I. Overview of SEC Proposals

The SEC has issued a public release (the “Release”)1 containing a variety of proposals to amend and expand Rule 15a-6 under the Securities Exchange Act of 1934 (the “Rule” or “Rule 15a-6”) (the “Exchange Act”), the principal SEC Rule permitting non-U.S. broker-dealers that are not registered with the SEC to conduct U.S. securities activities.2 Revisions to the Rule have been long promised, much rumored and highly anticipated. The Release, in print, is a mixed bag.

On the positive side, the liberalizing aspects of the Release will be welcomed by the securities industry, both buy-side (broker-dealers) and sell-side. Rule 15a-6, originally adopted in 1989 to facilitate cross-border securities activities, had come by the 1990s to be seen as an impediment to those activities. Given the pace of change in the financial markets, Rule 15a-6 was quickly outmoded; in fact, the inadequacy of the Rule to accommodate the demands of U.S. buy-side investors was clear within a year after the Rule was adopted. Notwithstanding the deficiencies of the Rule, buy-side and sell-side had found ways to conform to its form, albeit by devising expensive, inefficient and sometimes legally uncertain work-arounds. To the extent that the Release provides that the SEC will get out of the way of business that is already being done, albeit at greater cost and with more legal uncertainty than should be the case, the Release should and will be applauded. That said, the Release does not catch the SEC up with the internationalization of the financial markets, it merely closes the deficit. Further, the Release leaves open numerous questions as to the current operation of Rule 15a-6, and if adopted, its complexity is sure to raise more.

On the negative side (if you will accept that the prior paragraph was positive), there are significant difficulties with the Release, and those difficulties seem to me to be emblematic of issues with the SEC and its rulemaking generally, and for that matter with U.S. securities regulation. While the Release would eliminate a variety of complicated and seemingly ineffective conditions in current Rule 15a-6, it would leave other complicated conditions and in fact impose new ones that seem equally without purpose. The proposals reflect a lack of co-ordination between the Divisions of the SEC; for example, while the Release would facilitate the sale of non-U.S. listed options under the Exchange Act, it also warns that such sales may violate the Securities Act of 1933 (the “Securities Act”). A more significant failure of coordination (although one outside the SEC’s control) is the fact that the Rule 15a-6 exemptions do nothing about state law registration requirements, which remain 50 traps for the offshore unwary. But the most significant negative to the Release: I just do not perceive much in the way of an overall purpose or vision to the Release. All one can say is, out with the old Rule, in with the new Rule.

In several respects, the proposals contained in the Release appear to be motivated by a concern with regulatory arbitrage or the use of offshore activities to avoid U.S. regulation. Ultimately, however, arbitrage can not be fixed by an improved version of Rule 15a-6. That Rule, after all, permits firms to do business outside of the United States. What we have learned over the past 15 years, since the Rule was first adopted, is that the SEC can not reasonably prevent sell-side and buy-side from doing business outside the United States when they wish to do so. In that sense, the SEC must simply yield to the inevitable: the world outside of the United States is a big place that has some good investment opportunities that U.S. investors will find attractive.

On the other hand, to the extent that U.S. persons do business outside the United States because it is more attractive and efficient to do so under a different regulatory regime, that is something that the SEC can confront, though generally not by tinkering with Rule 15a-6. Rather, the real challenge that the SEC must address is to find ways to improve U.S. domestic securities regulation so that Rule 15a-6 is a means to invest abroad, and not a means to escape U.S. financial regulation.

From this opening, it may be thought that the remainder of this memorandum will be an attack on the constraints of Rule 15a-6. That is not the case. I suggest both some relaxation and some tightening of the proposals. What I do think more important, however is that the SEC change its view of the world, and of the way that the U.S. fits in. The SEC must recognize that it does not serve U.S. interests by starting from the view that U.S. regulation is superior (which is sometimes, but not inevitably the case), erecting a barrier between the U.S. economy and rest of the world, and exacting a toll on those outside wishing to enter. Maybe that once worked. Now, there are simply too many on the inside of the barrier who want to get out, and perhaps too few on the outside willing to pay a heavy toll to get in, given that its perfectly possible to do business on the outside, including with U.S. investment that has made its way out of the country. Rather, the SEC will serve U.S. interests by making the United States an attractive place to do business, finding a better balance of the benefits of regulation and its costs. In short, the SEC must focus on our domestic competitiveness, and if it will, then we will compete successfully internationally.

This memorandum is in five parts. The next part of the memorandum, which is extremely brief, describes the need for a Rule 15a-6 exemption. The next two parts, which are the bulk of the memo, describe the existing Rule 15a-6 exemptions, discuss how the Release would change those exemptions, and provide commentary on those changes. The first of these two parts goes over the SEC exemptions other than those relating to direct solicitation of U.S. institutional customers. The second focuses on the direct solicitation of customers, which is really the heart of the Release. Finally, the last part of the memo attempts to provide some further big picture observations.

II. Section 15 Registration Requirement and the Need for an Exemption

Any entity that does a “broker” or dealer” business in “securities” using U.S. “jurisdictional means” (including calling or emailing into the United States from abroad) is generally required to register with the SEC pursuant to Section 15 of the Exchange Act and is thereby subject to the rules of the SEC and to the additional rules of relevant self-regulatory-organizations (“SROs”) of which it is a member. In short, a non-U.S. broker-dealer that does any business with anyone in the United States (including a U.S. broker-dealer) could, under a strict reading of the Exchange Act, itself be required to register with the SEC and be subject to some very strict rules.

The principal exemption for non-U.S. broker-dealers that the SEC has adopted from the Section 15 registration requirement is Rule 15a-6 under the Exchange Act. This exemption has been expanded by at least one no-action letter that liberalized the types of U.S. investors that non-U.S. firms could contact in reliance on Rule 15a-6. In addition, there are several other no-action letters dealing with a variety of ancillary topics, including one fairly significant letter dealing with U.S. advisers for foreign clients and a number dealing with foreign options exchanges, that provide related relief.3

III. Rule 15a-6 Exemptions Other than Direct Solicitation of Qualified Investors

1. Unsolicited Transactions. Currently, Rule 15a-6 permits a non-U.S. broker-dealer to effect transactions for a U.S. customer where the transactions are wholly unsolicited by the non-U.S. broker-dealer. That is, if a U.S. customer, out of the blue, calls a non-U.S. broker-dealer to do a trade, the non-U.S. broker-dealer can execute the trade. The SEC disfavors this exception (the SEC said so in the original 1989 Rule 15a-6 adopting release and repeated this view in the most recent Release) and I am not aware of any major firm that relies on it.

Other than repeating the SEC’s dislike of this exemption, the Release would leave the exemption for unsolicited transactions in place.

Commentary. Like the SEC, I am very skeptical of the unsolicited transaction exemption. In theory, it sounds nice. If a broker-dealer receives a call out of nowhere from a U.S. customer, why shouldn't the broker-dealer be able to execute the transaction? In reality, the world does not work this way. Particularly as the class of qualified investors that non-U.S. broker-dealers may solicit expands under the Release, the class of investors that non-U.S. broker-dealers may not solicit shrinks to what are essentially retail, or maybe super-retail, investors. If there are really non-U.S. broker-dealers that are making a living on this business (the SEC does not think there are (Release at page 8) and I don't think so either) it is hard for me to believe that it is not "solicited" business, at least as the SEC defines solicitation. For example, if the non-U.S. broker-dealer has a web site-- and what broker-dealer does not?--it must determine that the retail customer did not learn of its existence through the non-U.S. broker-dealer's web site and, if the customer did, the broker-dealer must reject the business. Does anyone believe that this would really happen? (I do note that the one place where, arguably, a non-U.S. broker-dealer can do an unsolicited business, is in dealing with qualified investors that receive research from offshore; but that is not really unsolicited, it is just deemed to be unsolicited under Rule 15a-6(a)(2).)

Having expressed my skepticism of this exemption, I will add that I am not aware of any problems that have arisen from its use, and whatever the SEC does with it, that should not delay the consideration of the Release and the need to improve Rule 15a-6. Any re-examination of this exemption’s viability or purpose should not detract from the SEC focusing on the aspects of the Release that are actually significant to the economy.

2. Research. A non-U.S. broker-dealer can send research to a defined category of customers (currently called “major U.S. institutional investors”) without the intermediation of a U.S. brokerdealer. As a practical matter, this exemption permits a non-U.S. broker-dealer to send research directly to certain U.S. investors without complying with the burdensome U.S. rules applicable to research. Any non-U.S. broker-dealer making use of this exemption would also effect transactions in reliance on one of the other exemptions provided by Rule 15a-6.

The Release would expand this exemption by expanding the permitted class of U.S. investors to whom non-U.S. broker-dealers may send research directly without the intermediation of a U.S. broker-dealer. The new defined category of permitted investor is referred to as “qualified investors.” In short, unlike the current definition which generally requires $100 million in investment assets, the new definition would include investors (including individuals) that have only $25 million in assets. This definition is further discussed in Part IV.1 of this memorandum.

Commentary. This seems a positive, as it will allow a broader range of U.S. investors to obtain research reports from non-U.S. broker-dealers, presumably primarily on non-U.S. securities. It is to be expected that many non-U.S. broker-dealers (including those with U.S. affiliates) will find it more attractive to transmit research directly to U.S. customers, rather than sending the research through their U.S. affiliates and having that research become subject to the burdensome U.S. research regulations.

At a minimum, the SEC should provide that its research rules, and the rules of the SROs, do not apply to non-U.S. research provided by a non-U.S. broker-dealer that is merely transmitted by a U.S. broker-dealer to a U.S. qualified investor, provided the U.S. broker-dealer makes clear that it is not the author of the research. This would allow the U.S. sales force to stay involved in the sale of non-U.S. securities, rather than encouraging a process that eliminates the involvement of U.S. sales. Further, a global investment bank producing global research on securities should be able to tell its qualified investors in the United States that the non-U.S. aspects of the research were produced subject to non-U.S. rules.

3. Transactions with a U.S. Broker-Dealer or U.S. Bank as Principal or Agent. Rule 15a-6 currently permits non -U.S. broker-dealers to transact directly with a U.S. broker-dealer (acting as a principal or as agent for its customers) or with a U.S. bank conducting securities transactions pursuant to one of the bank exemptions from broker-dealer registration under the Exchange Act.4 The Release would not change these exemptions.5

Commentary. Currently, a very broad range of transactions are conducted for U.S. customers through U.S. broker-dealers and banks acting as agent or principal. The SEC did not comment on this exemption, and it would remain in place, though it would arguably become somewhat less important as the ability of non-U.S. broker-dealers to transact directly with U.S. customers would be substantially increased. Nonetheless, the reality is that even a liberalized version of Rule 15a- 6(a)(3) would “protect” U.S. investors to a greater degree than they desire, and accordingly Rule 15a-6(a)(4) will remain a significant outlet for U.S. investments.

4. U.S. Resident Fiduciaries Acting for Non-U.S. Clients. Under a no-action letter sometimes referred to as the “Offshore Client Letter,”6 the SEC permits non-U.S. broker-dealers to do business directly with U.S. fiduciaries for a defined category of “Offshore Clients” provided that the transactions are only in non-U.S. securities and are effected offshore.

The Release would replace this no-action letter with specific exemptive provisions including a variety of complicated definitions that would replace the complicated definitions in the no-action letter, allowing a U.S. fiduciary7 to transact in securities for “foreign resident clients” as defined in the Release.

The definition of “foreign resident client” in the Release is similar to the definition of “Offshore Client” in the Offshore Client Letter in that both definitions include an entity not organized or incorporated under the laws of the United States and not engaged in a trade or business in the United States for federal income tax purposes.8 As regards individuals, the proposed rule is somewhat more liberal than the Offshore Client Letter, covering any individual not a U.S. resident for federal income tax purposes. The equivalent definition in the Offshore Client Letter required an individual to be both a non-U.S. resident and non-U.S. citizen, or if a U.S. citizen, to reside outside the United States and meet an asset test. Finally, the proposed definition includes any entity not organized or incorporated under the laws of the United States, 85% or more of whose outstanding voting securities are beneficially owned by any other “foreign resident clients” under the proposed definition. The 85% foreign ownership test is designed “to capture foreign entities that are predominantly foreign-owned, while accommodating a small amount of U.S. ownership.”9 The equivalent definition in the Offshore Client Letter required that “substantially all” of the outstanding voting securities be owned by “Offshore Clients.”

The proposed rule imposes an additional requirement, not contained in the Offshore Client Letter, that the non-U.S. broker-dealer comply with the “foreign business test” discussed in Part IV of this memorandum below (i.e., that 85% of the aggregate value of the firm’s securities transactions for U.S. investors is derived from transactions in “foreign securities”). According to the Release, the basis of this restriction is that foreign resident clients would not expect a non-U.S. broker-dealer conducting a business primarily in foreign securities to be regulated by the SEC.10

The proposed rule is more liberal than the Offshore Client Letter in that the proposed rule permits transactions in U.S. securities (subject to compliance with the foreign business test), whereas the Offshore Client Letter specifically limited transactions to “foreign securities.”11

Commentary. My first problem with both the Release and the existing Offshore Client Letter is that the definition of foreign clients is simply too complicated and does not serve a clear purpose. Start with the fact that the relevant entity “must not be engaged in a trade or business for U.S. tax purposes.” As a securities lawyer, I am not entirely sure what this means or why the SEC thinks it is a particularly relevant fact. For example, I am aware that an offshore fund with all foreign investors may become engaged in a U.S. trade or business if it becomes heavily involved in the origination or the renegotiation of loans. But I don’t know why such a fund, assuming it were owned by non-U.S. investors for example, should, as a policy matter, be precluded from using a non-U.S. broker-dealer for its securities transactions.

I also do not like the fact that the eligibility of an offshore fund to use the exemption depends on the percentage of U.S. investment. It is inevitable that U.S and non-U.S. investors come in and out of an offshore fund, and thus the fund’s percentage of U.S. ownership will be periodically changing. It is not reasonable to expect that an offshore fund would discontinue all of its relationships with a non-U.S. broker-dealer because, for example, it lost one of its offshore investors and that caused its U.S. ownership to rise about 15%.

I discuss the foreign business test in part IV of this memorandum.

5. Non-U.S. Options Exchanges. The SEC is proposing to codify existing no-action relief permitting non-U.S options exchanges and non-U.S. broker-dealers that are members of those exchanges to engage in certain limited activities in order to familiarize U.S. investors with options traded on non-U.S. exchanges.12 While existing no-action relief requires non-U.S. exchanges and their members to limit contact to “qualified institutional buyers”13 the proposed rule would permit non-U.S. options exchanges to contact any “qualified investor” (including individuals) about these products.

The proposed exemption would also cover “OTC options processing services” offered by non-U.S. options exchanges.14

The options rules impose some fairly complicated provisions on just what an exchange can do in the United States, the types of material that it can provide to U.S. investors, and the activities that a non-U.S. broker-dealer can conduct with a U.S. customer when the customer has been solicited by a non-U.S. options exchange.

The Release also warns that the sale of foreign listed options into the United States is potentially subject to registration under the Securities Act.

Commentary. The options exchange proposal demonstrates two of the principal problems with the SEC’s rulemaking: (i) it is too complicated (part of the reason that the explanation above is reasonably short is that I still have not figured out all the conditions enough to describe them cogently), and (ii) there is no co-ordination between the SEC Divisions. The general premise of the options exemption should be that options exchanges can solicit business with U.S. qualified investors in just the same manner as non-U.S. broker-dealers can. To the extent that some additional or different conditions apply, they should be justified and minimized.

Instead, the options proposal has added conditions that serve no real purpose. For example, an options exchange is permitted to provide a qualified investor with a list of its member non-U.S. broker-dealers, but only if the U.S. customer asks for the list first. Is that condition really necessary? Is one to expect that non-U.S. options exchanges will have two sets of marketing materials: one for customers who ask the right questions and the others for those who only sit silently. More substantively, a U.S. qualified investor is only permitted to trade listed foreign options if it first has experience with U.S. options. I do not see the purpose of this requirement. We do not impose this experience requirement on U.S. customers wishing to trade otc non-U.S. options or non-U.S. listed equities. Why, for example, should a new U.S. investment company that trades in foreign securities be prevented from trading foreign options until it has U.S. options experience; it might not even trade U.S. securities or options.

The Release reminds firms that the exemption only covers broker-dealer and exchange registration issues; it does not cover registration issues under the Securities Act. In an ideal world, it would have been a great thing if the SEC’s proposed rulemaking on foreign options could cover all of the relevant aspects of the product and the transactions. It makes very little sense for the SEC to tell foreign options exchanges that they may market their products to U.S. qualified investors, but then for the SEC to tell broker-dealers that if they sell those options they will be subject to rescission risk because the options could not be legended in accordance with the safe harbor requirements of Regulation D under the Securities Act.15

6. Quotation and Trading Systems

(a) Third Party Systems

The Release proposes to adopt prior no-action letter guidance that permits the U.S. distribution of non-U.S. broker-dealers’ quotations through third party systems (i.e., systems operated by third party marketplaces or vendors), regardless of whether the system distributed those quotations primarily outside the United States.16

(b) Proprietary Trading Systems

The Release affirms previous staff guidance regarding the use of proprietary quotation systems, permitting a non-U.S. broker-dealer to distribute quotations to U.S. investors via a proprietary quotation system provided (i) the U.S. investor subscribes to the quotation system through an SECregistered broker-dealer, (ii) the SEC-registered broker-dealer has continuing access to the quotation system, (iii) the non-U.S. broker-dealer’s contacts with U.S. investors are permissible under Rule 15a-6, and (iv) any resulting transactions are intermediated in accordance with Rule 15a-6.17

(c) Alternative Trading Systems

The Release notes that a non-U.S. broker-dealer relying on an exemption under Rule 15a-6 is not permitted to operate an alternative trading system pursuant to Regulation ATS. This is because Regulation ATS requires an alternative trading system to register as a broker-dealer under Section 15 of the Exchange Act.18 The Release requests comment on whether the SEC should amend Regulation ATS to permit a non-U.S. broker-dealer relying on Rule 15a-6 to operate an alternative trading system in the United States so long as it otherwise complies with the requirements of Regulation ATS.

Commentary. As noted above, the Release’s provisions on Third Party Systems and Proprietary Trading Systems are just codifications of existing SEC positions.

I have to admit that I am puzzled by the SEC’s request for comment on non-U.S. ATSs. I don’t know whether the SEC is trying to encourage non-U.S. firms to operate ATSs that trade U.S. securities or ATSs that trade non-U.S. securities. Would these ATSs be able to have U.S. customers as members? The SEC’s request for comment on ATSs seems inconsistent with its prohibition on trading systems that allow for execution. Accordingly, I would not read anything too immediate into the SEC’s request for comment on non-U.S. ATSs. It seems more in the nature of a throwaway.

7. Innocents Abroad. Rule 15a-6 generally permits a non-U.S. broker-dealer to transact with U.S. persons abroad, so long as, in the case of a U.S. branch resident abroad, the resulting transactions are not effected in the United States. The Release does not change these exemptions.

Commentary. Many of the interpretative issues that have arisen over the years deal with the ability of non-U.S. broker-dealers to do business with U.S. persons that have offices or representative agents outside the United States. For the most part, I have to believe that most non-U.S. brokerdealers ignore these interpretative questions. Does a non-U.S. broker-dealer really refuse to transact in securities for a branch of a U.S. person located outside the United States because the resulting transaction might be executed in the United States? Imagine the tables were turned and a U.S. broker-dealer were effecting transactions for a non-U.S. entity that had a permanent office in the United States. It would never occur to the U.S. broker-dealer that it could not freely do business with that permanent office, nor should it have to.

Similar, but probably harder, interpretative questions arise in the case of non-U.S. advisers for U.S. persons, and in the case of advisers that have offices both within and without the United States.

How should these advisers and their clients be treated? The Release does not resolve these questions.

IV: Direct Solicitation of U.S. Qualified Investors

Rule 15a-6 currently permits non-U.S. broker-dealers to solicit and execute transactions more or less directly with defined groups of eligible U.S. investors, subject to the condition that a U.S. broker-dealer carry out specified tasks in connection with the sales. These tasks include (i) for some customers, and at some times, “chaperoning” the transactions, (ii) “effecting” the actual transactions, (iii) sending confirmations and statements, and (iv) providing any “custody” services and complying with any applicable capital rules.

The SEC is proposing to (i) significantly expand the categories of U.S. investors that may be contacted directly by non-U.S. broker-dealers, (ii) replace the current exemptions under Rule 15a- 6(a)(3) with two new exemptions, and (iii) limit the tasks that would be carried out by U.S. brokerdealers in the conduct of these exemptions.

As a general matter, the expanded exemptions fall into two categories. First, there is an executiononly exemption. Second, there is an exemption that allows non-U.S. broker-dealers to provide fullservice brokerage to U.S. customers, including custodial services. This second exemption is subject to certain significant conditions that do not apply to the execution-only exemption.

The first part of this section describes the expanded group of U.S. investors that non-U.S. firms may contact. The second part of this section focuses on the full-service brokerage and custody exemption. The third section addresses the trading-only exemption. The fourth section describes the reduced range of tasks that non-U.S. broker-dealers would be required to carry out in relation to these transactions.

1. Qualified Investors for Direct Solicitation.

Currently, non-U.S. broker-dealers may only solicit business from “major U.S. institutional investors” (any institution with over $100 million in investable assets) and, subject to additional conditions “U.S. institutional investors.”

The SEC is proposing to significantly expand the categories of U.S. investors to whom non-U.S. broker-dealers may send research and from whom they may directly solicit securities transactions under Rule 15a-6. Under the Release, non-U.S. broker-dealers would be permitted to send research directly to (as discussed in Part III of this memorandum), and conduct securities transactions with, any “qualified investor” as defined in Section 3(a)(54) of the Exchange Act.19 A“qualified investor” is one of fourteen listed types of entities. Most importantly, the definition includes a corporation, partnership, or natural person with $25 million or more in discretionary investment funds. The definition also includes an investment company, private investment fund, bank, small business investment company, trust, foreign bank, or government, and certain employee benefit plans, or a government or instrumentality thereof with $50 million or more in such funds.20

The SEC is proposing to adopt the “qualified investor” test in order to conform Rule 15a-6 with certain of the bank exemptions from broker-dealer registration adopted in the Gramm-Leach-Bliley Act of 1999, under which banks may enter into certain securities transactions with “qualified investors” without being subject to broker-dealer registration.21 According to the Release, as Congress deemed “qualified investors” sufficiently sophisticated to deal with banks that are not registered as broker-dealers, “qualified investors” should likewise be sufficiently sophisticated to enter into securities transactions with non-U.S. broker-dealers under Rule 15a-6.22

While adoption of the “qualified investor” test would generally expand the category of permitted customers under Rule 15a-6, the SEC acknowledges that the new standard would, in limited cases, exclude persons that are currently included in the definition of “U.S. institutional investor” or “major U.S. institutional investor.” For example, with respect to employee benefit plans, the definition of “U.S. institutional investor” does not require a fiduciary to make investment decisions for the plan, whereas the “qualified investor” test requires investment decisions to be made by a plan fiduciary.23 Similarly, in order for trusts to be “qualified investors” certain specified entities must direct purchases for the trust; the definition of “U.S. institutional investor” does not impose such a limitation.24

Commentary. There are two main implications of the proposed adoption of the “qualified investor” test. First, this test will significantly increase the number of permitted customers under Rule 15a-6 by reducing the assets required to qualify as a permitted customer from the current $100 millionlevel for “major U.S. institutional investors.”25 Second, the proposal would permit non-U.S. brokerdealers to conduct securities transactions directly with individual investors in the United States for the first time, provided the individual meets the $25 million test. Currently, non-U.S. broker-dealers are prohibited from conducting securities transactions directly with individual investors in the United States, regardless of their level of assets.

Although the SEC will be applauded for expanding the category of qualified investors, I think there are a few ways in which the SEC could go further. As a general matter, it should allow one investor that does not meet the asset test to piggyback off the qualifications of another investor. For example, if a hedge fund manager has one fund with $100 million in assets and starts another with $20 million in assets, then there is little reason that the second smaller fund should not qualify as a qualified investor; it is neither more nor less sophisticated than the larger fund.

2. Solicited Trades: Full-Service Brokerage and the Custody Exemption

Under the first exemption for direct solicitation, referred to in the Release as “Exemption (A)(1),” [i.e., Rule 15a-6(a)(3)(iii)(A)(1)] a non-U.S. broker-dealer would be permitted to provide “full-service brokerage” by effecting securities transactions for “qualified investors” and maintaining custody of securities and funds relating to those transactions. In order to fall under proposed Exemption (A)(1), the non-U.S. broker-dealer and SEC-registered broker-dealer would be required to comply with certain specific requirements, as described below.

(a) Non-U.S. Broker-Dealer Eligibility Requirements

In order to provide brokerage and custody services under proposed Exemption (A)(1), a non-U.S. broker-dealer would be required to meet two eligibility conditions, one as to the extent of its foreign business and the other as to the existence of a home country regulator.

(i) Foreign Business Test. Proposed Exemption (A)(1) would only be available to a non-U.S. broker-dealer that conducts a “foreign business.” Under the proposed rule, a non-U.S. brokerdealer would be deemed to conduct a “foreign business” if at least 85% of the aggregate value of “securities purchased or sold” by the non-U.S. broker-dealer in transactions with U.S. investors was derived from transactions in “foreign securities.”26

The proposed definition of “foreign security” would include equity and debt securities of a foreign private issuer; debt securities of U.S. issuers distributed wholly outside the United States in accordance with Regulation S under the Securities Act (although a U.S. security traded on a non- U.S. securities exchange would not, on the definition, be a “foreign security”); certain non-U.S. government debt, and derivatives on the above instruments.27 Derivatives that are not themselves securities, including swaps meeting the definition of “swap agreement” under Section 3A of the Exchange Act would not be considered “foreign securities” and would thus not be included in the determination of whether a non-U.S. broker-dealer is conducting a “foreign business.”28 However, derivatives that are securities, including options on securities and security futures, would be included in determining whether a non-U.S. broker-dealer meets the “foreign business” test.29

According to the Release, the foreign business test would provide U.S. investors increased access to foreign securities and markets without creating opportunities for regulatory arbitrage vis-à-vis U.S. securities markets because the non-U.S. broker-dealer’s business in U.S. securities would be limited.30 The SEC is proposing an 85% threshold “because we understand from industry representatives that foreign broker-dealers currently effect transactions pursuant to (a)(3) of Rule 15a-6 primarily in foreign securities and only do a small percentage of business in U.S. securities (less than 10% by most estimates).”31 The 85% threshold is intended to accommodate existing business models and allow non-U.S. broker-dealers to continue to do a limited amount of business in U.S. securities. The SEC indicates that any lower threshold could allow a non-U.S. broker-dealer to conduct “significant business” in U.S. securities with U.S. investors without being subject to the full scope of the SEC’s broker-dealer regulatory framework.32

Commentary. The 85% business threshold test came as a surprise, insofar as I am aware, to most of the securities industry. My immediate reaction to the test is that it recalls the various complicated conditions that the SEC originally attempted to impose on banks effecting securities transactions in its proposed Regulation B, and which the banks and the banking regulators were able to defeat. My second reaction is that I do not know what the purpose of the test is. The SEC cannot assert that U.S. investors are less safe dealing with foreign broker-dealers that do 25% of their business in U.S. securities, rather than 15%. If the purpose of this provision is not to protect U.S. investors, than what is the purpose?

According to the Release, the SEC imposed limits on non-foreign business in order to prevent regulatory arbitrage, although the Release does not specify which rules the SEC does not want arbitraged. To the extent that the SEC is in effect expressing its concern that trading in U.S. securities will move offshore, this does serve to demonstrate a real lack of confidence that US. traders find U.S. markets to be inherently attractive. It makes me wonder whether, in fact, the SEC fears that U.S. market structure regulation (in particular Regulation NMS) has made the U.S. market so unattractive that it provides an opportunity for non-U.S. exchanges to outcompete U.S. exchanges in trading U.S. securities. If so, this seems to me a fairly substantial (and probably deserved) criticism of Reg. NMS.

On a lesser note, although the SEC says that the test will be easy to implement, it will certainly require firms to develop additional systems to track which securities qualify as foreign securities and their total trading volume in such securities as opposed to U.S. securities. They will similarly need to track which of their customers are qualified investors.

Although I do not see that the business test serves any consumer protection need, I note that if the SEC does proceed with it, the SEC should clarify that repurchase transactions, securities loans and like financing transactions are not part of the 85% test. Otherwise, firms could game the measure by, for example, executing overnight repos on foreign securities and thus blowing up their foreign securities executions. The only transactions that should count for this purpose are those that result in a change in beneficial and economic ownership of the relevant securities.

(ii) Home Country Regulation. In order to conduct securities transactions under proposed Rule 15a-6(a)(3)(iii)(A)(1), the non-U.S. broker-dealer must be regulated by its home country securities regulator in the conduct of securities activities, including the specific activities which the non-U.S. broker-dealer engages in with U.S. investors.33 This means that unregulated entities, including offshore booking companies, would not be permitted to conduct securities activities under the proposed Rule. This is a new requirement, not currently included in Rule 15a-6.

Commentary. I do not see the purpose of this requirement given that we are not imposing any minimum standards on the conduct of that home country regulation.

(b) Disclosure Requirements

In order to put U.S. investors on notice that a non-U.S. broker-dealer operating under Exemption (A)(1) is not subject to the same regulatory requirements as SEC-registered broker-dealers, the non-U.S. broker-dealer would be required to disclose to U.S. investors that the non-U.S. brokerdealer is regulated by a foreign securities regulator, and not the SEC. In addition, the non-U.S. broker-dealer would be required to disclose that U.S. segregation requirements, bankruptcy and SIPC protections do not apply to any funds and securities of the U.S. investor held by the non-U.S. broker-dealer.34

Commentary. In my view, this requirement is too limited. Non-U.S. broker-dealers should be required to explain in writing to U.S. customers just what the applicable custody, segregation and bankruptcy rules are. (Presumably, firms of a particular type from a particular country could develop a standardized disclosure that all of them could use.) 

One thing we have learned from the events surrounding Bear Stearns is that very few U.S. customers (or even law firms) have much understanding or appreciation of the U.S. custody, segregation and bankruptcy rules. Accordingly, telling customers that those rules do not apply is likely not to have much impact.

In fact, for any criticism that I may have of the SEC, its financial protection rules for customers are extremely vigorous, and customers should draw a lot of comfort from them. By requiring that non- U.S. firms describe the non-U.S. rules that apply to them, the SEC would potentially draw attention to the advantages that may come from U.S. regulation. That would potentially help to keep U.S. customers doing business in the United States, and perhaps even draw non-U.S. customers to the safety of U.S. firms.

In addition to these legal disclosures, the SEC might consider additional financial disclosure requirements that non-U.S. firms should make; e.g., the amount of their capital.

(c) Books and Records

Under proposed Exemption (A)(1), an SEC-registered broker-dealer would be required to maintain books and records relating to transactions effected by a non-U.S. broker-dealer under the exemption.35 However, the proposed rule permits the SEC-registered broker-dealer to maintain the books and records in accordance with the local regulatory requirements to which the non-U.S. broker-dealer is subject. Further, the SEC-registered broker-dealer would be permitted to maintain the books and records with the non-U.S. broker-dealer provided the SEC-registered broker-dealer makes a reasonable determination that the records could be promptly furnished to the SEC upon request.

Commentary. The proposal would free U.S. broker-dealers from the requirement that they produce confirmations and statements for securities transactions executed by non-U.S. broker-dealers for U.S. customers. This is a positive development as it eliminates an administrative burden on U.S. broker-dealers that seemed to serve no real purpose; as the non-U.S. broker-dealers had no involvement in the relevant transactions, there was no great benefit in their producing the trade confirmations. All they could do was send along whatever their foreign affiliates produced.

The new proposal simply requires that the U.S. firm keep or have access to the records that the non-U.S. firm produces, so that these records can be made available to the SEC.

On the other hand, one oddity of the proposal is that it imposes no minimum standards on the records that a non-U.S. broker-dealer must maintain. Given that this requirement is intended to allow the SEC to monitor frauds on U.S. customers, and fraudulent trading by U.S. customers, it follows that the SEC should require that the non-U.S. firm have at least those records that will be sufficient for the antifraud purposes of the SEC in this regard. Such records need not be much, and they need not be more than the bare minimum of information that one would expect that any firm would keep. These required record might be limited to, for example, (i) the identity of the customer, (ii) the date and approximate time of the trade, (iii) the securities traded, (iv) whether the trade was a purchase or a sale, and (v) the price of the trade.

3. Non-Custodial Brokerage Exemption

The SEC is proposing a second exemption under Rule 15a-6(a)(3), referred to as proposed “Exemption (A)(2).” This exemption is designed to cover “qualified investors” that maintain accounts at, and custody their securities with, SEC-registered broker-dealers but that wish to enter into securities transactions with non-U.S. broker-dealers because of their knowledge of local markets or their ability to execute trades in particular markets. Given the more limited functions conducted by a non-U.S. broker-dealer under this exemption, the requirements applicable to the non-U.S. broker-dealer would be more lenient than for proposed Exemption (A)(1).

(a) Non-U.S. Broker-Dealer Eligibility Requirements

In order to fall within proposed Exemption (A)(2), a non-U.S. broker-dealer would be required to be regulated by its home country securities regulator.36 However, proposed Exemption (A)(2) would not require the non-U.S. broker-dealer to conduct a “foreign business.” According to the Release, this is because the non-U.S. broker-dealer may not operate a full-service brokerage under this exemption, and there is thus less risk of regulatory arbitrage.37

(b) Disclosure Requirements

Non-U.S. broker-dealers operating under proposed Exemption (A)(2) would be required to disclose to U.S. investors that the non-U.S. broker-dealer is regulated by a foreign securities regulator, and not the SEC.38

(c) SEC-Registered Broker-Dealer Requirements

Under proposed Exemption (A)(2), the SEC-registered broker-dealer would be required to perform certain specified functions, as follows:

(i) Books and Records

The SEC-registered broker-dealer would be required to maintain books and records relating to transactions effected by a non-U.S. broker-dealer under the exemption.39 Proposed Exemption (A)(2) does not permit the SEC-registered broker-dealer to maintain these records with the non- U.S. broker-dealer. 40

(ii) Protecting Customer Funds

Under proposed Exemption (A)(2), the SEC-registered broker-dealer would be responsible for safeguarding customer securities and funds in accordance with SEC Rule 15c3-3.41 The non-U.S. broker-dealer would, however, be permitted to clear and settle transactions on behalf of the SECregistered broker-dealer.42

4. Relief from Current Requirements of Rule 15a-6(a)(3)

(a) General Relief

Proposed Exemptions (A)(1) and (A)(2) would relieve an SEC-registered broker-dealer from some key obligations to which it is currently subject under Rule 15a-6(a)(3). In particular, the SECregistered broker-dealer would no longer be required to extend or arrange for the extension of credit; issue confirmations or account statements; or take capital charges on transactions that fail to settle within the standard settlement cycle. 43 Further, in relation to proposed Exemption (A)(1), the SEC-registered broker-dealer would not be subject to the requirements to deliver and safeguard funds and securities in accordance with SEC Rule 15c3-3.44 Further, the SECregistered broker-dealer would not be required to maintain accounts for customers of non-U.S. broker-dealers relying on proposed Exemption (A)(1), and would thus not be required to adopt antimoney laundering procedures with respect to customers of the non-U.S. broker-dealer.45

(b) Elimination of “Chaperoning” Requirement

The SEC is proposing to eliminate the “chaperoning” requirements currently imposed by Rule 15a- 6(a)(3). Under the proposal, non-U.S. broker-dealers would be permitted to have telephone or electronic communications with U.S. “qualified investors” without involvement of an SEC-registered broker-dealer.46

Commentary. I was always curious if anyone paid attention to this chaperoning requirement, and if so, whether the chaperon ever jumped into the middle of conversations to remind the parties that they must be on their best behavior.

(c) Visits to the United States

Further, the SEC is proposing to permit representatives of a non-U.S. broker-dealer to visit U.S. “qualified investors” without involvement of an SEC-registered broker-dealer, provided (i) any resulting transactions are effected pursuant to proposed Rule 15a-6(a)(3); and (ii) the visits do not exceed 180 days per calendar year, a requirement designed to prevent non-U.S. broker-dealers effectively having a permanent sales force in the United States.47

Commentary. Figuring 48 working weeks in a year, there are only 240 working days in a year, not counting holidays and sick days. So to permit 180 days of visits in a year seems pretty generous.

(d) Statutory Disqualifications

The SEC is proposing to shift the burden of determining whether representatives of the non-U.S. broker-dealer are subject to a “statutory disqualification” under Section 3(a)(39) of the Exchange Act from the SEC-registered broker-dealer (which is currently required to make this determination) to the non-U.S. broker-dealer.48 The SEC is proposing this change because the non-U.S. brokerdealer is in possession of the relevant information in order to make this determination.49 The proposed rule would require the SEC-registered broker-dealer obtain a representation from the non-U.S. broker-dealer that it has made this determination.50

Commentary. This change is just a formality. As the SEC indicates, it was really always the non- U.S. firm that had to make this determination since it is the one in possession of the information. The effect of this change is just that the non-U.S. firm must give its U.S. associated firm a representation that it is complying with the employee eligibility requirements.

(e) Effecting trades

The proposed rule would not require the SEC-registered broker-dealer to “effect” securities transactions under proposed Exemption (A)(1) or (A)(2). This contrasts with the requirement under current Rule 15a-6(a)(3), where the SEC-registered broker-dealer is required to “effect” transactions under the exemption, other than negotiating their terms. According to the Release, this means that the SEC-registered broker-dealer is no longer required to comply with applicable securities rules applicable to a broker-dealer “effecting’ securities transactions, unless the SEC-registered broker-dealer is, in fact, involved in effecting the trade (e.g., where the SEC-registered broker-dealer is involved in effecting a transaction on a U.S. securities exchange).51

Commentary. In Lofchie’s Guide, I said that I never understood if the “effecting” requirement actually had any meaning, and, if it did, I did not know what it was. Now, after 15 years, the requirement is being withdrawn and I will never learn what it meant.

V. Parting Commentary on the Release and the SEC

Big Picture. In the big picture, the Release will not change that much. It is simply a recognition of the reality that U.S. investors want to buy non-U.S. securities and they want to interact with non- U.S. broker-dealers. There is really very little that the SEC can do to prevent or effect that. The $25 million investors that the SEC purports to allow to buy non-U.S. securities or to deal with non- U.S. broker-dealers are in fact already doing so. What the Release will really do is to allow them to do so without some of the existing bells and whistles that broker-dealers now must impose to comply with the form of Rule 15a-6.

Research. The proposals will facilitate U.S. investors obtaining research on non-U.S. securities from non-U.S. broker-dealers. Similarly, the SEC must re-examine the burdensome research rules that were imposed following the internet research scandals. While there is no doubt that bad deeds were committed, I think there is also little doubt that the resulting rules imposed undue burdens on firms producing research. Put simply, the SEC should attempt to understand why firms in the U.S. produce research (what is the economic model) and should attempt to encourage firms to produce more. This can not be accomplished simply by imposing more rules; it requires the regulators to allow firms to have a model of producing research that can generate a profit.

Institutional Investor Exemptions. If Congress thinks that institutional investors are smart enough to deal with banks and the SEC thinks they are smart enough to deal with non-U.S. broker-dealers, then it follows that they are smart enough to deal with U.S. broker-dealers without implicating the full regulatory protections and burdens that apply to retail investors. To take but one example, the “mark up” rule that limits the prices at which securities can be sold is very appropriately applied to protect retail investors. It makes very little sense to apply that same rule to protect a billion dollar hedge fund that trades in exotic securities. The SEC needs to figure out not just which investors are smart enough to trade overseas, but which investors are smart enough to trade in the United States.

Reciprocity. I believe that, after some period of time, the SEC should allow the direct solicitation exemption only to broker-dealers in those jurisdictions that afford similar treatment to U.S. firms. For all its failings, and there are many, the U.S. regulatory system provides numerous protections to investors, and the SEC should provide a means by which U.S. firms can vigorously compete outside the United States by offering non-U.S. investors access to the protections that U.S. regulation affords.

Exchanges and Issuer Regulation. The SEC needs to figure out how to induce non-U.S. issuers to list their securities in the United States. As U.S. investors find it easier and easier to go abroad, there is less and less reason for non-U.S. issuers to subject themselves to what they perceive as a hostile regulatory environment. Obviously, the SEC is moving in a positive direction with the move towards international accounting standards, but it is playing catch up. The agency must both catch up, and figure out how it fell so far behind in the first place.

On a minor note, I point out that the SEC should rethink issuer registration requirements under the Exchange Act. It is inevitable that over time, regardless of the Release, U.S. ownership of non-U.S. companies will increase in numbers, with the theoretical result that non-U.S. issuers will become subject to the reporting requirements under the Exchange Act because of the number of their U.S. holders, even though those issuers have taken no action to have their securities listed or traded in the United States. Issuers will generally ignore these U.S. registration requirements, as they probably should, since it does not seem appropriate for the SEC to impose U.S. law on a non-U.S. company just by virtue of U.S. investors buying shares in the company on a non-U.S. exchange. The remedy to this “law breaking” seems to me to fix the law rather than to maintain laws that are neither reasonable nor practical.

Competitiveness. The real questions that I believe that the SEC must face are less about U.S. investors going offshore under Rule 15a-6 (they are already going and gone), but rather about how to bring both U.S. and non-U.S. investors into the United States. That is, how can the SEC devise a regulatory system that is reasonably safe, but that is not over-burdened by regulation, and which enforces regulation through sanctions which are proportionate to the violation.

It is inevitable that the ongoing problems in the U.S. financial markets require the SEC to focus on the protection of investors. But they do not require increased focus from the SEC. The reality is that the SEC is always focused on investor protection as its primary mission. Yet still things go wrong. As they always have and always will. Markets do not always go smoothly up. People make bad decisions and do bad things. If the SEC allows these inevitable and serious problems to delay confronting the separate necessity of improving and not merely increasing U.S. regulation, there will never be an end to delay.