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Are You a 'Large Trader' Subject to the New SEC Reporting Rules?

Client Alert

Authors: Gregory J. Nowak and Matthew R. Silver

8/26/2011

In yet another attempt to identify and obtain trading information on market participants that conduct a substantial amount of activity in the U.S. securities markets, on July 26, 2011, the Securities and Exchange Commission (SEC) adopted new Rule 13h-1 (the LT Reporting Rule)1 and the accompanying Form 13H promulgated under Section 13(h) of the Securities Exchange Act of 1934. Unlike many recent regulations proposed or adopted by the SEC, the LT Reporting Rule is not an outcome of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act) but has been adopted pursuant to the SEC’s authority under the Market Reform Act of 1990.

The LT Reporting Rule requires every “large trader” to register with the SEC by filing a new Form 13H, requires that they provide the identities of the broker-dealers they use to the SEC, and requires that they also provide the broker-dealers they use with a large-trader identification number (LTID) that will be assigned to all large traders by the SEC. The reporting burdens of the LT Reporting Rule are not limited to the large traders but also apply to the registered broker-dealers who effect trades for such large traders.

The SEC believes that the LT Reporting Rule is necessary, in part, because “large traders appear to be playing an increasingly prominent role in the securities markets.” As stated by the SEC, market observers have offered a wide range of estimates for the percent of overall volume attributable to one potential subcategory of large trader – high-frequency traders – which is typically estimated at 50 percent of total volume or higher.

Pepper Point: The Effective Date of the LT Reporting Rule will be October 3, 2011. Large traders will have to identify themselves on or before December 1, 2011. As a result of these new reporting requirements, large traders will be on the SEC radar and each broker who services a large trader will also be subject to an additional reporting burden, making it difficult for small brokers to service large traders.

So What Makes You a Large Trader?

If the size of your trades on any one given calendar day or in one calendar month exceeds the thresholds set forth in Rule 13h-1 you are deemed to be a large trader. Per the definition set forth in Rule 13h-12 a “large trader” is a person whose transactions in NMS securities (i.e., exchange-listed securities)3 equal or exceed (i) either 2 million shares or $20 million during any calendar day (the Daily Threshold), or (ii) 20 million shares or $200 million during any calendar month (the Monthly Threshold).

Therefore whether you are an individual trading on your own behalf or an entity, a private fund or an investment adviser that exercises investment discretion on behalf of investors, under the LT Reporting Rule you could potentially still be a large trader if, on any one calendar day, you sell or purchase one or more shares for $20 million or sell or purchase 2 million shares worth ten or more dollars, or in any one given year you sell or purchase one or more shares valued at $200 million (or twenty million shares). Potentially, selling $10 million of securities and using the proceeds to purchase $10 million in new securities on the same day will also push a trader over the threshold.4

Pepper Point: As a notable exception, the actual transfer of the basket of securities between an authorized participant and an ETF is not counted for purposes of large trader reporting.

Specific examples of large traders, provided the Daily Threshold or the Monthly Threshold is exceeded, are:

  • a Parent Company is a large trader when the aggregate trading activity of all entities controlled5 by the Parent Company collectively exceeds either the Daily Threshold or the Monthly Threshold
  • a Holding Company that owns a 100 percent ownership interest in a broker-dealer and an investment adviser (even if, as a practical matter, the Holding Company is not engaged in the day-to-day operation of either entity)
  • a broker-dealer that owns a 33 percent ownership interest in a proprietary trading firm. Note: if none of the firm’s other investors own a controlling interest of 25 percent or more of the firm, no LTIDs, other than that of the broker-dealer, would be attached to the trades of the proprietary trading firm
  • an investment adviser that owns a 100 percent ownership interest in two sub-advisers, and the two sub-advisers’ collectively exceed the Daily Threshold or the Monthly Threshold
  • a sub-adviser, which, on behalf of its clients, effects transactions in NMS securities on behalf of those accounts, which in the aggregate exceed the Daily Threshold or the Monthly Threshold
  • a broker-dealer that, while engaging in proprietary trading, effects transactions in NMS securities on behalf of those accounts, which in the aggregate exceed the Daily Threshold or the Monthly Threshold
  • a proprietary trading firm that effects transactions in NMS securities, which in the aggregate exceed the Daily Threshold or the Monthly Threshold.

Pepper Point: The SEC believes that the LT Reporting Rule will affect approximately 400 large traders and 300 registered broker-dealers. We believe that, given the $20 million reporting threshold and the fact that large clients sometimes open smaller accounts with local or minority-owned brokers as a form of community outreach, unless Hedge Fund managers or brokers adjust their current practices, the number of parties impacted by the rule is likely to be greater than the SEC anticipates.

Compliance under the LT Reporting Rule

Rule 13h-1 will present new burdens to persons who are large traders according to the LT Reporting Rule. In particular, the LT Reporting Rule will require such large traders to:

1. Identify itself to the SEC by filing a Form 13H.

Large traders will be required to file Form 13H with the SEC promptly after first effecting transactions that reach the identifying activity level and thereafter annually, within 45 days after the calendar year-end, in order to ensure the accuracy of all of the information reported to the SEC.

2. Submit annual updates, as well quarterly updates.

Each quarter after the Form 13H is filed, if the information stated in Form 13H changes or becomes inaccurate due to change of circumstances, the large trader is required to file correct information with the SEC.

3. Submit annual updates, as well as quarterly updates when necessary, to correct information previously disclosed that has become inaccurate.

In addition to the annual filings, large traders are required to file an amended Form 13H promptly following the end of a calendar quarter in the event that any of the information contained therein becomes inaccurate for any reason (e.g., change of contact information, type of organization, trading strategy, regulatory status, list of broker-dealers at which the large trader has an account, or description of affiliates).

4. Provide additional information requested by the SEC.

The LT Reporting Rule also requires, on request of the SEC, that large traders provide additional information to identify the large trader and all accounts through which the large trader effects transactions. Such requests for additional information may include, for example, a disaggregation request to assist the SEC in identifying accounts through which a large trader effects specific transactions.

5. Identify itself to each registered broker-dealer through which it effects transactions.

Such identification is not restricted to only the broker-dealers who transact the trades that put the person over the Daily Thresholds or Monthly Thresholds, but to all broker-dealers who transact trades for such person during the relevant period.

Form 13H: What Is It?

Form 13H is a short, six-page form to be completed online. While it mostly requests reasonably generic information, it does ask for, among other things:

  • a list of broker-dealers at which the large trader or its securities affiliates has an account (account numbers are not required)
  • a list of other filings by the large trader and its security affiliates6 with SEC and the Commodity Futures Trading Commission (CFTC) and basic information related to such filings
  • an organizational chart that identifies the large trader, its parent company (if applicable), all securities affiliates and affiliates registered with the CFTC.

In its adopting release, the SEC notes that it would not be compelled to disclose publicly any information required to be kept or reported under the LT Reporting Rule; Forms 13H will be exempt from the Freedom of Information Act and will not be shared with others and would not be available to other large traders or broker-dealers. Notwithstanding the above, as required by law, information on Form 13H may be provided to any other federal department or agency requesting information for purposes within the scope of its jurisdiction, or complying with an order of a court of appropriate jurisdiction.

Once a Large Trader, Always a Large Trader?

No. A person or an entity may terminate its large-trader status by reporting the termination of its operations or by stating that it has no potential to re-qualify for large-trader status in the future. For example, termination status will be relevant in the case of a merger or acquisition where the large trader does not survive the corporate transaction. In addition, large traders who may trip the threshold occasionally but do not otherwise trade at sufficient levels to merit continued status as a large trader may apply for an “inactive status” to reduce the potential costs of compliance with the LT Reporting Rule. The termination of a large-trader status or obtaining an inactive status is obtained by checking a box on the cover page of a trader’s next Form 13H filing.

Reporting Responsibilities of Broker-Dealers of Large Traders

In addition to the reporting requirements imposed on registered broker-dealers, under the LT Reporting Rule broker-dealers of large traders will also be required to:

  • record the LTID number and the time transactions of a large trader are executed
  • if the SEC requests, report information about each transaction of the large trader on a next-day basis to the SEC through the “Electronic Blue Sheets” system, which is currently used by broker-dealers for reporting trade information
  • perform limited monitoring of their customers’ accounts for activity that may trigger the large-trader identification requirements of Rule 13h-17
  • report transactions that equal or exceed the reporting activity level effected by or through such broker-dealer for both identified and unidentified large traders. More specifically, upon the request of the SEC registered broker-dealers will be required to report electronically, in machine-readable form, various data for all transactions effected directly or indirectly by or through accounts carried by such broker-dealer for large traders and other persons for whom records must be maintained, which equal or exceed the reporting activity level. These broker-dealers will need to report a particular day’s trading activity only if it equals or exceeds the “reporting activity level” but will be permitted to report all data without regard to that threshold.

Broker-dealers must start to maintain records, report, and monitor large-trader activity pursuant to the LT Reporting Rule by April 30, 2012.

Pepper Point: The LT Reporting Rule is designed to provide the SEC with prompt information to help determine the guilty parties in situations such as flash crashes and to aid the SEC in monitoring the activity of larger market players closely. However, the potential compliance burdens for smaller brokers with large-trader clients and entities that occasionally conduct isolated large trades in NMS securities may be significant. We also anticipate that many hedge fund managers and similar entities will implement programs to monitor their daily trading levels so as to avoid tripping the thresholds of the LT Reporting Rule.

Endnotes

1 The 179-page LT Reporting Rule is available at http://www.sec.gov/rules/final/2011/34-64976.pdf.

 

2 Section 13(h) of the Exchange Act, enacted as part of the Market Reform Act of 1990, defines a “large trader” as “every person who, for his own or an account for which he exercises investment discretion, effects transactions for the purchase or sale of any publicly traded security or securities by use of any means or instrumentality of interstate commerce or of the mails, or of any facility of a national securities exchange, directly or indirectly by or through a registered broker or dealer in an aggregate amount equal to or in excess of the identifying activity level.”

3 An “NMS security” is “any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options.” The term refers generally to exchange-listed securities, including equities and options.

4 As a notable exception, the actual transfer of the basket of securities between an authorized participant and an ETF is not counted for purposes of large trader reporting. The SEC will count toward the identifying activity level trading activity in the secondary market that relates to the acquisition or disposition of securities in connection with the creation or redemption of ETF shares, but not the transfer of such securities between an authorized participant and an ETF. See page 33 of LT Reporting Rule release for further details.

The transactions excluded for the purposes of determining the Daily Threshold are: (i) a journal or bookkeeping record to record the receipt or delivery of funds or securities pursuant to the settlement of a transaction; (ii) a transaction, other than those effected through NSE, by or on behalf of an issuer or underwriter (i.e., non-secondary transactions); (iii) gifts; (iv) distribution of a decedent’s estate by a court-appointed executor, administrator, or fiduciary; (v) a transaction effected pursuant to a court order or judgment; (vi) a transaction effected pursuant to a rollover of qualified plan or trust assets; (vii) a transaction between an employer and its employees effected pursuant to the award, allocation, sale, grant, or exercise of a NMS security, option or other right to acquire securities satisfying certain conditions; or (viii) a transaction to effect a business reorganization subject to Section 14(d) of the Securities Exchange Act of 1934 (15 U.S.C. 78n(d)); an issuer tender offer or other stock buyback by an issuer; or a stock loan or equity repurchase agreement.

5 Per Rule 13h-1(a)(3) a parent company is deemed to “control” (and the terms “controlling,” “controlled by,” and “under common control with”) when it directly or indirectly has the right to vote or direct the vote of 25 percent or more of a class of voting securities of an entity or has the power to sell or direct the sale of 25 percent or more of a class of voting securities of such entity, or in the case of a partnership, has the right to receive, upon dissolution, or has contributed, 25 percent or more of the capital, is presumed to control that entity. Controlled entities need produce only aggregated statistics in summary form, which would be added together at the parent level to determine whether the identifying activity level has been met. If it has, then the parent company is a large trader and will be required to provide information about itself and its affiliates, unless all of its affiliates comply on its behalf pursuant to Rule 13h-1(b)(3)(ii).

Under Rule 13h-1(b)(3)(ii), a controlling person or entity of one or more large traders (such as a Holding Company) would be required to comply with all of the large-trader requirements unless the entities that it controls discharge all of the responsibilities of the controlling person. This provision maintains the focus on the parent company by allowing, for example, a corporate entity to comply on behalf of one or more natural persons who are its controlling owners. If, for example, an investment adviser and broker-dealer owned by a Holding Company separately register as large traders, their Holding Company would not have to separately register as a large trader, assuming that those two entities capture all transactions and accounts controlled by the Holding Company. Instead, the investment adviser and broker-dealer would identify (in Item 4(c) of Form 13H) the other as an affiliate filing separately, and identify the Holding Company as their affiliate’s parent company on their respective Form 13H filings. In this way, the SEC will be able to tell that the entities are under the common control of the Holding Company, and the SEC could assign LTIDs that reference their common parent.

6 The term “Securities Affiliate” means an affiliate of the large trader that exercises investment discretion over NMS securities. The term “affiliate” means any person that directly or indirectly controls, is under common control with, or is controlled by the large trader.

7 For purposes of determining under the LT Reporting Rule whether a registered broker-dealer has reason to know that a person is a large trader, a registered broker-dealer generally needs to take into account only transactions in NMS securities effected by or through such broker-dealer. A registered broker-dealer would be deemed not to know or to have reason to know that a person is a large trader if: (1) it does not have actual knowledge that a person is a large trader; and (2) it established and maintained policies and procedures reasonably designed to assure compliance with the identification requirements. Unless a broker-dealer has actual knowledge to the contrary that a customer is a large trader (e.g., the customer voluntarily informs the broker-dealer that it is a large trader under Rule 13h-1), the monitoring requirements contemplate an inquiry by the broker-dealer into whether a customer meets the identifying activity threshold based upon transactions effected through an account or a group of accounts at that broker-dealer.

Gregory J. Nowak, Matthew R. Silver and Janaki Rege Catanzarite

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The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.