Updated Memorandum: SEC Expands Broker-Dealer Registration Requirement: The Rule, The Consequences, The Legal Questions

This memorandum has been updated from our February 2024 memo on the new Broker-Dealer Registration Requirement Rules.[1] The updated memorandum adds two Appendices: one a moderately detailed discussion of the application of the registration requirement to multi-strategy firms, and the other, a brief note on how to develop a compliance strategy. We have moved the summary of how to register as a broker-dealer into a third Appendix, so as not to break the continuity of the memo. 

In the prior memo, we hypothesized that the Rules would be the subject of regulatory challenge (not a daring prediction) and laid out some of the reasons why that challenge ought to be successful. Rather than recounting the potential legal deficiencies of the Rules, we largely refer back to our prior memo. In this memo, we also make mention of the two challenges and of two of the amicus briefs that have been filed, as well as Chairman Gensler's statements in defense or explanation of the Rules.

UPDATED MEMO - SEC Expands Broker-Dealer Registration Requirement: The Rules, The Consequences, The Legal Questions

The SEC has adopted two new rules ("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 Section 15 of the Securities Exchange Act of 1934 ("SEA") or as government securities broker-dealers pursuant to Section 15C of the SEA.[2]  The Rules were adopted by a 3-2 vote, with two dissenting Commissioners, Commissioner Mark T. Uyeda and Commissioner Hester M. Peirce, each issuing a statement that the Rules exceeded the SEC's authority under the SEA.[3]

Section I of this memorandum describes the scope of the new registration requirement. Section II provides a review of the key terms in the Rules, along with the SEC's explanation of those terms and our commentary on those explanations. The key takeaway from this discussion is that the Rule's defined terms, and thus the scope of the registration requirement, are materially ambiguous and in places inconsistent. Section III mentions the legal challenges 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 ("APA"), as well SEC Chair Gensler's statements in defense of the Rules. Section IV sets out the timetable for the Rules' implementation.

In Appendix A, we provide a moderately detailed discussion of the application of the Rules to multi-strategy firms or advisers.  Appendix B provides some limited (and we hope practical) advice as to compliance.  Finally, Appendix C to the memorandum 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.

1. The Rules

A. The Registration Requirement

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." [4]

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."[5] 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[6]:

• "[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"[7]; 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."[8]

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 from the Registration Requirement

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 Provisions

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

• engaging in activities that would "indirectly" result in registration; or
• "disaggregating accounts."[9]

The Release explains that evasive activity may include coordinating trading across commonly controlled entities to avoid falling within the scope of the rule.[10] 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[11]; 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.”[12]

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[13];

(b) whether a firm employs overlapping personnel across trading entities[14];

(c) whether there are separate account statements for each account[15];

(d) whether personnel with supervisory authority over multiple accounts have authority to execute trades or approve trading decisions for those accounts[16]; and

(e) whether there is a business purpose that shows that there is no coordinated buying and selling between accounts.[17]

Although the SEC has warned against evasive activity, there are nonetheless at least two circumstances in which firms will be as a practical matter required to restructure their activities in response to the Rules. The first is where the firm (or affiliated entities) is engaged in independent trading strategies but has not acted to monitor interaction between the trading strategies. In that case, the firm will likely wish to document the separateness of the trading strategies and perhaps to institute information or other barriers to demonstrate that dealer registration is not required. 

The second situation is where a firm conducts trading in one more strategy requiring dealer registration and other strategies that do not. In that case, the firm would likely want to separate out the dealer strategies and the non-dealer strategies into separate legal entities so that the non-dealer strategies are not burdened by the requirements that apply to registered dealers. 

2. SEC's Explanation of the Rules and Some Comments

As stated on page 2 of this memorandum, there are two activities that the SEC says may require dealer registration

• "[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"[18]; 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."[19]

The Release provides some explanation of the following key terms: "regularly"; "trading interest"; "accessible"; and "earning revenue primarily."  The following discussion is intended to review both how the SEC defined these terms and the fact that these terms are "defined" in way that are ambiguous, of uncertain (potentially limitless) scope, and in certain cases internally inconsistent.

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,"[20] but it does not require that the activity be carried on "continuously."[21] "One-off" activities are not considered to be regular, which would seem to be so obvious, on the one hand, as not to require stating; and also sets a very low bar as to what activities could be considered to be "regular."[22] 

In the Release, the SEC recounts that the original proposal had used the term "routinely," while the adopting Release and the Rules instead use the term "regularly." The SEC said that it made this change because commenters had complained that the term "routinely" would lead to “inconsistent interpretations.”[23] It is unclear why the SEC believed that a change in the word "routinely" to the word "regularly" brought clarity to the Rules. If the word "routinely" is unclear and subject to inconsistent interpretation, then the word 'regular' is equally unclear and subject to the same problems: six of one and half a dozen of another.[24]

As to the meaning of "regular," the SEC then goes on to identify firms that employ "automated, algorithmic trading strategies…" relying 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."[25]

But the SEC also says 'regular' means expressing trading interest "on both sides of the market both intraday and across days ..."[26] 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 of more interruptions or wider spreads for the best available prices."[27]

Expressing trading interest across trading days, with interruptions, and with wide spreads, seems quite a distance from a high frequency trading strategy. Yet in SEC Chair Gensler's remarks made after the Rules were adopted, he strongly implies that the Rules are intended to capture only high frequency trading firms.[28] Firms can draw some comfort from Chair Gensler's remarks, but they are not consistent with the words of the Rule and the accompanying Release.

In short, the term 'regular' is open to considerable interpretation and may vary based upon the type of 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. [29] The absence of any standard in the Release means that firms will just have to decide for themselves what it means for an activity to be “regular,” as further discussed in Appendix B. 

B. Trading Interest

According to the Release, the term "trading interest" is broader than the term "quotation."[30] "Trading interest" includes (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,"[31] 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."[32] 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."[33] In short, "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 results in conclusions that are counterintuitive. 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;

(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 one 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."[34] 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."[35]

The lack of clarity in the Release 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 or at least within a short period. Without attempting to defend the language or the explanation of the Release, both of which are problematic given how ambiguous they are, there is at least some support in the Release for the conclusion that the Rules do not reach all 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.)[36] At least for very 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. That said, what it would mean for activities to be near to simultaneous, for liquid securities, is in the eye (or the pocket watch, or perhaps the atomic watch) of the trader. Conversely, for illiquid securities, it seems that the Release establishes no standard at all for determining when a purchase and a sale of the same security are sufficiently separated.  Again, as set out in Appendix B, firms must use their own judgement in light of the securities that they trade.

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."[37] An offer to trade to a single person seems not to be "accessible"; however, an offer made to multiple persons (even if made to each of them individually) could be deemed accessible.

That definition of "accessible" is also quite problematic. How can an investor test for the best available price if any such testing with multiple potential counterparties may transform the firm into a "dealer?"

D. Primary Revenue

The fourth term concerns an entity's primary revenue, which may 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 has 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 that is 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.[38] 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.

3. Legal Challenges and Chair Gensler Statements

A. Challenges to the Rules

When we wrote the original version of this memorandum, we speculated that the Rules would very be the subject of legal change and we expressed our view that "[a]s with a number of the rules adopted and other actions taken by the SEC over the last few years, these Rules are 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 APA." We will not reiterate those arguments here, but simply refer back to our prior memorandum. While we will not repeat the arguments why the Rules should be rejected by the courts, we will list a few of the reasons why we think that should be the case:

• The SEC definition of dealer is inconsistent with historical understanding of the term.
• The various terms used by the SEC in its expanded definition are so open-ended that it is impossible to give them any agreed meaning.
• The SEC cost analysis is inadequate as it fails to take account of the costs of holding positions in securities other than U.S. governments (as to which the costs are trivial in comparison to positions in other instruments).
• The SEC cost analysis is inadequate in that its fails to account for the costs of converting an investment fund into a broker-dealer and for the costs of running a broker-dealer.
• The SEC analysis of benefits is on its face contrary to economic logic in that it assumes that imposing higher position costs on trading firms will encourage them to provide more liquidity in times of market disruption where common sense would indicate that it would motivate them to reduce their positions and take less risk.  

To date, at least two law suits have been brought: (i) one by several trade associations of private fund managers and private funds (the "Private Fund Complaint")[39] and (ii) one by two associations focused on the digital assets industry ("Digital Asset Complaint").[40] In addition, the Private Fund Complaint has been bolstered by at least two significant supporting amici briefs, one by the Committee on Capital Regulation and the other by the Futures Industry Association.        

B. Chair Gensler’s Remarks

In the face of criticism from his fellow Commissioners and in anticipation of legal challenges, SEC Chair Gensler’s statements in support of the Rules generally fall into two categories. 

The first category are remarks that are largely dismissive of objections. In this regard, Chair Gensler had the SEC produce a video called "Top Gun meets the Treasury Markets," in which he analogized the Rules to the movie Top Gun starring Tom Cruise, although in Chair Gensler's video Tom Cruise seemed to something of an out of control bad guy who rode a motorcycle with his mouth open and no helmet, which bad behavior is presumably in some way related to the narrow scope of existing dealer registration. While it is fine to say that the video is [41] just meant for retail public consumption, one also has to ask whether the video actually serves to inform the public of the relevant issues.

The other category into which Mr. Gensler's remarks fall is to play down the impact of the Rules. For example, he has quoted in various sources, including the Financial Times saying that hedge funds are not a target of the rule and that the rule is about "principal trading firms that dealer trade. That's what the Rule is principally about."  Mr. Gensler then suggests that there may be "some small number of hedge fund [ ] doing that. To my knowledge, that's not what they're doing as a regular business."  He then goes on to say that there might be up to 16 private funds, including hedge funds that would have to register. Finally, according to the Financial Times, he "emphasized that it was "up to" that figure."  As to Mr. Gensler's estimate, one wonders how he could make any estimate given the ambiguity of all of the definitions.   

Perhaps the forthcoming litigations will require the SEC to demonstrate how it produced both its estimates of costs and its projections of the number of firms that could be required to register in light of the uncertain scope of the defined terms in the Rules. If the SEC is called upon in court to defend the number of firms that it estimated would be required to register, it would not be surprising if the SEC were forced to concede that its estimate assumes that no firms would be required to register by reason of trading debt securities, foreign equities or cryptocurrencies. 

4. Effective Date.

The Rules became effective April 29, 2024.[42] The compliance date for the final rules will be on April 29, 2025.[43]

It seems unlikely, which is to say near impossible, 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 only exchange members to become FINRA members as well, the SEC allowed those firms a full year to accomplish that 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.

 

APPENDIX A

Application of the Registration Requirement to Multi-Strategy Firms

For multi-strategy firms and advisers, a question arises as to whether the factors (a)-(e) listed in Section I.C of this memo (page 4) can be used to demonstrate that multiple trading strategies that are under common control or in one legal entity (rather than in separate entities) can be shown to be independent.[44]

As explained below, the view that separate trading strategies may be conducted in the same legal entity without the requirement of aggregation under the Rules is consistent with the (i) SEC’s guidance on the separate account exemption from the prohibition on short sales during the Regulation M restricted period, (ii) SEC requirements for independent aggregation units under SEC Regulation SHO and (iii) FINRA requirements for preventing self-trades between different trading desks and algorithms. Each of these rules acknowledges that separate trading desks or algorithms may operate independently within the same legal entity.

In our view, firms should be able to treat trading desks or algorithms that pursue separate trading strategies as independent for purposes of the dealer definition subject to implementing appropriate safeguards to prevent coordination of trading between the trading desks or algorithms. This should be the case regardless of whether those trading desk are located in the same, or different, legal entities.  Further, we do not believe it to be the case that a firm must meet every factor identified by the SEC to demonstrate a distinction between trading strategies.  Rather, firms must consider the totality of the circumstances.

We review below three instances of regulatory guidance as to firms maintaining distinct trading strategies for regulatory purposes: (i) the SEC’s Regulation M, (ii) the SEC’s Regulation SHO and (iii) FINRA's guidance on self-trading.

1. SEC Guidance on Separate Account Exemption from Prohibition on Short Sales During Regulation M Restricted Period 

The factors considered by the SEC in determining whether accounts are independent for purposes of the dealer definition reflect SEC guidance in connection with the "separate account" exemption from the prohibition on short sales during the Regulation M restricted period. [45] The "separate account" exemption permits a person to purchase a security in a public offering in an account where the person sold short during the Rule 105 restricted period in a separate account, "if decisions regarding securities transactions for each account are made separately and without coordination of trading or cooperation among or between the accounts.”[46] 

For purposes of this exemption, the SEC considers accounts to be "separate and operating without coordination of trading or cooperation" if:

"(1) The accounts have separate and distinct investment and trading strategies and objectives;

(2) Personnel for each account do not coordinate trading among or between the accounts;

(3) Information barriers separate the accounts, and information about securities positions or investment decisions is not shared between accounts;

(4) Each account maintains a separate profit and loss statement;

(5) There is no allocation of securities between or among accounts; and

(6) Personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and account owners of multiple accounts, do not have authority to execute trades in individual securities in the accounts and in fact, do not execute trades in the accounts, and do not have the authority to pre-approve trading decisions for the accounts and in fact, do not pre-approve trading decisions for the accounts."[47]

The question is whether a firm must meet all of these conditions to fall within the separate account exemption, or if these are indicative factors to be viewed in light of all facts and circumstances.  While the SEC noted that implementing policies and procedures to ensure that these conditions are “fully implemented” would indicate that accounts are separate, the SEC noted that "[d]epending on the facts and circumstances, accounts not satisfying each of these conditions may nonetheless fall within the exception if the accounts are separate and operating without coordination of trading or cooperation."[48] For this purpose, firms may implement policies and trade reviews reasonably designed to confirm that accounts are operated separately, including “reviewing activities that are indicative of coordination between accounts and reviewing trading activity of a particular account that does not appear to be consistent with the stated strategy or objectives of such account.”[49]

The SEC noted that "accounts that have separate and distinct investment and trading strategies and personnel that are prohibited from coordinating trading between or among accounts would be considered to make separate decisions regarding securities transactions for purposes of Rule 105."[50] For this purpose, "…there can be no communication of securities positions, investment decisions or other trading matters between accounts."[51]  

The SEC specifically provided that "[a]n adviser that operates a black box using a trading algorithm," may rely on the separate account exemption under Regulation M "if the black box is separate from another black box or another trading unit."^[52]

2. SEC Guidance on Separation and Aggregation Under Regulation SHO 

The separate account exemption under Regulation M is based on the treatment of independent trading units under SEC Regulation SHO. [53]  Under Rule 200(f) of SEC Regulation SHO, a broker-dealer is required to aggregate all of the firm’s positions in an equity security to determine the firm’s net position unless trading desks within the firm operate as independent trading units. In this case, each independent trading unit may calculate its trading units positions in a security without regard to the positions of other independent trading units. 

A broker-dealer may treat a trading desk as an independent trading unit if:

(i) the broker-dealer has "a written plan of organization that identifies each aggregation unit, specifies its trading objective(s), and supports its independent identity.”  The written plan is required in order to show that each aggregation unit is “independent and engaged in separate trading strategies without regard to other trading units."[54] The independence of aggregation units may be evidenced by a variety of factors, including "separate management structures, location, business purpose, and profit and loss treatment."[55] 

(ii) each aggregation unit within the firm separately determines its net position for each security that it trades at the time of each sale;

(iii) all traders in an aggregation unit pursue only the particular trading strategy of that aggregation unit and "do not coordinate that strategy with any other aggregation unit"; and 

(iv) traders are only assigned to a single aggregation unit at any time.

3. FINRA Requirements for Preventing Self-Trades

Under FINRA Rule 5210.02, a broker-dealer is required to implement policies and procedures to review trading activity to prevent a pattern of "self-trades resulting from orders originating from a single algorithm or trading desk, or related algorithms or trading desks."[56] By contrast, "[t]ransactions resulting from orders that originate from unrelated algorithms or separate and distinct trading strategies within the same firm would generally be considered bona fide self-trades."[57] 

For this purpose, algorithms or trading strategies within the "most discrete unit of an effective system of internal controls" are presumed to be related.[58] This is because FINRA presumes that "multiple algorithms or trading desks within a discrete control unit would be permitted to communicate or would be under the supervision of the same people, and thus will be related."[59] However, FINRA acknowledges that firms have different supervisory structures, and permit a firm to rebut this presumption by demonstrating the independence of algorithms or trading desks even within a discrete unit of the firm. For example, a firm may implement information barriers between the algorithms or desks, assign different personnel with responsibility for managing or supervising the algorithms or desks, or demonstrate that the algorithms or desks operate independently from one another in other ways.[60] 

APPENDIX B

A Note on Compliance Testing

For firms that are concerned that they may fall within the dealer definition, and who wish to demonstrate that they do not, the question of how the firm may make such a demonstration does not have an obvious answer in light of the ambiguity of the SEC’s explanation of the significant terms of the Rules. For the most part, we do not believe that there is much benefit in attempting to decipher the terms that the SEC used based on the explanations in the Release in the hope of finding some commonly agreed meaning. Ask ten traders what “regularly” means in the context of securities trading, and it is not going to happen that one truth emerges. The difficulty of developing any exact meaning of the SEC’s Rules is illustrated by SEC Chair Gensler’s statements to the Financial Times, as it is not possible to reconcile those statements to the Rules or the Release.

Rather than attempting to parse out the SEC's meaning (you would have better luck with Ezra Pound's Cantos), firms should create their own definitions that are consistent with their understanding of these terms as they can be reasonably applied to the products in which the firm trades. Likewise, firms should consider which interactions between traders for different strategies ought not to require aggregation in light of the manner in which the firm trades. 

Having developed a set of definitions, that is appropriate to it, for the terms used in the Rules, firms should document the meanings that they have deduced and the reasons for those conclusions. Having thus establish what will be firm-specific requirements, firms must have a methodology to test whether their trading is consistent with that methodology, which is to say that it does not require registration as a dealer. If their trading crosses the lines of their own definitions, they must decide whether the deviations are too eccentric to be considered "regular," whether they need to re-evaluate their methodology, whether they need to further restrict their trading activities or their internal co-ordination, or whether they must in fact register.

Firms that must register may turn to Appendix C for a brief overview of what that entails.

APPENDIX C

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. 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.[61] 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. Practically speaking, this means that the firm will need to hire a FinOp to perform this function, at least initially.

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.[62] 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 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 and may have to supervise activities of representatives who perform services for other entities. 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 cannot be freely withdrawn. For any investment in a broker-dealer to be treated as equity, the investor cannot 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" 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.