US SEC Adopts Rules on Definitions of “Dealer” and “Government Securities Dealer”: Focus on Investment Advisers and Investment Companies

On February 6, 2024, the Securities and Exchange Commission (SEC) adopted Rules 3a5-4 and 3a44-2 under the Securities Exchange Act of 1934 (Exchange Act), which significantly expand the definitions of “dealer” and “government securities dealer” to cover additional market participants engaged in liquidity-providing activities.¹ This Legal Update focuses on the potential impact of the rules specifically on investment advisers² and investment companies.³ The rules have an effective date of April 29, 2024, and a compliance deadline of May 29, 2025.

Brief Background

The Exchange Act defines “dealer” as “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise,” subject to certain exceptions, one of which is known as the “trader” exception. This exception carves out from the term “dealer” a person that “buys

or sells securities … for such person’s own account, either individually or in a fiduciary capacity, but not as a part of a regular business.” The Exchange Act similarly requires a person to register as a government securities dealer only if the person buys and sells government securities for its own account “as a part of a regular business.”

The rules provide a new qualitative standard for determining what it means for a person’s securities activities to be conducted “as a part of a regular business.” Specifically, under the rules, a person is engaged in buying and selling securities or government securities⁴ for its own account “as part of a regular business” if it engages in a “regular” pattern of buying and selling securities or government securities that has the effect of providing liquidity to other market participants by either:

• Regularly expressing trading interest that is at or near the best available prices on both sides of the market for the same security and that is communicated and represented in a way that makes it accessible to other market participants (Trading Interest Element);

OR

• Earning revenue primarily from capturing bid-ask spreads, by buying at the bid and selling at the offer, or from capturing any incentives offered by trading venues to liquidity-supplying trading interests (Revenue Element).

There are exclusions, however, for the following:

• A person that has or controls total assets of less than $50 million;⁵

• An investment company registered under the 1940 Act (Registered Fund); and

• A central bank, sovereign entity, or international financial institution.⁶

It is important to bear in mind that just because a person is excluded from or otherwise not covered by the rules does not necessarily mean that the person is not a dealer or government securities dealer as those terms are defined in the Exchange Act. Existing judicial precedent and SEC interpretations will continue to apply.

By adopting the rules, the SEC sought to:

• Obtain a more comprehensive view of the markets through regulatory oversight of a broader scope of market participants;

• Support market stability and resiliency and better protect investors; and

• Promote competition among entities that regularly provide significant liquidity to the markets and otherwise level the competitive playing field among market participants.

Focus on Investment Companies

Registered Funds

As mentioned above, Registered Funds are specifically excluded, the regulatory rationale being that such funds are already subject to restrictions on leverage and other comprehensive regulatory requirements under the 1940 Act. The Adopting Release, and the rules themselves, are silent on the treatment of an entity that has elected to be regulated as a “business development company.”⁷

Private Funds

The SEC specifically declined to exclude private funds.⁸ The SEC advised that, depending on the totality of the facts, a private fund may be engaged in the business of buying and selling securities for its own account, citing a 2021 administrative proceeding against hedge fund managers that were found to have caused the fund’s violation of Section 15(a) of the Exchange Act.⁹ However, the SEC expects that only a limited number of private funds will be affected by the rules, referencing its economic analysis. In this analysis, the SEC relied on various proxies and incorporated a number of assumptions.

The SEC’s Estimates Based on Government Securities Trading Data

Relative to government securities, the SEC’s proxy definition of dealing was trading a security for at least 15 days in a month with a positive average trading spread, but the SEC stressed that the determination of whether an entity is engaged in regular dealing activity depends on the facts and circumstances. Based on its analysis, the SEC identified the number of non-broker-dealers appearing to meet the Revenue Element for US government securities in 2022:

• Of the 31 non-broker dealers that appear to meet the Revenue Element in 2022 for at least 1 month included 4 hedge funds.

• Of the 12 non-broker dealers that appear to meet the Revenue Element in 2022 for 20 days included only 1 hedge fund.

• Of the 40 non-broker dealers that appear to meet the Revenue Element in 2022 for 10 days included 7 hedge funds.

The SEC’s Estimates Based on Form PF Data

The SEC also used Form PF data to provide an estimate of the number of possibly affected hedge funds and in this regard focused on Question 20, which asks about the breakdown of funds’ reliance on several categories of strategy (e.g., “Equity, Market Neutral” or “Equity, Long/Short”), and on Question 21, which asks how much of the funds’ assets are dedicated to high-frequency trading (HFT) strategies.¹⁰ Based on the SEC’s understanding of the trading objectives that hedge funds report pursuant to Questions 20 and 21, the SEC believes that any hedge funds employing trading strategies that would fit the rules’ qualitative standard, as adopted, would likely report them as HFT.¹¹ The SEC identified 40 hedge funds (with 21 investment advisers) that used HFT strategies in an amount less than 10% of net asset value and 12 hedge funds (with 10 investment advisers) that used HFT strategies in an amount equal to or greater than 10% of net asset value. The SEC admitted, however, that its use of HFT strategies is an imperfect proxy for whether these funds would qualify under the qualitative standard, and ultimately it is unable to determine whether the HFT activities that these funds report would satisfy the Trading Interest Element or the Revenue Element because it does not receive information about individual transactions in Form PF.

Registration Consequences for Private Funds

The SEC identified a number of potential consequences for private funds that are required to register, as summarized below:

Revised Documentation

If a private fund is required to register as a dealer, the SEC suggested that the fund’s response might be to revise its organizational documents and agreements with third parties such as prime brokers and executing brokers; modify its investing strategies (which can require investor consent and also trigger investors’ redemption rights) to avoid dealing; or accommodate investors that withdraw from the fund. Although these costs may be significant for individual funds, the SEC does not expect that the combined impact, in aggregate, will be significant because of the limited number of funds likely to be affected by the rules.

Impact on Investor Withdrawal/Redemption Rights

Private funds that are required to register as dealers might need to decrease the charges to their net capital or raise additional capital in order to comply with the net capital rule, which might be particularly problematic for funds that provide withdrawal/redemption rights to their investors, and the net capital rule requires a dealer to subtract from net worth when calculating net capital any contribution of capital to the dealer (1) under an agreement that provides the investor with the option to withdraw the capital or (2) that is intended to be withdrawn within a period of one year of the contribution. Accordingly, the SEC stated that such funds might need to amend their contractual agreements with investors and that investors may lose substantial liquidity rights.

The SEC suggested that, alternatively, an affected private fund may choose to separate its dealing activities into a separate entity,¹² and added that it estimates that the rules will affect only a small percentage of private funds.

Impact on IPO Activity

The SEC acknowledged that some private funds might invest in initial public offerings (IPOs) in addition to engaging in dealing strategies, but if required to register as dealers, the funds might be subject to restrictions against participating in the IPO market. In this case, the SEC expects such funds will choose the activity that adds more value to the fund and its investors; some may choose to register and stay out of the IPO market while others may forgo dealing to be able to invest in IPOs. Because hedge funds are important players in the IPO market, any large-scale exit of hedge funds from this market could impact the ability of issuers to raise new capital as well as reduce efficient pricing in new issues. Similarly, any large-scale exit from dealing could impact liquidity. According to the SEC, the magnitude of these costs depends on the extent to which there are hedge funds that engage in both activities simultaneously as well as on hedge funds’ total share of aggregate IPO and dealing activity.

Other Pooled Vehicles

Also not excluded from the rules are other entities that may rely on an exception from the definitions of “investment company” (either by statute or rule), other than the Private Fund Exceptions. But unlike private funds, these entities were not addressed in the Adopting Release.¹³

Focus on Investment Advisers

The SEC made it clear that investment advisers trading on behalf of their clients, including those advisers exercising discretion, generally will not be captured by the final rules because they would not be buying and selling for their “own account.”¹⁴ In contrast, investment advisers trading on their own behalf (or arguably on behalf of related operating companies) would need to be evaluated to determine whether the adviser may be acting as a dealer. Importantly, it is unclear whether the SEC or its staff will apply the position that the staff adopted for principal trades under the Advisers Act and treat an account of which the adviser or an affiliate owns 25% or more as a proprietary account (“own account”) for these purposes.¹⁵

The Anti-Evasion Provisions

Each of the rules includes an anti-evasion provision, which prohibits a person from evading the registration requirements of the rules by:

• Engaging in activities indirectly that would satisfy the “as a part of a regular business” section of the rule; or
• Disaggregating accounts.

According to the SEC, the anti-evasion provision is intended to capture persons dividing or structuring their activity to evade the application of the rules. The SEC offered examples of potentially evasive activity:

• Coordinating and integrating trading across commonly controlled groups of legal entities such that one or more persons would not meet the Revenue Element (including by switching which legal entity is engaged in trading to evade the “regular” requirement of the Revenue Element);
• Using two legal entities to separately purchase and sell securities (noting that the separation of purchases and sales in distinct legal entities could also indicate evasive behavior with respect to the Trading Interest Element, which requires expressing trading interest on both sides of the market); and
• Using several legal entities to purchase and sell securities but “rotating” the activity across or among entities in a way that none of the legal entities trades frequently enough to satisfy the “regular” element in the rules.

The SEC warned that a determination of whether a person has violated the anti-evasion provision would be based on the totality of the facts and circumstances, but it also offered the following examples of factors it might use in evaluating whether a person has violated the anti-evasion provision:

• Whether there are information barriers to prevent sharing of information or sufficiently segregated trading;¹⁶
• Whether there are overlapping personnel across accounts or entities;
• Whether there are separate account statements for each account;
• Whether there are personnel with oversight or managerial responsibility over multiple accounts in a single entity or affiliated entities, and account owners of multiple accounts, that do not have authority to execute trades or pre-approve trading decisions for accounts or entities; and
• Whether there is a business purpose that demonstrates that there is no coordinated buying and selling between accounts or entities.

Conclusion

The SEC repeatedly provided comfort that, based on its analysis, the number of private funds and investment advisers impacted by the rules is expected to be quite small. However, funds and investment advisers should review their trading activities and strategies in light of these rules to determine whether they might meet the definition of “dealer” or of “government securities dealer” and take appropriate steps to either register as such or modify their activities such that they would not meet either definition. In addition, funds and investment advisers should review and modify as necessary or appropriate the investment objective, strategy, trading, and related descriptions and disclosures in their applicable governing documents, offering documents, regulatory disclosures (including Form PF and Form ADV), marketing materials, and other communications.

¹ Adopting Release, Federal Register version, and our February general discussion of the rules.

² Investment adviser refers to the definition of “investment adviser” in the Investment Advisers Act of 1940 (Advisers Act).

³ Investment company refers to the definitions of “investment company” in the Investment Company Act of 1940 (1940 Act).

⁴ The rules apply to transactions in any “security” or “government security” (based on the Exchange Act’s definitions of those terms) and include crypto assets that are securities or government securities.

⁵ Neither the Adopting Release nor the release proposing the SEC’s new dealer rules (Proposing Release) provide guidance on the scope of this exception or the manner in which it should be calculated other than to say the exception “parallels” the “institutional account” definition under FINRA Rule 4512(c)(3). FINRA Rule 4512(c)(3) defines “institutional account” to mean the account of “any other person (whether a natural person, corporation, partnership, trust or otherwise) with total assets of at least $50 million.” Despite the differences in the text of the rules (in particular, “has or controls” vs. “with”), the SEC does not acknowledge the differences or provide explanation. Additionally, although the version of the rules in the Proposing Release defined the term “control,” the Adopting Release and the version of the rules in it do not define that term, and neither release offers a definition of the term “total assets.”

In terms of the timing of the calculation and value fluctuation, the SEC did not offer guidance. Presumably, market participants would need to assess their total assets continuously for purposes of this exception.

⁶ These terms are defined under the rules.

⁷ Technically, business development companies are not “registered” under the 1940 Act; they elect to be regulated under the 1940 Act.

⁸ In the Proposing Release, the SEC stated that a private fund, including a hedge fund, is an issuer that would be an investment company as defined in Section 3 of the 1940 Act if not for Section 3(c)(1) or 3(c)(7) of that act (such exceptions, the Private Fund Exceptions).

⁹ In the Matter of Murchison Ltd., Marc Bistricer, and Paul Zogala, Exchange Act Release No. 92684 (Aug. 17, 2021).

¹⁰ The SEC noted that algorithmic HFT is a primary feature of the private funds that are most likely to meet the final rules’ qualitative factors since such trading can involve regularly expressing trading interests on both sides of the market (the Trading Interest Element) or earning revenue from bid-ask spreads or incentives offered for liquidity-providing trades (the Revenue Element).

¹¹ The SEC also focused on monthly turnover reported in Form PF in each of 10 different asset classes.

¹² Presumably, implementation of the SEC’s suggestion would not violate the anti-evasion provisions in the rules, which are discussed below.

¹³ Such entities might include, for example, entities relying on Section 3(c)(5) of or Rule 3a-7 under the 1940 Act.

¹⁴ We note that the SEC removed the aggregation standard from the definition of “own account,” stating that these changes mean the rules are not likely to prevent investment advisers who are also dealers from receiving carried interest from their private fund clients.

¹⁵ See, e.g., this SEC staff no action letter.

¹⁶ The SEC cited a comment letter that suggested that the SEC should not aggregate trading activities across independent entities, portfolio managers, or trading strategies when assessing whether the proposed qualitative criteria are met, particularly if there are information barriers in place.