there is no reason for the reference to purchases. It is also inconsistent with the statement that dealers make revenue "through bid-ask spreads." Further, in discussing the comments that the SEC received on the Proposal, the SEC noted that "capturing bid-ask spreads" was an indicator of dealer activity. Given that the SEC was explicit that it was not referring to "profit," we could guess that the SEC is defining "revenue" as "profit" made on bid-ask spreads without regard to any factor other than transaction costs; e.g., without regard to personnel or technology costs. But there is no explicit definition of the term revenue.

As to the definition of the term "primarily," the SEC noted that it had not "established a bright-line test," but indicated that if a person derived a "majority of its revenue" from the specified sources, that would "likely" satisfy that definition of primarily. Notably, the Rules apply the "primarily" test at the level of the "person." This means that whether a person is a dealer under this test would depend not only on the specific activity being conducted, but also on other activities conducted by such person. Thus, in the case of two persons engaged in trading at the spread and earning the same revenue, one might be a dealer and the other not, depending on the extent of each person’s revenue from other activities.

III. What Will Be Required of Firms Required to Register

The Release assumes that the firms required to register will be proprietary trading firms and hedge funds, presumably largely based in the United States.[6] There is not necessarily a hard and fast line between the two types of entities, so the information below will be generally relevant to either type of entity that is engaged in activities that would require it to register as a dealer.

A. Restructuring.

To only slightly overstate the point, there is very little reason for a securities dealer to own any assets other than securities. Even as to securities positions, it should only own those securities that are part of its dealing business. Further, to the extent that a firm conducts activities that may be considered dealing in U.S. securities from within the United States and activities that may be considered dealing in non-U.S. securities from outside the United States, the U.S. dealer activities should be separated off from the non-U.S. activities.

It is common for dealers of any scale to operate under a holding company structure under which the holding company owns the broker-dealer and perhaps other firms that are engaged in financial activities. The holding company or a subsidiary of the holding company may hold the technology or other assets required by the dealer, and lease those assets to the dealer.

B. Dealer Registration Process.

Firms that are required to register with the SEC as dealers will be required to become members of the Financial Industry Regulatory Authority ("FINRA"). For this purpose, firms will be required to complete and submit FINRA Form NMA, a lengthy membership application form that requires firms to address how they will meet their regulatory requirements under the SEC and FINRA Rules and provide supporting documentation (e.g., written compliance and supervisory procedures).

Form NMA Preparation: Firms that have not previously been registered with the SEC in any capacity will likely require at least 3-5 months to prepare the application and supporting documentation. Firms that have been registered (or whose affiliate) with the SEC as an investment adviser may require less time to prepare the application, though the FINRA application process is significantly more involved that Form ADV filings.

Compliance and Supervisory Procedures: Broker-dealers are required to adopt and implement written compliance and supervisory procedures reasonably designed to achieve compliance with applicable regulatory requirements. Firms registering as securities dealers will be required to adopt compliance and supervisory procedures tailored to their securities activities, and submit these procedures to FINRA as part of the membership application.

FINRA Review Process: FINRA has six months to review the application from the time FINRA deems the application substantially complete (subject to additional extensions of time). During the review period, FINRA submits requests for additional information and, typically towards the end of the review process, conducts a membership interview with firm personnel .[7] In light of the one year compliance date for the new dealer rule, firms will be under considerable time pressure to determine whether they fall within scope of the dealer registration, and complete the FINRA membership application process. (As discussed below, the one year time period for completion of registration by numerous firms is not realistic.)

C. Broker-Dealer Officers.

Broker-dealers are required to appoint specified officers to supervise the firm’s securities activities, including a CEO, CCO, and Financial and Operations Principal ("FinOp") responsible for compliance with net capital and financial reporting requirements. The role of FinOP in particular is a specialized function that requires knowledge of the SEC and FINRA regulations governing broker-dealer capital and financial reporting requirements. An unregulated firm’s CFO, who does not have broker-dealer experience, will not possess the requisite knowledge to fulfill this function without additional training.

D. Employee Registration and Qualification.

Individuals involved in the management, supervision or conduct of securities activities on behalf of a broker-dealer are required to register with FINRA and pass FINRA examinations. Personnel conducting securities activities for entities required to register as dealers will be required to pass the required FINRA exams.[8] As a general matter, employees will require a meaningful amount of study time to pass the exams.

E. Broker-Dealers Are Not Run By Advisers.

In the case of a fund, the adviser making trading decisions and the fund that is buying and selling are wholly legally distinct entities. The persons who make the trading decisions are the employees of the adviser, not of the fund.

That is not the way it works for broker-dealers. The persons making decisions on for a broker-dealer must be "associated persons" of the broker-dealer, acting directly for the broker-dealer, not for an adviser. Where an individual makes trading decisions on behalf of both a broker-dealer and other funds, the individual will have to be "dual-hatted" as working for both the broker-dealer and the adviser that manages the funds. Entities will have to give a good deal of careful consideration as to how this structure will work, particularly as a broker-dealer is responsible for payment of any compensation to its personnel for securities-related activities. Thus, if a fund registers as a broker-dealer, the fund (not the investment adviser) should be responsible for payment of securities-related compensation to the fund’s trading personnel. In short, firms will need to consider both the legal structure under which employees operate and how they are to be paid.

F. Permanent Capital.

Broker-dealers are required to have capital that can not be freely withdrawn. For any investment in a broker-dealer to be treated as equity, the investor can not have a right to withdraw the capital for at least a year. Further equity can not be withdrawn if as a result the broker-dealer would be subject to a capital deficiency. This means that entities that provide investors with withdrawal rights will have to completely redo their capital structures.

G. Capital Charges.

Entities required to register as dealers will be subject to significant capital charges on their securities positions. We address this issue in part IV of this memorandum.

H. Financial Reporting.

Broker-dealers are subject to significant financial reporting requirements, including filing FOCUS reports each month or quarter (depending on the firm’s business), and annual audited financials (subject to limited exemptions). As noted above in regard to the duties of the FinOp, the computation of broker-dealer capital is a complicated, specialized tasks that takes GAAP as a starting point and adds substantial complexity.

I. Trade Reporting.

Broker-dealers must comply with SEC and FINRA trade reporting requirements, including reporting (i) transactions in NMS securities (i.e., exchange-listed equity securities and options) and OTC equity securities to the Consolidated Audit Trail ("CAT"), and (ii) transactions in debt securities to FINRA’s Trade Reporting and Compliance Engine ("TRACE"). Entities that are required to register as dealers will need to address operational requirements to meet these requirements, including entering into agreements with service providers.

J. Recordkeeping.

Broker-dealers are subject to significant recordkeeping requirements, which include maintaining specific records relating to all aspects of the firm’s securities business, including trading activities, financial and employee records. In addition, a broker-dealer is required to maintain all communications sent or received by the firm "relating to its business as such." The scope of records that a broker-dealer is required to maintain is significantly broader than the records required to be maintained by an investment adviser, particularly in connection with the scope of communications that must be retained by a broker-dealer.

IV. Legal Challenge

As with a number of the rules adopted and other actions taken by the SEC over the last few years, these Rules could be vulnerable to legal challenge, either on the grounds that they go beyond the SEC’s authority under the SEA or on the grounds that they were adopted in a manner that is inconsistent with the requirements of the Administrative Procedures Act (the "APA").

The following discussion of these issues is intended to simply suggest some directions that a legal challenge might take, rather than in any way to predict how a court would eventually rule. We also note that some of the discussion that follows is based on the Peirce Dissent and the Uyeda Dissent cited above.

A. Statutory Basis.

i. SEC Authority. The Release states, at page 5, "Under the Exchange Act, the SEC has the authority to define the terms used in the statutory definitions of 'dealer' and 'government securities dealer.'" The Release repeats its assertion at page 16 in regard to a challenge as to whether the SEC was exceeding its statutory authority.

Notwithstanding the bluntness of this assertion, the statute does not provide the SEC with the definitional authority that it claims.

SEA Section 3, which is the statutory section containing all of the definitions, begins by stating, "When used in this chapter, unless the context otherwise requires [terms have the following meaning]." There is nothing in SEA Section 3 which gives the SEC a general authority to reinterpret (or expand) definitions. Nor does SEA Section 4, which sets out the general powers of the SEC, provide such a definitional power.

The SEC’s general claim of definitional authority is also undermined by the fact that there are actually definitions in the SEA where the statute gives the SEC some specific authority; e.g., (i) Section 3(a)(3(A), with respect to the definition of a "member"; (ii) Section 3(a)(11), with respect to the definition of an "equity security"; (iii) Section 3(a)(27), with respect to the "rules of an exchange."

There is no reason that the SEC would have been given specific authority to define the terms referenced above if it in fact had a general authority to reinterpret all definitions.

We also observe that SEA Section 36 gives the SEC "general exemptive authority." [Emphasis added.] There is no parallel authority to expand the scope of the SEA.

ii. Best Interpretation. If the SEC does not have statutory authority to expand the scope of the definitions in the SEA, then the question becomes whether the SEC’s interpretation of the statute is reasonable and consistent with precedent.

Since at least 1986 when the Government Securities Act was adopted, the SEC staff has published a laundry list of activities that are deemed to be those of a "dealer." Those lists do not include the provision of liquidity. This would at least suggest that the SEC may be expanding the definition of a dealer beyond its historical meaning.

The SEC makes two assertions to overcome this concern. The first is the assertion that Congress in 1934 intended for the dealer definition to be broadly interpreted. However, the SEA does not say that; it just says that the following terms have the meanings given them. Beyond that, the statement that the dealer definition is meant to be broadly interpreted is not obvious. In fact, a principal point made by the Peirce Dissent is that the dealer definition is intended to be narrowly interpreted. In the words of the Peirce Dissent:

[the SEC’s broad reading of the dealer definition] "produces absurdities. The adopting release acknowledges that the market participants that will be forced to register under the final rule may not have any characteristics of dealers under the current rule. Instead, simply executing any of a number of common trading, investing and risk management strategies could turn a market participant into a dealer . . . "

The other argument that the SEC makes is that the regulation of dealers is very important to the securities markets. That is certainly true. However, it is not actually relevant to the question of what the definition of "dealer" means and whether the SEC has the authority to expand the definition.

iii. Reasons for a Fresh Look. There are some other reasons to treat the SEC’s new interpretation of the term "dealer" with a jaundiced eye.

For example, as we will discuss again in reference to the APA discussion, in its Proposal, the SEC asserted with equal confidence and by reference to supposedly long-standing interpretation, that an entity could be judged a dealer either on the basis of its volume of trading or on the fact that it engaged in day trading or even on the fact that the entity engaged in "aggressive trading strategies, including structural or directional trading . . ." These interpretations of the dealer definition were so very far outside of any reasonable legal support that the SEC actually abandoned them in the Release. But having made these very expansive statutory assertions, even if it has now abandoned them, the SEC now has made it appropriate to regard its interpretations as ones that should not be taken without question.

Of far greater significance, both of the dissenting SEC Commissioners issued statements that the Rules exceeded the SEC’s authority under the SEA.

The dissent of Commissioner Uyeda provides:

The Commission’s effort to classify nearly any person who buys and sells securities as a "dealer" under the [SEA] extends beyond its statutory authority. The lack of any limiting principle creates the potential for arbitrary and capricious government action.

The dissent of Commissioner Peirce provides:

The rule defines dealer in a way that is inconsistent with the statutory framework. . .This rule turns traders, many of whom are customers, into dealers. Doing so runs counter to the statute, as the Commission and market participants have read it for decades.

1. Administrative Procedures Act.

Leaving the question of whether Rules are wholly outside the statutory bounds of the SEA, we turn to the question of whether the Rules were properly adopted.

1. Need for Reproposal. It is considered appropriate practice for an agency to repropose a rule, before adoption, when changes have been made that significantly alter the substance or the impact of the rule. In the current instances, the Rules have been very significantly shrunk down in their scope. This means, among other things, that the cost-benefit analysis contained in the Proposal is inherently deficient. Assuming that there were benefits by expanding the scope of the registration requirement, these benefits must be much less than anticipated.

Now it may be argued that this general rule should not apply on the current facts because the Rules are so much reduced from the Proposal. Therefore, market participants have had a chance to comment on the full scope of the Rules. While that may sound true in theory, it is not in practice.

To take a real-world example, one of the authors of this memorandum was the principal author of the letter submitted by Fried Frank on behalf of certain funds.[9] Although the Lofchie Letter is fairly lengthy, much of it was devoted to places where the SEC had obviously over-extended its statutory authority; e.g, by basing dealer status on the quantity of trading that a firm did. In fact, the SEC, in the Release adopting the Rules, retreated from its position on a number of the challenges raised by the Lofchie Letter and by numerous other commenters. However, because certain problems created by the original Proposal issues were so major and so egregious, it was simply not possible to comment on every aspect of the Proposal. Therefore, at least in the case of the Lofchie Letter, and doubtless in the case of many other comments, there was limited attention focused on a parsing of specific language. The comments were focused on the most significant deviations from the terms of the SEA.

In a prior commentary on another newly adopted SEC Rule, Why Comment Periods Matter: The SEC Rulemaking on Securities Loans,[10] Mr. Lofchie explained how the SEC’s failure to repropose after a very significant revision of the adopted rule from the proposal had resulted in a number of significant problems with the language in the rule as adopted. The same is true here. For example, as discussed above, the SEC’s explanation of the term "trading interest" is internally inconsistent. [11]

2. Analysis of Costs. We have been told by broker-dealers already registered with the SEC (who thus have little skin in the game as the Rules do not impact their status) that the SEC underestimated operational costs (such as TRACE reporting) by several factors. That said, as outside lawyers, it is not generally practical for us to assess operational costs. But we are able to make some assessment of capital and funding costs because these are either driven by SEC Rules or are in agreements as to which we may participate in negotiation.

As stated in the Release, compliance with "the Net Capital Rule may require additional capital. . . . For example, less liquid investments are subject to greater haircuts (see below) and will require more capital." The SEC then goes on to say that "[c]rypto assets that are not securities would be subject to a 100% deduction when computing net capital"; i.e. a firm holding $1 million dollars of bitcoin (in fact, of any cryptocurrency) would be deemed to have $0 net capital. But it is not just cryptocurrencies that have no value for net capital purposes. Many illiquid securities and non-U.S. securities have no value, or little value, for capital purposes. Requiring firms to take huge capital charges with respect to transactions now deemed to be dealing in such securities can not but significantly discourage trading activity in these securities.

There is simply no meaningful discussion of these major costs in the Release. In fact, the most detailed discussion of capital costs is with respect to certain positions in U.S. Treasuries (see page 174 of the Release) where the SEC concludes that many of the positions would have no net capital charge whatsoever. Ironically, it is not even obvious that these positions are dealing positions, since they are arbitrages of different positions. What is more troubling is that the SEC does not put forth any similarly detailed discussion of the impact of its Rules on illiquid positions where the net capital costs would not be zero; in fact, they would be in many cases equal to the total value of the position.

3. Restructuring of Legal Entities. Another major cost that the SEC largely dismisses is that firms that become subject to the Rules will be required to restructure their legal entities and to completely redo the manner in which they fund themselves. As a practical matter, positions that may be considered "dealing" positions may have to be isolated in a vehicle separate from non-dealing positions so as to avoid, among other things, becoming subject to the net capital and other costs of the dealing positions. Similarly, if the firm has what could be considered dealing positions in non-U.S. securities that may be managed from outside the United States, it will want to separate out those positions from its U.S. dealing positions. The terms that investors may want in order to put money into a securities dealer that must restrict withdrawals of capital are not the same terms as those that they may require for a hedge fund that allows for periodic redemptions. Accordingly, firms required to register will require new offering documents that describe the additional legal burdens that fall on investors in a broker-dealer.

4. Not all Securities Are Like. The SEC’s expansion of the dealer definitions is intended to be comprehensive in terms of the types of securities to which it refers--that is, it applies equally to U.S. government securities, listed equities, illiquid debt and cryptocurrencies (assuming for purposes of this memo that cryptos are securities). However, the cost-benefit analysis is quite different for each of these types of securities.

To start with costs, the net capital charges of holding a position in U.S. government securities may be close to zero (according to the SEC’s analysis beginning on page 174). By contrast, the net capital cost of holding a position in an illiquid debt security may be 100% of the value of the position. A cost-benefit analysis that makes no distinction between the two type of positions, or that concentrates its analysis on the net capital charge of holding the Treasury positions is not conducting the required analysis.

Turning to benefits, there is the same problem. According to the SEC, one of the benefits of the expanded dealer registration is that the SEC would receive more detailed trade reports. However, there is no trade reporting system in place for cryptocurrencies, so the SEC’s claim of benefits simply is not relevant.

To put costs and benefits together, for cryptocurrencies the costs are perhaps 50x higher than for US. Treasuries and the trade reporting benefits are non-existent.

a. What About the Benefits? The Release identifies a number of benefits that may be provided by the Rules. Below we list a number of them and provide some observations as to why these may not be significant:

a. More Oversight. The Release states that subjecting more "market participants to dealer requirements will thus enable oversight by regulators . . ." As a starting matter, the purpose of dealer registration is not to ease the job of the SEC. In her dissent, Commissioner Peirce commented that a "clear-eyed view takes into account the costs of such comprehensive oversight," and indicated that she believed that such costs were inconsistent with the "healthy, dynamic function of the market . . ."

b. Reducing Errors in Algorithms. The Release states that "SRO supervision may also reduce the risks that [result from] errors in algorithms . . ." This seems to suggest that the SROs review code and look for errors, which is not the case.

c. Protecting Unsubordinated Creditors. The Release states "[i]n the event that a significant liquidity provider fails, the Net Capital Rule will ensure that it has sufficient liquid assets to meet all its liabilities to unsubordinated creditors." The types of firms that could be required to register as dealers do not have "customers" to be protected. It is not the purpose of the Net Capital Rule to protect unsubordinated creditors. To take as an example the most recent high-profile failure of a broker-dealer, unsecured creditors of Lehman Brothers were certainly not made whole.

d. Trading During Market Disruptions. The Release states that "[m]arkets in which significant liquidity providers are required to hold some amount of liquid assets and face constraints on leverage may be less sensitive to sudden market disruptions that could otherwise reduce their capacity to provide liquidity." This actually seems counter-intuitive. If a firm is required to maintain a certain amount of net capital at all times, it would seem that the firm should become more risk-averse and withdraw from the markets sooner, lest it fail its net capital requirements. The Peirce Dissent reaches the same conclusion: "By penalizing trading and investing strategies that have the effect of providing liquidity to the markets, the rule will dampen liquidity provision . . . [which will make] the market more fragile."

V. Effective Date.

The Rules are to become effective 60 days following the date of publication of the adopting release in the Federal Register. The compliance date for the final rules will be one year after the effective date of the final rules.

It seems unlikely that this time table can be met by hedge funds or other entities that must restructure their businesses and investment terms. If one assumes that FINRA will generally require six months to approve an application that is completed in near final form, that leaves firms only a bit more than six months to restructure themselves and to demonstrate that they are able to comply with the regulatory requirements.

By way of contrast, when the SEC amended Rule 15b9-1 to require certain registered broker-dealers that were not FINRA members to become FINRA members, the SEC allowed those firms a full year to become FINRA members even though: (i) they were already SEC-registered broker-dealers, so any additional requirements should have been fairly light; (ii) their businesses must have been quite simple as the pre-existing exemption from FINRA membership is very narrow; and (iii) the SEC subsequently provided for a simplified path to FINRA member. If one year is to be allowed for existing broker-dealer to join FINRA, it does not seem reasonable to believe that firms that may have to restructure their legal entities, their activities and their employment structures, and are not already registered, to also achieve all of that in one year.

Steven Lofchie	917-597-7295
Mark Highman	929-378-0326

[1] See SEC Release 34-99477 (Feb. 6, 2024) (the "Release"). The Rules, in very different form, were originally proposed in March of 2022, See SEC Release 34-94524 (Mar. 28. 2022), 87 Fed. Reg. 23054 (Apr. 18, 2022) (the "Proposal").

[2] See Dealer, No Dealer at https://www.sec.gov/news/statement/peirce-statement-dealer-trader-020624 (the "Peirce Dissent");

Statement on Further Definition of "as a Part of a Regular Business" in the Definition of Dealer at https://www.sec.gov/news/statement/uyeda-statement-dealer-trader-020624 (the "Uyeda Dissent").

[3] SEA Section 15 does not apply to "exempted securities," which for this purpose includes U.S. government securities. As Section 15 does not apply to U.S. government securities, the SEC adopted parallel amendments to both the dealer definition and the government securities dealer definition.

[4] We also note that the Release’s statement that in the case of illiquid securities, there may be wider spreads does not seem to be particularly meaningful, one way or the other. The Rules, as adopted, refer to the "best available prices."

[5] This last condition also seems an odd one: is the Commission saying that quoting bad prices that are far from the market means that one is not a dealer?

[6] We note that the Rules do have potential applicability to foreign entities and foreign activities as well. For purposes of this memorandum, we will focus on the types of entities and activities that are the subject of the SEC’s immediate attention.

[7] The Release notes "FINRA’s expressed commitment to expedite the application process." See Release, text at fn. 339.

[8] Relevant examinations for dealer personnel will likely include the Series 7 (General Securities Representative Exam), Series 57 (Securities Trader Representative Exam) and, for supervisory personnel, the Series 24 (General Securities Principal Exam)

[9] The comment letter is on the SEC website at https://www.sec.gov/comments/s7-12-22/s71222-20129927-296182.pdf (the "Lofchie Letter").

[10] https://www.findknowdo.com/us-federal/law-firms/law-firm-analysis/regulatory-intelligence-commentary-why-comment-periods-matter-sec-rulemaking-securities-loans

[11] In the very recent case of Chamber of Commerce v. SEC, the Fifth Circuit found that the SEC’s justification for adopting amendments to SEA Rule 10b-18 (regarding issuer repurchases) did not pass muster because the "SEC’s theory is internally contradictory." It seems at least as problematic that the SEC’s explanation of a rule term is internally contradictory.

Regulatory Intelligence Commentary: SEC Expands Broker-Dealer Registration Requirement: The Rule, The Consequences, The Legal Questions

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