On July 26, 2011, the Securities and Exchange Commission (the “SEC”) voted unanimously to adopt Rule 13h-1, along with a new web-based Form 13H, under Section 13(h) of the Securities Exchange Act of 1934 (the “Exchange Act”).1 Rule 13h-1 establishes a large trader reporting system that is intended to assist the SEC in identifying and obtaining information about traders that engage in a substantial level of trading activity in the U.S. securities markets.
Rule 13h-1 will require “large traders” to identify themselves to the SEC and make certain disclosures on Form 13H. Upon receipt of Form 13H, the SEC will assign to each large trader a “large trader identification number” (“LTID”) that will identify the large trader. The large trader will be required to provide its LTID to each registered broker-dealer that effects transactions for the large trader. Such broker-dealers will then be required to maintain records of two items in connection with transactions effected through the accounts of such large traders: (1) the LTID; and (2) the time that each transaction in the account is executed. In addition, the SEC will require broker-dealers to report large trader transaction information to the SEC upon request through the Electronic Blue Sheets (“EBS”) system currently used for reporting trade information. Finally, certain broker-dealers will be required to perform limited monitoring of customer accounts for activity that may trigger the identification requirements of Rule 13h-1.
Rule 13h-1 will be effective October 3, 2011. The compliance date for large traders to identify themselves to the SEC is December 1, 2011, and the compliance date for broker-dealers to maintain records of, report, and monitor large trader activity is April 30, 2012.
The SEC hopes to use the data provided by Rule 13h-1 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 also expects to use the data to support its investigative and enforcement activities. According to the SEC, there has been a “dynamic transformation” of the securities markets in recent years, with the evolution from manual to automated trading leading to fundamental changes in market structure, market participants, and trading strategies. 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 increasing prominence of large traders led the SEC to assess a range of market structure issues.2
In the 1990s, the SEC twice proposed a large trader reporting system, but did not adopt either proposal.3 However, the increasing sophistication, technical capacity, and trading capability of certain market participants, coupled with the recent turbulence in the securities markets, 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.
In the Adopting Release, the SEC cited with particularity the events of May 6, 2010, commonly known as the “flash crash,” when the Dow Jones Industrial Average fell nearly 1,000 points in a short period of time, only to partially rebound shortly thereafter. According to the SEC, this was “an extremely active trading day in our high-speed, diverse, and complex markets” showcasing how the reconstruction of trading activity can involve an enormous undertaking to collect uniform data and analyze thousands of products, millions of trades, and hundreds of millions (and perhaps even billions) of data points.4 While SEC Rule 17a-25 facilitates the SEC’s ability to collect electronic transaction data to support its investigative and enforcement activities,5 the SEC found that rule inadequate with respect to its efforts to monitor the impact of large trader activity on the securities markets.
OPERATION OF THE RULE
Rule 13h-1 has two primary components: (1) registration of large traders with the SEC; and (2) recordkeeping, reporting, and monitoring duties imposed on registered broker-dealers that provide services to large traders.
Large Trader Registration
A “large trader” is any person that: (i) 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 security6 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”7; or (ii) voluntarily registers as a large trader by filing Form 13H.8 All transactions in NMS securities will count towards the identifying activity level, except for exercises or assignments of option contracts, and certain specifically enumerated transactions.9
Under Rule 13h-1, a large trader must identify itself, its affiliates, its accounts, and its transactions to the SEC, and make certain other disclosures, by filing Form 13H.10 While Form 13H filings will be processed through the SEC’s EDGAR system, they will not be accessible through the SEC’s website or otherwise be publicly available. A large trader is required to file Form 13H “promptly” after effecting aggregate transactions that result in the large trader reaching the identifying activity level.11 According to the Adopting Release, under normal circumstances it would be appropriate for Initial Filings (and Reactivated Status filings, see below) to be filed within 10 days after the large trader effects aggregate transactions equal to or greater than the identifying activity level.12 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.13 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.14
Rather than requiring a large trader to disclose specific brokerage account numbers on Form 13H, the SEC requires a large trader to provide a list of all registered broker-dealers with whom the large trader and any of its Securities Affiliates has an account. The large trader must also disclose whether each such broker-dealer provides prime broker, executing broker, and/or clearing broker services. The SEC may contact a large trader directly to seek additional information to further identify the large trader and its accounts.
Upon receipt of an initial Form 13H, the SEC will assign each large trader its unique LTID. Rule 13h-1(b)(2) requires each large trader to promptly disclose its LTID to each registered brokerdealer through which it trades, and identify each account with such broker-dealer to which the LTID applies. 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 broker-dealers. Registered broker-dealers must (1) maintain specified records of transactions effected by or through accounts of large traders and “Unidentified Large Traders”15; (2) electronically report all transactions by such persons to the SEC upon request utilizing the existing EBS infrastructure; and (3) perform a limited monitoring function to promote awareness of and foster compliance with the rule.
For complex, multi-tiered organizations, the large trader definition focuses on the parent company of the entities employing or controlling 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 all the requirements applicable to such large trader with respect to all of the controlled person’s accounts.16 This is to allow “the identification requirement to be pushed up the corporate hierarchy to the parent entity,”17 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.18 However, a parent would not have to comply with Rule 13h-1(b) with respect to its controlled persons that comply independently with the requirements of Rule 13h-1(b)(1), (2) and (4) applicable to such large trader with respect to all of its accounts.
Form 13H will also accommodate large traders that wish to voluntarily identify themselves with more particularity, permitting them to assign LTID suffixes to further identify persons, divisions, groups, and entities under their control (for example, independent divisions within a large trader). The SEC expects that the use of suffixes to identify sub-groups could facilitate a large trader’s ability to accurately and efficiently track with greater particularity the trading for which it exercises investment discretion, and thus facilitate the ability to respond to SEC requests to further identify accounts or disaggregate trading data.19
Rule 13h-1 applies to all transactions in NMS securities except for the purchase or sale of such securities pursuant to exercises or assignments of option contracts. For the sole purpose of determining whether a person is a large trader, however, the following transactions are excluded:
- 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 (except for an offering of securities effected through the facilities of a national securities exchange);
- 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;
- Transactions between an employer and its employees pursuant to the award, allocation, sale, grant, or exercise of a security, option, or other right; and
- Any transaction to effect a business combination, including a reclassification, merger, consolidation, or tender offer subject to Section 14(d) of the Exchange Act, an issuer tender offer or other stock buyback by an issuer; or a stock loan or equity repurchase agreement.20
In order to show the full extent of purchase and sale activity, offsetting or netting transactions among or within accounts, even for hedging purposes, will 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. 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.21
The large trader reporting requirements are designed to collect information about important market participants that exercise 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.22 Employees would be deemed to exercise investment discretion on behalf of their employers when they act within the scope of their employment.23
A large trader previously assigned an LTID, but whose aggregate transactions did not at any time during the previous calendar year reach the identifying activity level, is eligible to file for “inactive status” using Form 13H.24 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 level again are required to reactivate their status by filing a “Reactivated Status” Form 13H promptly after effecting transactions that equal or exceed the identifying activity threshold.25 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 ceases operations may file an amended Form 13H to indicate its terminated status.26
Broker-Dealer Recordkeeping, Reporting and Monitoring Responsibilities
The rule requires broker-dealers to maintain detailed information regarding transactions by each specific large trader,27 electronically report large trader transaction information to the SEC upon request, and monitor compliance with the self-identification requirements. Registered broker-dealers will be required to maintain records for all transactions effected directly or indirectly by or through: (i) if the broker-dealer is itself a large trader, any proprietary or other account over which it exercises investment discretion; or (ii) an account such broker-dealer carries for a large trader or an Unidentified Large Trader. The SEC will not require broker-dealers to maintain records for accounts over which they exercise investment discretion together with a large trader or an Unidentified Large Trader. As a practical matter, the SEC will have access to records of such accounts because they will be large trader accounts and thus subject to the recordkeeping requirements. In addition, where a non-broker-dealer carries an account for a large trader or an Unidentified Large Trader, the broker-dealer effecting transactions directly or indirectly for such large trader or Unidentified Large Trader must maintain records of all of the required information. A broker-dealer will not have to maintain records of transactions by an inactive large trader after receiving notice that the trader has filed for inactive status.
Broker-dealers must report a particular day’s trading activity if it equals or exceeds the “reporting activity level,” which is: (i) for each transaction in NMS securities effected in a single account during a calendar day, at least 100 shares; (ii) for any transaction in NMS securities of less than 100 shares effected in a single account during a calendar day, an amount that the broker-dealer deems appropriate; or (iii) such other amount that the SEC may establish by order.28 Transaction reports must be submitted no later than the day and time specified in the request for transaction information, which shall be no earlier than the opening of business of the day following such request, unless, in unusual circumstances, the same-day submission of information is requested.29 In addition, a broker-dealer is allowed to voluntarily report trading activity below the applicable threshold; for example, where a broker-dealer prefers to avoid implementing systems to filter the transaction activity and would rather use a “data dump” approach to reporting large trader transaction information.30
Information that a large trader will be required to disclose on Form 13H or provide in response to a SEC request will be exempt from disclosure under the Freedom of Information Act (“FOIA”). The SEC will not be compelled to disclose the information collected from large traders and registered broker-dealers under the relevant portions of Exchange Act Section 13(h), subject to certain limited exceptions.31
Foreign large traders are included within the scope of the rule 13h-1(b). The SEC is concerned that excluding foreign large traders from the identification requirements could create a competitive disparity between domestic and foreign markets and persons. The SEC expects all large traders, regardless of their place of domicile, to identify each broker-dealer at which it or any Securities Affiliate has an account and disclose the type(s) of services provided. However, the rule’s recordkeeping or reporting requirements apply only to U.S.-registered broker-dealers.
IMPACT OF THE RULE
Rule 13h-1 will have a critical impact on all types 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 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.
Those firms that file Form 13F will have to review their systems to determine whether they can be adapted to comply with the additional burdens of Rule 13h-1, and perform the necessary steps to comply with the new filing requirements. However, such firms must be cognizant of the fact that the 13F and 13H filing regimes are not identical and may involve different parties, different timing considerations, and very different information gathering and reporting requirements.
RELATION TO CONSOLIDATED AUDIT TRAIL PROPOSAL
Separate from Rule 13h-1, in 2010 the SEC proposed a consolidated audit trail for equities and options that would capture customer and order event information for most orders in NMS securities across all markets from the time of order inception through routing, cancellation, modification, or execution (the “CAT Proposal”).32 The large trader requirements of Rule 13h-1 are much more limited in terms of their scope, objectives, and implementation burden than the consolidated audit trail system that is still under consideration by the SEC.
The recordkeeping and reporting provisions of Rule 13h-1 are based substantially on existing Rule 17a-25 and the SEC’s current EBS system, and therefore can be implemented more expeditiously and at less cost than the CAT Proposal. The large trader reporting requirements are intended to address the SEC’s near-term need for access to more information about large traders and their trading activities and to improve the SEC’s ability to analyze such information. In contrast, the CAT Proposal would require the development, over a longer time frame, of significant technology systems to collect and consolidate more extensive information regarding orders, trades, and customers in a uniform manner across all markets and other execution venues. Furthermore, although it recognizes that the two proposals may in some ways be duplicative, the SEC believes that the requirements of Rule 13h-1 are compatible with the CAT Proposal, and it will address the concerns of overlap as it proceeds with the CAT Proposal.33