White Collar

SEC’s Novel Unregistered Dealer Theory Creates New Risks for Securities Market Participants – Steps to Mitigate Exposure

By: Lucosky Brookman
SEC’s Novel Unregistered Dealer Theory Creates New Risks for Securities Market Participants – Steps to Mitigate Exposure

A recent federal court decision granting summary judgment to the Securities and Exchange Commission (SEC) in an unregistered securities dealer enforcement action sent shockwaves through the financial services sector. By endorsing the SEC’s expansive new legal interpretation of the statutory dealer definition, the ruling exponentially grows the universe of market participants potentially requiring registration as a broker-dealer. Companies across the financial industry should urgently examine their trading activities for any heightened risks under this shifting regulatory paradigm.

Securities Exchange Act Framework and Historically Narrow Interpretation

The Securities Exchange Act of 1934 contains registration requirements under Section 15 meant to regulate securities market intermediaries and ensure basic investor protections. Under the Act, entities acting as securities dealers must register with the SEC unless they qualify for an exemption.

The Act defines a “dealer” in relevant part as any person or entity “engaged in the business of buying and selling securities” for their own trading account. However, those simply buying and selling securities “not as a part of a regular business” are exempted from registration.

Historically, this dealer definition has been interpreted relatively narrowly by the SEC as focusing on intermediaries engaged in the business of executing securities trades on behalf of customers. Entities buying and selling securities for their own investment or trading accounts without transacting opposite customers generally avoided dealer status under longstanding SEC guidance, interpretations, and enforcement.

SEC’s Novel “Customer-Agnostic” Approach Requires Only Regular Buying and Selling

However, in a series of recent enforcement actions, the SEC has advanced a far broader legal theory of the statutory dealer definition divorced from the customer concept. This interpretation argues anyone engaged in the regular business of buying and selling securities for their own account fits the dealer definition regardless of interacting with customers.

Several federal courts have now adopted the SEC’s novel “customer-agnostic” theory. Most impactfully, in SEC v. Fierro the U.S. District Court for the Western District of Texas granted summary judgment against defendants who systematically traded securities from their own accounts without registration.

The Fierro defendants purchased convertible corporate debt instruments, held them for six months, converted the notes to equity shares, then sold the equity at a profit. But because this involved regular business of buying and selling securities from their own accounts to generate trading income, the court endorsed the SEC’s view that they acted as unregistered dealers in violation of Section 15(a).

In adopting this broad interpretation, the court followed two prior decisions from Florida agreeing that essentially anyone engaged in systematically trading securities as a revenue-generating business likely requires broker-dealer registration under the statute – devoid of other considerations like having customers that informed the Act’s original enactment and purpose.

Massive Expansion of Potential Registration Obligation and Disgorgement Risks

By diminishing the overarching focus on transacting opposite customers, the emerging judicial consensus adopting the SEC’s new dealer theory exponentially grows the universe of market participants potentially subject to the registration requirement for the first time.

Rather than the narrower historical focus on intermediaries handling trades for clients, this expansive interpretation opens the door to sweeping in hedge funds, private equity firms, investment companies, insurance companies, pension funds, family offices, and potentially any active securities trader – including individuals if deemed a business.

Equally concerning, this opens up years of trading activities widely viewed as completely legal at the time to disgorgement liability. The SEC staff could use the threat of enforcement actions forcing firms to disgorge years of trading profits, plus interest and civil penalties, as leverage to demand settlements. This risk exists even if the trading required no registration under the SEC’s own prior guidance.

Prudent Steps to Mitigate Regulatory Risks and Scrutiny

While debate continues over the legality of the SEC’s novel interpretation with court challenges likely, the potential implications require prudent risk assessment and mitigation. Companies actively trading securities for their own accounts should urgently consult experienced securities regulatory counsel to conduct a privileged review of their activities under the paradigm the SEC is now aggressively advocating.

If the analysis identifies any heightened risks of dealer status, several options exist to mitigate exposure and reduce chances of facing disruptive SEC enforcement action:

  • - Adjust trading strategies to reduce dealing activity risks, such as by limiting position turnover, holding for longer duration, or avoiding transactions that could be viewed as making markets.
  • - Assemble detailed documentation substantiating potential grounds for availing of Exchange Act dealer exemptions, such as engaging in limited dealing through a registered broker-dealer agent or qualifying as a trader.
  • - Ultimately register as a broker-dealer if required under the emerging expansive interpretation, which brings its own compliance challenges.

The SEC currently possesses momentum and inherent advantages as this major shift in interpreting the decades-old dealer definition plays out in courts. But for entities actively trading securities, navigating this complex, shifting area through experienced counsel is crucial to remaining compliant and avoiding devastating enforcement action as the SEC racks up early wins.

Please contact Lucosky Brookman if you need assistance assessing unregistered dealer risks and implementing mitigation strategies. SEC rules and expectations are changing rapidly, so engaging seasoned securities counsel is key to staying ahead of the curve. We will continue monitoring developments in cases interpreting the dealer definition as they progress toward appellate courts.