I.          Executive Summary and Compliance Deadlines  

The Securities and Exchange Commission (the “SEC”) recently adopted new Rule 13h-1 and Form 13H under Section 13(h) of the Securities Exchange Act of 1934¹ in an effort to improve the SEC’s ability to expeditiously analyze market movements and investigate the causes of market events, as well as to assist the SEC in its enforcement actions.  Rule 13h-1 requires “large traders” to register as such with the SEC via new web-based Form 13H.  The scope of the term “large trader” is broad, encompassing individuals and entities, including non-U.S. entities, who engage in NMS securities transactions² at a level which exceeds the rule’s threshold for large trader status.  Upon reaching large trader status, the large trader must promptly (i.e., within 10 days) file an initial Form 13H with the SEC which will then  assign a unique identification number to each reporting large trader (such number, a “LTID”).  The large trader must then provide its LTID to all of its U.S. registered broker-dealers and identify for them each account to which the LTID applies.  Unless a large trader qualifies for inactive trader status or is subject to the limited circumstances permitting termination of large trader status, a large trader will have a continuing obligation to periodically update its Form 13H.  A person is a “large trader” if its transactions (excluding certain specified types of transactions) in NMS securities equal or exceed 2 million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month.

Rule 13h-1 imposes certain recordkeeping, SEC reporting and customer monitoring duties on U.S. registered broker-dealers with respect to large traders.  Broker-dealers must maintain records about large trader transactions effected by or through the broker-dealer and will be required to provide the SEC with this data upon request in a prompt manner (i.e., generally within one day, but under unusual circumstances, a same day response may be required).  The rule also requires broker-dealers to monitor their customers’ accounts with an eye towards identifying large traders that may have failed to comply with Rule 13h-1’s larger trader reporting obligations.

Rule 13h-1 took effect on October 3, 2011.  However, large traders must comply with the rule by December 31, 2011 (i.e., November 21, 2011 is the earliest date when a trader could meet or exceed the trading level that triggers a mandatory Form 13H filing due on December 1, 2011).  Broker-dealers have until April 30, 2012 to comply with their obligations under the rule.  This memorandum provides a summary of the obligations Rule 13h-1 imposes on both large traders and U.S. registered broker-dealers. 

If you would like additional information about Exchange Act Rule 13h-1 and its requirements, please contact Geraldine Cunningham (gcunningham@kmollp.com; 212-906-8310) or your usual attorney contact at Kavanagh Maloney & Osnato LLP.

II.        Definition of a Large Trader 

Rule 13h-1(a)(1) defines a large trader as any person that directly or indirectly, including through other persons “controlled” (defined in Section III below) by such person, exercises “investment discretion” (defined in Section IV below) over one or more accounts and effects “transactions” (defined in Section VI below) for the purchase or sale of any NMS security (defined in Footnote 2 above) 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” (defined in Section V below).  In addition, a large trader includes any person who voluntarily registers with the SEC as a large trader via Form 13H. The SEC has allowed for voluntary large trader registration in order to reduce the transaction monitoring burden on persons approaching the rule’s “identifying activity level” trigger for mandatory large trader registration.   

III.       Definition of Control; Compliance by Parent or Subsidiaries

For multi-level organizations, Rule 13h-1(b)(3) permits large trader registration compliance by either the parent company (whose Form 13H would provide information about itself and its affiliates) or the individual large traders which are controlled by the parent entity.  The rule defines “control” (and the terms controlling, controlled by and under common control with) as the direct or indirect 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.  Control will be presumed where a person has the power to vote or direct the vote of 25% or more of a class of voting securities of another entity or the power to sell or direct the sale of 25% or more of a class of voting securities of such entity, or, in the case of a partnership, has contributed or has the right to receive at least 25% of the partnership’s capital.  Thus, to determine whether a parent company is a large trader, it must analyze the aggregate daily and monthly share volume and dollar value of relevant transactions in NMS securities effected by entities under the parent’s control.  Form 13H allows, and the SEC encourages, large traders to assign LTID suffixes to sub-identify persons, divisions, groups, and entities under the filer’s control.  According to the SEC, sub-identification by reporting control persons would facilitate the ability of a large trader to respond to any SEC request to further identify accounts or disaggregate trading data and diminish the need for the SEC to contact large traders for assistance in further identifying their accounts.           

IV.       Definition of Investment Discretion

For purposes of Rule 13h-1, a person with “investment discretion” includes any person who (i) is authorized to determine what securities or other property shall be purchased or sold by or for the account, or (ii) 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.

V.        The “Identifying Activity Level” that Triggers Mandatory 13H Reporting 

Exceeding a specified amount of trading activity during any calendar day or any calendar month can result in larger trader status.  Rule 13h-1(a)(7) defines “identifying activity level” to mean aggregate transactions in NMS securities that are equal to or greater than: (i) during a calendar day, either two million (2,000,000) shares or shares with a fair market value of $20 million; or (ii) during a calendar month, either twenty million (20,000,000) shares or shares with a fair market value of $200 million. 

VI.       “Transactions” that Count Toward Calculating a Person’s Identifying Activity Level 

For purposes of Rule13h-1, the term “transactions” generally includes all transactions in NMS securities, excluding the purchase or sale of such securities pursuant to exercises or assignments of option contracts and certain specified excluded transactions described below in Section VII.  The purchases and sales of options themselves (referencing the volume and value of the securities underlying the options) must be counted in the identifying activity level calculation.  However, the transactions in the underlying securities pursuant to exercises or assignments of such options should not be counted since this would result in double-counting.³ 

Aggregation rules set forth in Rule 13h-1(c) must be followed when a potential large trader calculates whether its trading activity reaches the rule’s trading level threshold.  First, the volume or fair market value of transactions in equity securities and the volume or fair market value of the equity securities underlying transactions in options on equity securities, purchased and sold, must be aggregated.  Second, the fair market value of transactions in options on a group or index of equity securities (or based on the value thereof), purchased and sold, must be aggregated.  Lastly, potential large traders must “gross up” when calculating their trading activity levels.  Accordingly, offsetting or netting transactions among or within accounts, even for hedged positions, would be added to a market participant’s activity level in order to show the full extent of a trader’s purchase and sale activity.  The SEC follows this grossing up approach to reflect the fact that substantial trading activity has the potential to impact the market regardless of the trader’s net position.

VII.     Excluded Transactions

The following transactions should be excluded for the purpose of calculating whether a person is a large trader:

1. any journal or bookkeeping entry made to an account in order to record or memorialize the receipt or delivery of funds or securities pursuant to the settlement of a transaction;
2. any transaction that is part of an offering of securities by or on behalf of an issuer, or by an underwriter on behalf of the issuer, or an agent of the issuer, whether or not such offering is subject to registration under the Securities Act of 1933, provided however, that this exemption shall not include an offering of securities effected through the facilities of a national securities exchange;
3. any transaction that constitutes a gift;
4. any transaction effected by a court appointed executor, administrator, or fiduciary pursuant to the distribution of a decedent’s estate;
5. any transaction effected pursuant to a court order or judgment;
6. any transaction effected pursuant to a rollover of qualified plan or trust assets subject to Section 402(a)(5) of the Internal Revenue Code;
7. any transaction between an employer and its employees effected pursuant to the award, allocation, sale, grant, or exercise of a NMS security, option or other right to acquire securities at a pre-established price pursuant to a plan which is primarily for the purpose of an issuer benefit plan or compensatory arrangement; or
8. any transaction to effect a business combination, including a reclassification, merger, consolidation, or tender offer subject to Section 14(d) of the Securities Exchange Act of 1934; an issuer tender offer or other stock buyback by an issuer; or a stock loan or equity repurchase agreement.

If, however, the SEC asks a broker-dealer for data regarding a large trader, the broker-dealer must report all transactions that it effected through the accounts of the applicable  large trader without excluding any of the above-listed excluded transactions. 

VIII.    Rule 13h-1’s Application to Retirement Plans

In the Adopting Release, the SEC provided guidance as to Rule 13h-1’s application to defined contribution plans and other retirement plans.  Specifically, the SEC noted that some defined contribution plans allow employees to select their investments from an investment menu provided by the employer.  With respect to contribution plans structured this way, investment discretion will be deemed to rest with the individual plan participants and not with the employer or the plan’s trustee.   Additionally, the SEC has clarified that generally trustees of retirement plans, rather than plan sponsors or administrators, will exercise investment discretion with respect to the plans.  Such retirement plan trustees, therefore, must assess whether they effect transactions at a level mandating large trader reporting under Rule 13h-1.      

IX.       The Various Types of Form 13H Filings

1. Initial Filing.  A large trader’s initial Form 13H must be filed “promptly” after effecting aggregate transactions equal to or greater than the triggering threshold (i.e., the identifying activity level).  Normally, an initial filing made within 10 days after reaching the identifying activity level will meet this timing requirement.
2. Annual Filings.  With the exception of large traders on “inactive status” (described below), all large traders must submit an annual filing within 45 days after the end of each full calendar year.
3. Amended Filings.  With the exception of large traders on “inactive status,” a large trader must file an amended filing no later than the end of the calendar quarter in which any Form 13H information becomes inaccurate for any reason.  More frequent amendments may also be filed on a voluntary basis.
4. Inactive Status.  A large trader who has not effected aggregate transactions at any time during the previous full calendar year in an amount equal to or greater than the identifying activity level may obtain inactive status by filing for “Inactive Status” through a Form 13H submission.  Inactive status will become effective upon filing.  Inactive status was designed to reduce the rule’s burden on infrequent traders and natural persons who infrequently trade at the Rule 13h-1 threshold level. During inactive status, an inactive trader need not submit annual or amended 13H filings and may ask its broker-dealers to stop maintaining records of its transaction by the trader’s LTID. 
5. Reactivated Status.  A person on inactive status who effects aggregate transactions that are equal to or greater than the identifying activity threshold must file a “Reactivated Status” Form 13H promptly after effecting such transactions.  Upon filing for Reactivated Status, the person once again would be subject to the filing requirements of Rule 13h-1 and must inform its broker-dealers of it reactivated status. 
6. Termination Filings.  Under narrow circumstances, such as when a large trader dissolves, ceases doing business, or, in some cases, is acquired, a person may permanently end its large trader status by submitting a “termination filing.”  The purpose of this termination filing is to signal the SEC that there is no chance that this person may again qualify as a large trader in the future.

X.        How to File; Confidential Treatment of Form 13H; LTID Notice to Brokers

All Form 13H filings must be made electronically through the SEC’s EDGAR system which is currently being revised to accommodate Form 13H.  Thus, traders required to submit 13H filings and who have not already received EDGAR access codes will need to ensure that they have obtained the necessary EDGAR filing access codes prior to the trader’s initial Form 13H filing deadline.  Although 13H filings will be submitted via EDGAR, these filings will not be publicly available.  As noted previously, large traders, in addition to their Form 13H filing obligations, must promptly notify all registered broker-dealers who effect transactions on their behalf of the large trader’s LTID and identify the accounts to which the LTID applies. 

XI.       Information Required by Form 13H

According to the SEC, Form 13H is designed to collect basic identifying information about large traders that will allow the SEC to understand the character and operations of the large trader.  Information required by Form 13H includes the following: 

1. types of business that the large trader or its affiliates engages in (e.g., broker, dealer, bank (including a foreign bank), bank holding company, investment adviser to registered investment companies or to unregistered investment companies, such as hedge funds);
2. a description of the large trader’s operations, including a general description of its trading strategies;
3. disclosure as to whether the large trader or any of its affiliates that exercise discretion over NMS securities (“Securities Affiliates”) file any other forms with the SEC;
4. disclosure as to whether the large trader or any of its affiliates is registered with Commodity Futures Trading Commission (together with CTFC registration numbers, if applicable) and disclosure as to whether the large trader or any of its Securities affiliates are regulated by a foreign regulator (together with identification of the primary foreign regulator, if applicable);
5. attachment of an organizational chart identifying the large trader, its parent company (if applicable), all Securities Affiliates, and all affiliates registered with the CFTC and a narrative description of the relationship between these entities;
6. disclosure of the form of the large trader (e.g., individual, corporation, limited partnership), together with the identification of all general partners and all limited partners that own more than a 10% financial interest in the accounts of the large trader and the identification of each executive officer, director, or trustee of a large trader corporation or trustee;
7. a list of broker-dealers at which the large trader or its Securities Affiliates has an account and the capacity in which these broker-dealers act for the account (i.e., prime broker, executing broker, or clearing broker).

XII.     Recordkeeping Responsibilities of Broker-Dealers Under Rule 13h-1

Registered broker-dealers must maintain records for all transactions effected directly or indirectly by or through (i) an account such broker-dealer carries for a large trader or an “Unidentified Large Trader” (defined in Section XIV below) or (ii) if the broker-dealer is a large trader, any proprietary or other account over which such broker-dealer exercises investment discretion.  In addition, if 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.  When a broker-dealer has been notified by a large trader that the trader has filed for inactive status with the SEC, the broker-dealer can cease maintaining the records required under Rule 13h-1 for such large trader.  The rule specifies that the following information must be maintained with respect to large trader transactions:

1. the clearing house number or alpha symbol of the broker or dealer submitting the information and the clearing house numbers or alpha symbols of the entities on the opposite side of the transaction;
2. identifying symbol assigned to the security;
3. date transaction was executed;
4. the number of shares or option contracts traded in each specific transaction and the character of the transaction (e.g., purchase, sale, short sale, call or put option, opening purchase or sale, closing purchase or sale, an exercise or an assignment);
5. transaction price;
6. account number;
7. identity of the exchange or other market center where the transaction was executed;
8. a designation of whether the transaction was proprietary or for a customer;
9. if part or all of an account’s transactions at the registered broker-dealer have been transferred or otherwise forwarded to one or more accounts at another registered broker-dealer, an identifier for this type of transaction; and if part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise received from one or more other registered broker-dealers, an identifier for this type of transaction;
10. if part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise received from another account at the reporting broker-dealer, an identifier for this type of transaction; and if part or all of an account’s transactions at the reporting broker-dealer have been transferred or otherwise forwarded to one or more other accounts at the reporting broker-dealer, an identifier for this type of transaction;
11. if a transaction was processed by a depository institution, the identifier assigned to the account by the depository institution;
12. the time that the transaction was executed; and
13. the large trader identification number(s) associated with the account, unless the account is for an Unidentified Large Trader.  

In addition, with respect to transactions effected for an account of an Unidentified Large Trader, the information required to be maintained for all transactions also shall include such Unidentified Large Trader’s name, address, date the account was opened, and tax identification number(s). 

The above-listed information must be available on the morning after the day the transactions were effected (including Saturdays and holidays).   

XIII.    Reporting Responsibilities of Broker-Dealers Under Rule 13h-1

If requested by the SEC, registered broker-dealers must report the information that they are required to maintain about the accounts they carry for large traders and Unidentified Large Traders for all transactions equal to or greater than the “reporting activity level.”  “Reporting activity level” is defined as (i) each transaction in NMS securities, effected in a single account during a calendar day, that is equal to or greater than 100 shares; (ii) any transaction in NMS securities for fewer than 100 shares, 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 order of the SEC from time to time.  Broker-dealers must submit the requested reports to the SEC no later than the day and time specified in the SEC’s information request, which generally will be no earlier than the opening of business of the next day.  In unusual circumstances, however, the SEC may require same-day submission of the requested information. Thus, in the Adopting Release, the SEC stated that it expected that certain system enhancements would be required to prepare broker-dealer’s existing Electronic Blue Sheets system for compliance with Rule 13h-1. 

XIV.    Monitoring Responsibilities of Broker-Dealers Under Rule 13h-1

Rule 13h-1 defines an “Unidentified Large Trader” as any person who has not complied with the rule’s large trader identification requirements that a broker dealer knows or has reason to know is a large trader.  Thus, broker-dealers must treat as an Unidentified Large Trader any person that the broker-dealer “knows or has reason to know” is a large trader where such person has not complied with the identification requirement applicable to large traders (i.e., identified itself as a large trader to the broker-dealer and disclosed the accounts to which its LTID applies).  In making this assessment, a broker-dealer need only consider transactions effected by or through the broker-dealer and need not consider transactions effected by or through other broker-dealers.  The rule also provides broker-dealers with a safe harbor for compliance with this customer monitoring obligation. 

Under the rule’s safe harbor, a broker-dealer would be deemed not to know or have reason to know that a person is a large trader if the broker-dealer does not have actual knowledge that a person is a large trader and the broker-dealer establishes policies and procedures reasonably designed to: (i) identify persons who have not complied with Rule 13h-1’s large trader identification requirements but whose transactions effected through account(s) carried by such broker-dealer or through which such broker-dealer executes transactions, as applicable equal or exceed the identifying activity level; (ii) treat any persons identified as Unidentified Large Traders as Unidentified Large Traders (e.g., maintaining the required records with respect to such trader); and (iii) inform the Unidentified Large Trader of its potential Rule 13h-1 obligations.  Broker-dealers are not required to cease trading with a person it has deemed an Unidentified Large Trader and they are not required to determine whether the applicable customer is in fact a large trader within the meaning of Rule 13h-1.  In its Adopting Release, the SEC noted that it may periodically ask broker-dealers to provide the SEC with a report of all persons whom the broker-dealer is treating as Unidentified Large Traders. 

XV.      Rule 13h-1’s Application to Non-U.S. Entities

While the obligations of broker-dealers under Rule 13h-1 only apply to U.S. registered broker-dealers, the rule’s obligation with respect to large traders apply to all persons who meet the “large trader” definition, including non-U.S. entities. 

XVI.    No Blanket Exemptions Under Rule 13h-1

Rule 13h-1 does not provide for any category of persons who would be exempt from the rule’s requirements.  However, the rule states that upon written application or upon the SEC’s own motion, the SEC may by order exempt, upon specified terms and conditions or for stated periods, any person or class of persons or any transaction or class of transactions from the rule.

If you would like additional information about Exchange Act Rule 13h-1 and its requirements, please contact Geraldine Cunningham (gcunningham@kmollp.com; 212-906-8310) or your usual attorney contact at Kavanagh Maloney & Osnato LLP.

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