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News August 1, 2011 Issue

SEC Adopts Large Trader Reporting Rule

Large trader activity in the markets has been tracked for years, but it has been lacking in a few critical details. The "flash crash" on May 6 last year provided a painful illustration of the problem. It took the SEC months of work to investigate the sources of runaway trading that in less than ten minutes caused almost $900 billion in market value to evaporate (at least initially). All because it lacked information about which traders were behind various transactions. "That day dramatically demonstrated the need to enhance the Commission's ability to quickly and accurately analyze market events," said SEC Chairman Mary Schapiro.

On July 26, the SEC unanimously adopted new Rule 13h-1, which fills in those gaps in trading information. The new large trader reporting rule requires so-called "large traders" to identify themselves to the SEC and time-stamps their trading activity. The rule also requires monitoring of large trader activity and next-day reporting by brokers and dealers.

Before the rule was adopted, brokers and dealers were required to track and report a more limited subset of trading activity data through the SEC's Electronic Blue Sheets (EBS) system. The new rule leverages the EBS system, adding two data points - large trader identification and the time of the transaction - to the information captured and reported for regulatory use.

Brokers and dealers must monitor and report trading by all large trader customers, and must report trading activity of a customer it knows or has reason to know is a large trader even though that customer has not identified itself as a large trader.

Such monitoring and reporting will "encourage compliance by [broker-dealer] customers with the requirement to identify themselves as large traders to the SEC," said the adopting release. Broker-dealers do not need to cease trading with, or on behalf of, "unidentified" large traders. On the contrary, the system is designed to assist in the identification of all large traders and to encourage them to file Form 13H and obtain an LTID.

The information submitted through the EBS system is not publicly available. Form 13H information is also unavailable to the public, and is maintained on a confidential basis by the SEC. Both resources serve as tools for SEC use in its oversight of the U.S. securities markets. Schapiro said in her remarks that Rule 13h-1 will allow the SEC to "promptly and efficiently identify significant market participants on a cross-market basis, collect data on their trading activity, reconstruct market events, conduct investigations and, as appropriate, bring enforcement matters." The new rule is considered an important stepping-stone along the way to adopting the more comprehensive consolidated audit trail rule that is still a work in progress.

The SEC's fact sheet on the rule noted that "the need for the SEC to have better access to information on these entities is heightened by the fact that large traders, including high-frequency traders, appear to be playing an increasingly prominent role in the securities markets."

Large trader defined.

The rule defines a large trader as:

  • "a person that directly or indirectly, including through other persons controlled by that person, exercises investment discretion over one or more accounts and effects transactions for the purchase or sale of any National Market System security, for or on behalf of such accounts, by or through one or more registered broker-dealers, in an amount equal to or greater than the identifying activity level," or
  • a person that voluntarily registers as a large trader by filing a Form 13H with the SEC.

A large trader's "identifying activity level" is defined as transactions in exchange-listed securities equaling or exceeding:

  • two million shares or $20 million during any calendar day; or
  • 20 million shares or $200 million during any calendar month.

New Form 13H.

Large traders must identify themselves to the SEC by filing new Form 13H. The six page, six item form is submitted through the SEC's electronic data gathering, analysis and retrieval (EDGAR) filing system, and its contents are maintained on a confidential basis by the SEC. "Confidential" still permits Congress, other federal departments and agencies, and federal courts under certain orders to obtain access to the information. The release noted however, that confidentiality is expected to be preserved down the line.

Form 13H requests basic identifying information about the large trader, as well as information about its organization, affiliates, whether it is subject to CFTC and/or foreign regulation, and the identity of broker-dealers with whom it does business.

Upon filing Form 13H, the large trader receives a unique "large trader identification number" (LTID) from the SEC. The large trader must disclose the LTID to each of its broker-dealers and identify to each respective broker-dealer all of the accounts at the broker-dealer through which the trader trades. The large trader does not report each individual account maintained with broker-dealers on the Form 13H.

Only the ultimate parent company receives an LTID.

The rule focuses on the ultimate parent company that controls an entity or multiple entities (where applicable). The parent company registers as a large trader based on its own trading activity aggregated with the trading activity of any "controlled" trading entities. The rule permits only the parent entity to register on behalf of itself and its controlled entities. The parent entity may then assign LTID suffixes to sub-identify the individual entities under its control.

The SEC encouraged the use of LTID suffixes to reduce the need for the SEC to contact large traders for such identifying assistance at a later date.

"Control" definition broadened.

Control focuses on the ability to affect the management of another entity. Control (controlling, controlled by, and under common control) is defined as "the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of securities, by contract, or otherwise."

The adopting release noted that for the purposes of this rule only, any person that directly or indirectly has the right to vote or direct the vote, or has the power to sell or direct the sale, of 25 percent or more of a class of voting securities of an entity is presumed to control that entity. In the case of a partnership, a person is presumed to control the partnership if that person has the right to receive upon dissolution, or has contributed 25 percent or more of the capital.

Under the Investment Company Act, for example, control is presumed with ownership of 25 percent of all of an issuer¡¦s voting securities, not simply a class of voting securities. This definition broadens controlling influence by including rights to vote without necessarily being a beneficial owner of a security.

Calculating the large trader activity levels.

All accounts over which the large trader exercises investment discretion, as that term is defined in Section 3(a)(35) of the Exchange Act, are considered when reviewing trading activity for purposes of the large trader rule.

Transactions that must be included in the activity level calculation are:

  • All transactions in NMS securities, including offsetting or netting transactions within or among accounts. The SEC noted that this "gross up" approach "reflects the fact that substantial trading activity has the potential to impact the market regardless of the trader's net position."
  • Transactions by advisers on behalf of registered investment company and pension fund clients, to serve the rule's goal of "collect[ing] information about important market participants that exercise investment discretion."
  • Purchases and sales of options on NMS securities, but not exercises or assignments of option contracts. The volume and value of options purchased or sold is determined by reference to the securities underlying the option.

The calculation of the trading thresholds in the rule permits the exclusion of certain transactions not characteristic of arms-length trading and not characterized by investment discretion.

Transactions that are excluded from the large trader activity calculation include:

  • Registered or unregistered OTC offerings by an issuer or on the issuer's behalf by an underwriter;
  • Transactions to affect a business combination, such as a tender offer, merger, or acquisition;
  • Gifts and transactions executed to settle a decedent's estate;
  • Transactions executed pursuant to a court order or judgment;
  • Employer option grants, and option exercises and assignments;
  • ETF creations and redemptions;
  • Rollovers of qualified plans or trust assets; and
  • Issuer securities buy-backs, or stock loan or equity repurchase agreements.

The exclusions apply only to the determination of the identifying activity level. Broker-dealers must include all transactions in NMS securities and related options from accounts where investment discretion is exercised by a large trader when reporting to the SEC.

Asset managers with discretionary trading authority over assets that could generate trading activity at or above triggering thresholds for large trader status must implement daily and monthly monitoring processes for self-reporting purposes. Aggregation of controlled entity trading activity will require reporting regimes for those entities.

Trade monitoring, reporting and recordkeeping by broker-dealers.

Broker-dealers must monitor, maintain data on, and report to the SEC the trading activity of large traders that occurs within the broker-dealer's "four walls."

Large trader activity includes trading activity in the broker-dealer's proprietary accounts.

While all brokers and dealers must monitor and analyze trading activity for the purposes of reporting to the SEC, detailed recordkeeping of large trader account activity is generally only the responsibility of the ultimate clearing broker or prime broker. Executing brokers are only required to keep records for large trader activity where the large trader is not itself another registered broker or dealer, such as a bank or insurance company client.

Broker-dealer reporting occurs the morning after the day a reportable transaction occurs. Specific SEC requests for data generally require response by the opening of business on the following day, but in extraordinary circumstances may require a same-day response.

Broker-dealer reporting safe harbor.

Rule 13h-1 contains a safe harbor for broker-dealers under paragraph (f) relating to failures to report large trader activity. A broker-dealer will be deemed not to know a customer is a large trader if the broker-dealer has no actual knowledge to the contrary and has policies and procedures in place designed to identify persons trading at or above the established limits.

Records to be kept by obligated broker-dealers.

Besides those suitable policies and procedures that must be generated to reasonably detect large trader activity, broker-dealers with recordkeeping responsibilities must develop recordkeeping systems to monitor large trader activity.

Records must be kept on a three-year rolling basis, with the first two years of data in that "readily accessible location" all registrants maintain.

Related to each purchase and sale of an NMS security by a large trader, a broker-dealer must capture:

  • LTID and account number;
  • Transaction date, price, and time;
  • Security CUSIP, or other identifier;
  • Number of shares or option contracts and nature of the transaction (purchase, sale, call, put, opening, closing, exercise, assignment);
  • Whether the transaction is proprietary or agency;
  • The exchange effecting the transaction;
  • Partial or full transfers or forwarding of the transaction, identifying other involved broker-dealer(s) and whether the transaction was sent out from or received by the reporting broker-dealer; and
  • Any depository id, if a depository processed the transaction.

Updating your Form 13H.

Form 13H must be updated at least annually after the end of each calendar year whether or not changes have occurred. Any changes to reported information must be filed in an updating amendment at least by the end of the calendar quarter in which the change occurs.

If a large trader goes for one calendar year without meeting or exceeding the triggering large trader activity levels, the large trader may obtain inactive status. All the large trader needs to do is check "Inactive Status" on the first page of the Form 13H filing and enter the date inactive status commenced. Inactive status is effective upon filing, without any action by the SEC. Broker-dealers that receive notice from a large trader of the trader's inactive status can cease maintaining transaction records for that trader.

Things to think about.

  • If you think you're on the edge and don't want to deal with monitoring your trading activity, you can voluntarily register as a large trader and be done with it.
  • Nine months is not a very long time for broker-dealers to develop and implement the monitoring systems contemplated by the rule. "[B]roker-dealers may want to obtain representations regarding large trader status from customers," said law firm Morgan Lewis in a client alert.
  • Remember to add a line item in your risk matrix for large trader monitoring, and include those appropriate policies and procedures in your compliance manual.

Form 13H items.

The six requested pieces of information in Form 13H are:

Item 1 - Businesses of the large trader. Declaration of all businesses engaged in, such as adviser, broker or dealer, pension trustee, futures commission merchant, bank, or bank holding company, insurance company, or "other" (specify).

Item 2 - Securities and Exchange Commission filings. Declaration of all forms filed with the SEC, if any. It includes all filings by any "Securities Affiliate" of the large trader, defined as any affiliate that exercises investment discretion over NMS securities.

Item 3 - CFTC registration and foreign regulators. Declaration of whether the large trader or any of its affiliates (note, not Securities Affiliates) is registered with the CFTC, and if so, disclosure of the entity name and registration number.

Also, declaration of whether the large trader or any Securities Affiliate is regulated by a foreign regulator, and if so, disclosure of the entity name and foreign regulator.

Item 4 - Organization information. Disclosure includes organization charts, parent of the large trader, list of all affiliates and Securities Affiliates with descriptions of their businesses, and identification of any LTID suffixes assigned to affiliates.

Item 5 - Governance of the large trader. Disclosure includes organizational form, identification of general and limited partners, if any, and identification of all executive officers, directors, or trustees.

Item 6 - List of broker-dealers at which the large trader or its securities affiliates has an account. The list also requires indication of whether the broker-dealer is a prime broker, clearing broker, or executing broker.

Form 13H must be submitted by an "authorized person," a natural person authorized to file the information on a large trader's behalf. The authorized person will be the SEC's point of contact should further information be requested. Authorized persons must represent that all the information submitted on Form 13H is "true, correct, and complete," and that when updating amendments are filed, that unchanged information remains true, correct, and complete.

Effective and compliance dates.

New Rule 13h-1 will be effective on October 3. Large traders have until December 1 to comply with the identification requirements of the rule.  Broker-dealers have seven months after the effective date, April 30, 2012, to comply with the requirements to monitor large trader activity, maintain records, and report transaction data.