On April 14th, the Securities and Exchange Commission (the “SEC”) published proposed Rule 13h-1 (the “Proposed Rule”) and Form 13H under Section 13(h) of the Securities Exchange Act of 1934 (the “Exchange Act”).1 Rule 13h-1 would establish a large trader reporting system to assist the SEC in identifying and obtaining information about traders that engage in a substantial amount of trading activity in the U.S. securities markets. The SEC hopes to use that information to assess the impact of large trader activity on the securities markets, to reconstruct trading activity following periods of unusual market volatility, and to analyze significant market events for regulatory purposes. The SEC expects the system to enhance its ability to detect and deter fraudulent and manipulative activity and other trading abuses, and provide valuable data for studying markets and market activity.

I. Background

According to the SEC, there has been a “dynamic transformation” of the securities markets in recent years. The evolution from manual to automated trading has led to fundamental changes in market structure, market participants, trading strategies, and products traded. Exchanges and other trading centers offer innovative products and services, lower fees, and higher rebates as they compete for order flow. Large institutions and other professional market participants trade electronically in unprecedented volumes with extraordinary speed, and the average daily share volume and number of trades has increased exponentially. The resulting prominence of these large traders has caused the SEC to assess a range of market structure issues.2

While the SEC first proposed a large trader reporting system in 1991, and a revised version in 1994, it never took final action. However, the recent turbulence in the securities markets, and the increasing sophistication, technical capacity, and trading capability of certain market participants has led the SEC to conclude that it is now time to enhance its ability to collect and analyze trading information with respect to the most active market participants. In particular, the SEC believes that it needs a way to reliably identify large traders, and promptly and efficiently obtain their trading information on a market-wide basis.

II. The Proposed Rule

Large Trader Self-Identification  

A “large trader” would be any person that “directly or indirectly, including through other persons controlled by such person, exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any NMS security for or on behalf of such accounts, by or through one or more registered broker-dealers, in an aggregate amount equal to or greater than the identifying activity level.”3 The “identifying activity level” would be “aggregate transactions in NMS securities that are equal to or greater than: (1) during a calendar day, either two million shares or shares with a fair market value of $20 million; or (2) during a calendar month, either 20 million shares or shares with a fair market value of $200 million.”4

Each large trader would be required to identify itself, its affiliates, its accounts, and its transactions to the SEC, and to make certain other disclosures, on proposed Form 13H. A large trader would be required to file Form 13H “promptly” after effecting the transactions that result in it reaching the identifying activity level. Thereafter, large traders would be required to amend Form 13H promptly after the end of a calendar quarter if any of the information in the form has become inaccurate for any reason (e.g., change of name or address, contact number, type of organization, principal business, regulatory status, or accounts maintained), and to provide, upon request, additional information that would allow the SEC to further identify the large trader and all accounts through which it trades. Regardless of whether it files any amendments during the year, a large trader would be required to update Form 13H annually, within 45 days after calendar year-end, to ensure the accuracy and currency of the reported information.

Upon receiving an initial Form 13H, the SEC would assign each large trader a unique Large Trader Identification Number (“LTID”). Each large trader would be required to disclose its LTID to each registered broker-dealer through which it trades, and identify all of its accounts. This will enable the SEC to aggregate accounts and transactions, and thus capture a large trader’s activity even where it trades through a number of different brokerdealers. Broker-dealers would be required to identify themselves as large traders if they effect transactions for proprietary or other accounts over which they exercise investment discretion, and they meet or exceed the identifying activity level. Large traders also would be required to provide to the SEC, upon request, additional information to allow the SEC to further identify the large trader and all accounts through which it trades.

For complex, multi-tiered organizations, the large trader definition focuses on the parent company of the entities that employ or control the individuals that ultimately exercise investment discretion. Thus, a large trader controlled by another person or entity would not be required to separately comply with the reporting requirements if its controlling person complies with the Proposed Rule’s requirements with respect to all of the controlled person’s accounts. The SEC hopes to “push the identification requirement up the corporate hierarchy to the parent entity,”5 enabling it to identify entities that operate as large traders, by themselves or through subsidiaries or employees, while limiting the burdens to a smaller universe.6 However, a parent would not be required to comply with the Proposed Rule with respect to its controlled persons that choose to comply independently with the Proposed Rule with respect to all of their accounts.

Although a controlled person would have no obligation to report if its parent complies with the reporting requirements with respect to its accounts, the reporting system will accommodate large traders that wish to voluntarily identify themselves with more particularity; for example, by subsidiaries, trading desks, or other business units that exercise investment discretion.7 A registered investment adviser that advises one or more registered investment companies would file and identify itself as a large trader; the investment companies would not directly or indirectly exercise investment discretion and would not file Form 13H. Where two persons exercise investment discretion, and neither would individually qualify as large traders but collectively they do, their firm would be a large trader and would file Form 13H and identify itself as the large trader. A natural person would file Form 13H and identify itself as a large trader only where it qualifies as a large trader and is not employed by an entity.

Investment Discretion

“Investment discretion” will have the meaning provided in Exchange Act Section 3(a)(35), i.e., a person who, directly or indirectly, “(A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the [SEC], by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this title and the rules and regulations thereunder.” This definition will be familiar to many institutional investment or shares with a fair market value of $200 million.”4

Each large trader would be required to identify itself, its affiliates, its accounts, and its transactions to the SEC, and to make certain other disclosures, on proposed Form 13H. A large trader would be required to file Form 13H “promptly” after effecting the transactions that result in it reaching the identifying activity level. Thereafter, large traders would be required to amend Form 13H promptly after the end of a calendar quarter if any of the information in the form has become inaccurate for any reason (e.g., change of name or address, contact number, type of organization, principal business, regulatory status, or accounts maintained), and to provide, upon request, additional information that would allow the SEC to further identify the large trader and all accounts through which it trades. Regardless of whether it files any amendments during the year, a large trader would be required to update Form 13H annually, within 45 days after calendar year-end, to ensure the accuracy and currency of the reported information.

Upon receiving an initial Form 13H, the SEC would assign each large trader a unique Large Trader Identification Number (“LTID”). Each large trader would be required to disclose its LTID to each registered broker-dealer through which it trades, and identify all of its accounts. This will enable the SEC to aggregate accounts and transactions, and thus capture a large trader’s activity even where it trades through a number of different brokerdealers. Broker-dealers would be required to identify themselves as large traders if they effect transactions for proprietary or other accounts over which they exercise investment discretion, and they meet or exceed the identifying activity level. Large traders also would be required to provide to the SEC, upon request, additional information to allow the SEC to further identify the large trader and all accounts through which it trades.

For complex, multi-tiered organizations, the large trader definition focuses on the parent company of the entities that employ or control the individuals that ultimately exercise investment discretion. Thus, a large trader controlled by another person or entity would not be required to separately comply with the reporting requirements if its controlling person complies with the Proposed Rule’s requirements with respect to all of the controlled person’s accounts. The SEC hopes to “push the identification requirement up the corporate hierarchy to the parent entity,”5 enabling it to identify entities that operate as large traders, by themselves or through subsidiaries or employees, while limiting the burdens to a smaller universe.6 However, a parent would not be required to comply with the Proposed Rule with respect to its controlled persons that choose to comply independently with the Proposed Rule with respect to all of their accounts.

Although a controlled person would have no obligation to report if its parent complies with the reporting requirements with respect to its accounts, the reporting system will accommodate large traders that wish to voluntarily identify themselves with more particularity; for example, by subsidiaries, trading desks, or other business units that exercise investment discretion.7 A registered investment adviser that advises one or more registered investment companies would file and identify itself as a large trader; the investment companies would not directly or indirectly exercise investment discretion and would not file Form 13H. Where two persons exercise investment discretion, and neither would individually qualify as large traders but collectively they do, their firm would be a large trader and would file Form 13H and identify itself as the large trader. A natural person would file Form 13H and identify itself as a large trader only where it qualifies as a large trader and is not employed by an entity.

Investment Discretion

“Investment discretion” will have the meaning provided in Exchange Act Section 3(a)(35), i.e., a person who, directly or indirectly, “(A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the [SEC], by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this title and the rules and regulations thereunder.” This definition will be familiar to many institutional investment managers, since it is the definition that applies to quarterly reporting on Form 13F.8 Employees would be deemed to exercise investment discretion on behalf of their employers when they act within the scope of their employment.9

Covered Transactions

The Proposed Rule would apply to all transactions in NMS securities,10 including exercises or assignments of option contracts. It would apply to trading through any facility of a national securities exchange, as well as trading in foreign or domestic over-the-counter markets and after-hours systems. The Proposed Rule would exclude a limited set of transactions that are not generally characterized by the exercise of investment discretion:

  • Journal or bookkeeping entries that record or memorialize the receipt or delivery of funds or securities pursuant to the settlement of a transaction;  
  • Transactions that are part of an offering by or on behalf of an issuer, whether or not subject to Securities Act registration;  
  • Gifts;  
  • Transactions related to estate distributions;  
  • Transactions effected pursuant to a court order or judgment;  
  • Transactions effected pursuant to rollover of qualified plans or trust assets subject to Section 402(c)(1) of the Internal Revenue Code; and  
  • Transactions between an employer and its employees pursuant to the award, allocation, sale, grant, or exercise of a security, option, or other right.

In order to show the full extent of purchase and sale activity, offsetting or netting transactions among or within accounts, even for hedging purposes, would be included in a person’s activity level, and the volume or fair market value of equity securities purchased and sold would be aggregated with the market value of transactions in options or on a group or index of equity securities.11 This is because a trader that nets or hedges its positions, including one that seeks to have a net position of zero at the end of a trading day, may trade in a substantial volume or fair market value during that day, and substantial trading activity has the potential to impact the market, regardless of the person’s end of day net position.

The Proposed Rule would prohibit persons from splitting activity among multiple broker-dealers, accounts, or transactions for the purpose of avoiding the identification and reporting requirements. Moreover, where separate entities engage in coordinated trading strategies that result in the joint exercise of investment discretion over accounts, each entity would be required to count the transactions effected through those accounts toward its identifying activity level.

Inactive Status

A large trader previously assigned an LTID, but whose aggregate transactions during the previous calendar year did not reach the identifying activity level at any time, would be eligible to file for “inactive” status. The large trader would then be relieved from the filing requirement and the requirement to provide its LTID to broker-dealers and others with whom it shares investment discretion. Inactive large traders that later reach the identifying activity again would be required to reactivate their status by filing a Form 13H promptly after effecting transactions that equal or exceed the identifying activity threshold. The large trader would retain the same LTID that was initially assigned to it, and would be required to notify registered broker-dealers and others of its renewed status and its LTID. A large trader that discontinues operations could file an amended Form 13H reflecting “Termination” status.

Broker-Dealer Recordkeeping and Reporting

Under the Proposed Rule, broker-dealers would be required to maintain records of transactions by specific large trader, electronically report large trader transaction information to the SEC upon request, and monitor compliance with the proposed rule. The Proposed Rule also would require systems and procedures to help assure compliance with the identification requirements. Broker-dealers also would be required to maintain the required information and report the activity of any account that the brokerdealer knows or has reason to know is for an “Unidentified Large Trader.”12

For each transaction, broker-dealers would be required to record and maintain: (i) execution date; (ii) account number; (iii) security symbol; (iv) price; (v) number of shares or contracts; (vi) whether the transaction was a purchase, sale, or short sale and, if an option, call or put, opening purchase or sale, closing purchase or sale, or exercise or assignment; (vii) clearing house numbers of the entity maintaining the information and the entities on the opposite side of the transaction; (viii) whether the transaction was for a customer or a proprietary account; (ix) executing exchange or market center; (x) transaction time; (xi) LTID(s); (xii) prime broker identifier; (xiii) average price account identifier; and (xiv) if the transaction was processed by a depository, the identifier assigned to the account by the depository. For trades by Unidentified Large Traders, the broker-dealer also would be required to retain and report the person’s name, address, date the account was opened, and tax identification number(s). Records would have to be kept for three years, the first two in an accessible place.

Broker-dealers would be required to report information on request electronically, in accordance with a specified format based on the existing “electronic blue sheet” format, all required information for all transactions effected directly or indirectly by or through accounts carried by such broker-dealer for large traders and Unidentified Large Traders, if they equal or exceed the reporting activity level. Broker-dealers would be required to report a particular day’s activity only if it equals or exceeds the “reporting activity level,” which is: (i) where each transaction in NMS securities, effected in a single account during a calendar day, is equal to or greater than 100 shares; (ii) any other transaction in NMS securities, effected in a single account during a calendar day, that a registered broker-dealer may deem appropriate; or (iii) such other amount that may be established by SEC order. In addition, a broker-dealer would be allowed to voluntarily report trading activity below the applicable threshold.

Unlike the identifying activity level, when calculating the reporting activity level a broker-dealer would consider only the trading activity for each large trader and unidentified account; it would not aggregate transaction information on an intra-broker-dealer basis. Thus, if a large trader maintains two separate accounts at a registered broker-dealer under the same LTID, the broker-dealer would be required to report activity in each account only if the activity in that account equaled or exceeded the reporting activity level on the specified day. A registered broker-dealer would report each account separately and would not need to aggregate accounts with the same LTID. The SEC believes that most active large trader accounts should contain sufficient transactions on any day to make the accounts reportable in response to an SEC request.

Confidentiality  

Information provided on proposed Form 13H or in response to an SEC request would be exempt from disclosure under FOIA, as would transaction information reported under the Proposed Rule.

Foreign Entities

Because the SEC is concerned that excluding foreign large traders from the Proposed Rule could create a competitive disparity between domestic and foreign markets and persons, it would include foreign large traders within the scope of the Proposed Rule. However, unregistered foreign broker-dealers would not be subject to the recordkeeping or reporting requirements. A foreign investment adviser would be required to disclose its LTID to its U.S.-registered broker-dealer and anyone else with whom it shares investment discretion, but would not be required to disclose on its Form 13H the identity of any client that has not itself been issued an LTID.

Implementation

The large trader identification requirements would become effective three months after adoption of a final rule. The brokerdealer recordkeeping and reporting requirements would become effective six months after the adoption of a final rule, to permit sufficient time for broker-dealers to plan, design, and implement the necessary enhancements to their systems.

III. Request for Comments

The SEC is requesting comments on all aspects of the Proposed Rule, including the following:  

  • Whether the proposed definition of “large trader” is appropriate and sufficiently clear, or whether the SEC should consider an alternative definition;  
  • Whether the proposed “identifying activity level” is appropriate, or whether there are other factors that the SEC should consider;
  •  Whether basing the large trader definition on aggregated transactions during a different measuring period would be more appropriate; for example, over several days or a week; 
  • Whether, instead of requiring Form 13H to be filed “promptly,” the Proposed Rule should specify a hard deadline, such as 10 business days;  
  • Whether the focus on parent entities is appropriate or whether the SEC should require identification and LTID assignment at lower levels;
  • Costs and burdens of modifying existing systems to accommodate the Proposed Rule;  
  • Whether broker-dealers should report large trader activity on a routine basis such as daily, weekly, or monthly;  
  • Whether securities other than NMS securities should be included;  
  • Whether the reporting requirements would influence trading decisions, such as inducing traders to avoid reportable securities or to trade off-shore; and  
  • Whether the proposed treatment of foreign entities is appropriate and whether foreign laws will complicate foreign large traders’ ability to comply with the Proposed Rule.  

Comments should be submitted on or before June 22, 2010.  

IV. Impact

The Proposed Rule will have a critical impact on all forms of institutional investors and advisers that trade in amounts that exceed the identifying activity level, including many entities that heretofore have not been subject to SEC reporting (for example, firms that do not hold large securities positions for long periods and therefore do not qualify for quarterly reporting on Form 13F). While all firms, including broker-dealers, will need to review the Proposed Rule carefully and consider its impact on their trading strategies and infrastructure, for firms that currently do not provide ongoing reports to the SEC, and thus have no significant procedures or infrastructure for complying with this type of reporting regime, the burden could prove to be significant.