SEC’s New Dealer Rule: A Paradigm Shift in Securities Market Regulation

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The Securities and Exchange Commission (SEC) plays a critical role in regulating and monitoring the activities of market participants, such as dealers and government securities dealers, in order to maintain the integrity and stability of the securities markets. Recently, the SEC has proposed Rules 3a5-4 and 3a44-2 aimed at further clarifying the definitions of “dealers” and “government securities dealers” under the Exchange Act.

As the financial landscape continues to evolve, it is essential for you, as a market participant, to stay informed about regulatory developments and adapt your operations accordingly. Below you’ll find key aspects of the proposed SEC Dealer Rules and learn how our firm can empower you to navigate these changes successfully. 

By understanding the implications and ensuring your company’s compliance, you’ll be well-positioned to seize opportunities for growth in the evolving securities markets.

SEC Dealer Definition And Rule

Overview of the SEC Dealer Proposal

The new rules further clarify the definitions of “dealers” and “government securities dealers” under the Exchange Act. These rules aim to ensure that entities engaged in activities similar to traditional dealers are subject to appropriate regulatory oversight.

SEC Dealer Definition Under the New Rule

Under the proposed rules, a “dealer” is defined as an entity that engages in the buying and selling of securities as part of its regular business. The rules set forth qualitative standards to identify entities that play dealer-like roles in the markets, particularly those acting as liquidity providers.

Key Aspects of the SEC Dealer Rule

The SEC Dealer Rule comprises several components, including:

  1. Qualitative standards for identifying dealer-like activities
  2. A quantitative standard for determining when a person buying and selling government securities is considered a dealer
  3. Exemptions for certain entities, such as those with total assets less than $50 million and registered investment companies under the Investment Company Act of 1940

Understanding these aspects of the SEC Dealer Rule will help you assess your compliance obligations and evaluate the potential impact on your business operations.

Who the SEC Dealer Rule Applies To:

The SEC Dealer Rule primarily targets entities engaged in activities similar to traditional dealers, such as market making and high-frequency trading firms. However, other entities may also be affected, depending on their trading activities and roles in the securities markets.

  • Market Making Firms: Market making firms, which provide liquidity and facilitate transactions by quoting both buy and sell prices for securities, are directly impacted by the proposed rules. These firms are likely to be classified as dealers under the new definition, as they engage in buying and selling securities as part of their regular business activities.
  • High-Frequency Trading Firms: High-frequency trading firms use powerful computer systems and sophisticated algorithms to execute a large number of trades at extremely fast speeds. Given their significant role in providing liquidity to the markets, these firms may also be classified as dealers under the proposed rules.
  • Other Entities Affected by the Rule: Other entities that engage in dealer-like activities or buy and sell securities as part of their regular business operations may also be affected by the SEC Dealer Rule. This includes proprietary trading firms and certain hedge funds that actively trade securities.

Assessing The Impact On Hedge Funds’ Capital

As a market participant, it’s essential to evaluate your activities and determine if they align with the proposed SEC Dealer Rules. This internal assessment can help you ensure compliance with registration requirements and regulatory obligations, ultimately protecting your business operations, and fostering growth and success in the securities markets.

Exemptions from the SEC Dealer Rule

Although the SEC Dealer Rule is intended to encompass a wide range of market participants, certain entities and activities are exempt from its provisions.

Types of Entities or Activities Exempt from the Rule

The proposed rules provide exemptions for specific types of entities or activities, including:

  1. Entities with total assets less than $50 million
  2. Registered investment companies under the Investment Company Act of 1940
  3. Activities conducted by entities that do not meet the qualitative and quantitative standards defined in Rules 3a5-4 and 3a44-2

Criteria for Exemptions

To be exempt from the SEC Dealer Rule, entities must confirm that their activities don’t meet the specified criteria for classification as a dealer or government securities dealer. For instance, entities with total assets below $50 million or registered investment companies may be exempt.

Carefully reviewing the exemption criteria and evaluating your business activities is crucial to determine if your entity is exempt from registration requirements and regulatory obligations. Consider seeking professional guidance to ensure a thorough assessment and minimize potential non-compliance risks.

Court Challenges To The SEC Dealer Rule

The SEC Dealer Rule has faced legal challenges from various industry participants who argue that the SEC has overstepped its authority or created ambiguity with the new rule.

Overview of Legal Challenges to the Rule

Several industry groups, including hedge funds and private equity firms, have filed lawsuits in federal court, arguing that the SEC Dealer Rule:

  1. Exceeds the SEC’s authority under the Exchange Act
  2. Creates ambiguity and conflicts with established securities laws
  3. Is arbitrary and capricious in its application

Implications of Potential Court Outcomes

The outcome of these court challenges could have significant implications for the SEC Dealer Rule and affected entities, including:

  1. A ruling in favor of the SEC would uphold the rule, requiring entities meeting the dealer. definition to comply with registration requirements and regulatory obligations.
  2. A ruling against the SEC could lead to the rule being struck down, amended, or sent back to the SEC for further clarification.

It is essential to monitor these court proceedings and assess the potential impact on your business, as the outcome could significantly influence the regulatory landscape for dealers and government securities dealers. Seeking professional guidance can help you stay informed of these developments and adapt your compliance strategies accordingly.

Impacts of Avoiding The SEC Dealer Rule

While some entities may consider avoiding the SEC Dealer Rule to evade registration requirements and regulatory obligations, it is crucial to understand the potential consequences, risks, and ethical considerations associated with non-compliance.

Consequences of Non-Compliance

Non-compliance with the SEC Dealer Rule can result in severe consequences, including:

  1. Substantial fines and penalties imposed by the SEC or other regulatory authorities
  2. Reputational damage, leading to a loss of clients and business opportunities
  3. Potential legal liabilities stemming from violations of securities laws

Risks Associated with Avoiding the SEC Dealer Rule

By avoiding the SEC Dealer Rule, entities expose themselves to various risks, such as:

  1. Increased scrutiny from regulatory authorities and potential enforcement actions
  2. Heightened risk of legal disputes and litigation from counter parties or investors
  3. Difficulties in attracting new clients or investors due to concerns about compliance and integrity

Ethical Considerations

Beyond the legal and financial implications, avoiding the SEC Dealer Rule raises ethical concerns about transparency, fairness, and maintaining the integrity of the securities markets. Market participants have a responsibility to uphold ethical standards and promote confidence in the financial system.

In light of these potential impacts, it is essential for entities to carefully evaluate their obligations under the SEC Dealer Rule and seek professional guidance to ensure compliance. By doing so, you can protect your business from potential risks, foster trust among stakeholders, and contribute to the overall stability of the securities markets.

Broker-Dealer Compliance: Complex and Essential

The regulatory requirements for broker-dealers are complex and ever-evolving. Compliance with these regulations is essential to maintain good standing, protect investors, and avoid penalties. Navigating the intricacies of broker-dealer registration and ongoing compliance can be daunting, particularly for those unfamiliar with the process.

Failing to comply with SEC regulations can have serious consequences, including fines, reputational damage, and even legal liabilities. Given the complexity and importance of regulatory compliance, it is crucial for broker-dealers to seek expert guidance from experienced professionals who can help ensure they meet all their compliance obligations.

By enlisting the assistance of a knowledgeable firm, broker-dealers can focus on their core business activities while leaving the intricacies of regulatory compliance in the hands of trusted experts. This can provide peace of mind and allow firms to operate confidently in the securities markets.

How ACI Can Help You Understand And Comply With The SEC Dealer Rule

ACI offers comprehensive support to help you navigate the complexities of the SEC Dealer Rule, especially as it relates to financial reporting and net capital compliance. With years of experience in regulatory accounting, ACI understands the important relationship between these two areas in the broker dealer community, ensuring you receive high-quality care tailored to your needs.

ACI partners with leading compliance consulting firms, allowing you to benefit from the best expertise across both the compliance and accounting spectrums. 

Reach out today for a confidential conversation about your broker-dealer regulatory needs.

SEC Grants Additional 30 Days for Certain Broker-Dealers to File Annual Reports

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Certain broker-dealers received much-needed relief this month when the Securities and Exchange Commission agreed to extend the annual audit filing deadline by 30 calendar days, cementing 90 days as the new regulatory obligation.

The extension, issued in a February 12th order, allows broker-dealers who meet certain criteria to file the reports within 90 calendar days after the end of their fiscal year. Previously, the reports were due within 60 calendar days.

The SEC extended the deadline in response to a request from the Financial Industry Regulatory Authority, accepting FINRA’s position that the extra 30 calendar days would reduce the burdens that certain smaller broker-dealers face in obtaining audit services. The extension also provides needed time for their PCAOB registered independent public accountants to perform the audit work necessary to comply.

Full details of the SEC order are included here, but in general the deadline for filing the annual reports is extended 30 calendar days for broker-dealers who:

1) Are in compliance with Rule 15c3-1;

2) Have total capital and allowable subordinated liabilities of less than $50 million, as reported in box 3530 of Part II or Part IIA of its FOCUS Report;

3) Are permitted to file an exemption report as part of their most recent fiscal year-end annual reports;

4) Submit written notification to their designated examining authority of their intent to rely on this order on an ongoing basis for as long as they meets the conditions of the order;

5) File the annual report electronically with the Commission using an appropriate process.

Jay Gettenberg, ACI Managing Partner, has been advocating for this change since being elected to the FINRA Small Firm Advisory Committee (SFAC) effective January 1, 2020.  He has stressed the need for the 30-day extension to senior FINRA staff, citing increasing audit costs, availability of PCAOB registered auditors, and logistical challenges of completing an audit within only one month of the regulatory Focus filing deadline. 

Mr. Gettenberg said, “We believe this rule change will ease the time pressures broker-dealers face, while simultaneously ensuring higher-quality audits and providing the readers of the financial statements with both greater transparency and an increased likelihood of accuracy in the representations being made by senior management.”

Gettenberg, as a member of SFAC, assisted in laying the groundwork for FINRA’s request.  His efforts to ensure a successful implementation will continue, and will include having other regulatory organizations, most notably SIPC, NFA/CFTC and the various states, accept similar 90-day filing deadlines.

ACI will continue to provide updates on our Resources page as more information becomes available.

New FAQ Clarifies FINOP Site Visit Requirements

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FINRA just clarified a question that has been a thorn in the side for many outsourced FINOPs and their broker-dealer clients for many years: Are FINOPs required to make on-site inspections of their clients’ records to fulfill their regulatory duties? The short answer: No.

FINRA examiners had been using a 2006 Notice to Members to effectively attempt to obligate FINOPS to go onsite on a periodic basis.  While this Notice to Members was not technically a rule, FINRA seemed to insist that FINOPS needed to be physically onsite to oversee the regulatory activities of the firms at which they were registered, irrespective of the securities activities or risk profile of the member firm. Examinations occasionally have even tried to cite firms if the FINOP could not demonstrate an annual onsite visit.   

In reality, many outsourced FINOPS service small, limited purpose broker-dealers, who do not hold customer funds nor pose any inherent risk to the investing public.  Access to the books and records, bank statements and vendor invoices, and supplementing FINOP reviews with financial statement approvals by internal, full-time, supervisory principals, generally has been sufficient to ensure controls are in place and accurate reporting is not compromised.

In a new FAQ, FINRA has made clear that FINOPs is not required to conduct an on-site visit “if the FINOP can fulfil his or her obligations through other means.”

Advocating for FINOPs and their clients

ACI Managing Partner, Jay Gettenberg, as a member of FINRA’s Small Firm Advisory Committee (SFAC) has long been an advocate for FINRA to make clear that on-site inspections were not necessary. The travel restrictions due to COVID-19 added urgency to the need for FINRA to act.
 
“The fact is, over the last six months FINOPs have done their jobs remotely, without the industry crumbling,” Gettenberg said. “It’s important that FINRA recognize this and amend their guidance to mirror the new reality. If FINRA and SEC claim that they can continue cycle examinations remotely, then the argument should hold true for FINOPs being able to perform their supervisory responsibilities in the same manner.”

The new guidance provides relief to FINOPS to make risk-based assessments into how to perform their duties most effectively, Gettenberg said. He plans to continue to advocate for changes that will help FINOPs and their clients fulfill their compliance duties as the economy emerges from the lockdown.

Answering the On-Site Inspections FAQ

Here is the full wording of the FAQ:

I am registered as a Financial and Operations Principal (FINOP) for several firms and conduct my work off-site. Do I need to conduct an on-site inspection of the firms’ books and records as part of fulfilling my FINOP obligations? 

All FINOPs, regardless of whether they work part-time, work off site or hold multiple registrations are responsible for fulfilling the duties outlined in FINRA Rule 1220(a)(4)(A). FINRA has previously provided guidance to member firms to help them assist their FINOPs in fulfilling the obligations specified in Rule 1220(a)(4)(A). See Notice to Members 06-23 (May 2006). The guidance, which includes a provision regarding on-site visits, should not be viewed as requirements (i.e., a FINOP is not required to conduct an on-site visit if the FINOP can fulfill his or her obligations through other means). A member firm’s written supervisory procedures, however, may impose additional requirements for FINOPs, such as an on-site visit to review a location’s books and records. In addition, nothing in this guidance relieves a firm from the obligation to conduct periodic office inspections in accordance with the requirements of Rule 3110(c).

ACI will provide updates on our Resources page as we continue to work with the SEC and FINRA on matters that affect FINOPS and our clients.

SEC Footnote 74 Provides Alternative for Broker-Dealers Who Don’t Hold Customer Funds

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The SEC recently provided non-carrying broker dealers with an alternative option as to how they can maintain their exemptive status under SEC Rule 15c-3-3. 

ACI Managing Partner, Jay Gettenberg, has worked closely with the Public Company Accounting Oversight Board  (PCAOB)  and FINRA in recent years to address the practical reality that there are FINRA member firms who do not hold customer funds, yet do not technically qualify under any of the four exemptions listed on the X-17A-5 Focus Report. These firms historically have been electing the k(2)(i) exemption, which effectively was the least incorrect option. 

To address the situation, the SEC issued Footnote 74 in July, providing a much needed alternative, specifically for firms engaging in capital raising activities (often Capital Acquisition Brokers). The guidance refers to such broker-dealers as “Non-Covered Firms.”  Non-Covered Firms that solely engage in Non-Covered Firm activities are no longer characterized as exempt under Rule 15c3-3(k), and thus no longer subject to any Rule 15c3-3 requirements, according to the footnote. Any broker-dealer that determines itself to be a Non-Covered Firm engaging in Non-Covered Firm activities may ask FINRA to amend its FINRA membership agreement to reflect this change.

Proposed Amendment

Mr. Gettenberg, while calling the new guidance “a great step by the SEC,” stills hopes additional clarity can be provided.  He said one step could be to amend the Focus Report to include SEC Footnote 74 as one of the exemption boxes that can be checked by member firms in the preparation and submission of their regulatory filings.  As currently proposed, the expectation is that these firms will claim no exemption, but still be exempt.  It would make sense to provide a formal box for the Footnote 74 exemption, so firms can formally state their exemption on these mandatory submissions.

Advocating a Simpler Solution

Mr. Gettenberg continues to advocate for a simpler solution for the implementation and use of this rule. He has proposed to the FINRA Small Firm Advisory Committee and various other regulatory committees that firms should be allowed to simply select “exempt” or “non-exempt,” without needing to specify the reason for which an exemption is applicable. This would particularly make sense if the SEC is going to offer firms an exemption option that is not listed in the current exemption section of the filings. He believes that restating a common-sense approach to regulation will be the basis for effective change in the future.

ACI and Mr. Gettenberg appreciate the work the SEC and FINRA have done to help firms handle this situation and hope progress on the issue will continue.

Footnote 74 Details

On July 1, 2020, the SEC and FINRA issued guidance on the characterization of U.S. registered broker-dealers under Securities Exchange Act Rule 15c3-3. In the past, FINRA required all broker-dealers to claim an exemption under Rule 15c3-3, as provided in paragraph (k), in their membership agreements even when their business activities did not require the exemption.

This might include broker-dealers who:

  • Don’t carry accounts of or for customers
  • Don’t receive customer funds or securities, or self-clear customer transactions through a separate account
  • Don’t receive or hold funds or securities for customers, either directly or indirectly, or otherwise owe such funds and securities to customers
  • Don’t carry proprietary accounts of other broker-dealers

The July guidance refers to such broker-dealers as “Non-Covered Firms.” The guidance states that Non-Covered Firms that solely engage in Non-Covered Firm activities are no longer characterized as exempt under Rule 15c3-3(k), and thus no longer subject to any Rule 15c3-3 requirements. Such broker-dealers no longer can claim the exemption from the rule in their FINRA membership agreements, FOCUS report filings, and annual exemption reports as required under the provisions of Exchange Act Rule 17a-5.

Any broker-dealer who determines it is a Non-Covered Firm engaging in Non-Covered Firm activities may ask FINRA to amend its FINRA membership agreement to reflect this change. The broker-dealer should state in this request that it is not required to comply with Rule 15c3-3 by reason of the SEC’s guidance set forth in circumstances described in footnote 74 to Exchange Act Release No. 34-70073 (July 30, 2013). Such broker-dealers generally include:

  • Private placement agents that effect securities transactions on a best efforts or subscription basis (not on a firm commitment basis) and don’t receive or hold customer funds or securities
  • Merger and acquisition advisory firms that refer securities transactions to other broker-dealers
  • Broker-dealers that provide technology or platform services and do not receive or hold customer funds or securities

The guidance also states that broker-dealers who engage in business activities that fit within the paragraph (k) exemption will continue to be exempt. These broker-dealers are not required to change their FINRA membership agreement unless they at some point restrict their business activities to those of a Non-Covered Firm.

Going forward, Non-Covered Firms will have to file annual exemption reports and periodic FOCUS reports differently. Firms that no longer need to claim a Rule 15c3-3 exemption with respect to Non-Covered Firm activities should describe their business activities in their exemption reports and also state that, during the reporting period, they:

  • Didn’t directly or indirectly receive, hold, or otherwise owe funds or securities for or to customers other than money or other considerations received and promptly transmitted in compliance with paragraph (a) or (b)(2) of Exchange Act Rule 15c2-4
  • Didn’t carry accounts of or for customers
  • Didn’t carry broker-dealer proprietary accounts as defined in Exchange Act Rule 15c3-3

Also, a Non-Covered Firm should no longer indicate in its FOCUS report that it is claiming an exemption from Rule 15c3-3 with respect to Non-Covered Firm activities. Specifically, Items 4550, 4560, 4570 and 4580, Part II or Part IIA, under “Exemptive Provision under Rule 15c3-3” should be left blank.

ACI will provide updates on our Resources page as we continue to work with the SEC and FINRA to simplify FOCUS report filings