Court Overturns SEC’s Dealer Rule: Implications for Private and Digital Asset Funds

On November 21, 2024, Judge Reed O’Connor of the U.S. District Court for the Northern District of Texas vacated the recently adopted Rules 3a5-4 and 3a44-2 (collectively, the “Dealer Rule”) of the Securities Exchange Act of 1934, as amended (“Exchange Act”). The court determined that the Securities and Exchange Commission (SEC) exceeded its statutory authority in adopting the Dealer Rule, describing it as “untethered from the text, history, and structure of the [Exchange] Act.”

The court emphasized that Congress’s definition of a “dealer” presumes the presence of customers. This ruling is significant for private funds and digital asset funds, as it implies that entities without customers cannot generally be considered “dealers.” The impact on the SEC’s enforcement efforts, which predate the Dealer Rule, remains uncertain. Whether to appeal the ruling will be a decision for the new administration.

Exchange Act Section 3(a)(5)(A) defines a “dealer” as “any person engaged in the business of buying and selling securities … for such person’s own account through a broker or otherwise.” Section 3(a)(5)(B) excludes from the definition individuals who trade securities for their own accounts, either individually or in a fiduciary capacity, but not as part of a regular business. This exclusion is intended for individuals who trade for personal investment purposes (e.g., “traders”).

On February 6, 2024, the SEC adopted the Dealer Rule to clarify what it means to be “engaged in the business” of buying and selling securities for one’s own account. The Dealer Rule introduced two non-rebuttable qualitative standards (“Qualitative Tests”) that, if met, would require registration with the SEC as a “dealer” or “government securities dealer.”

On March 18, 2024, various associations of private fund managers challenged the Dealer Rule, arguing it violated the Administrative Procedure Act (APA) by exceeding the SEC’s statutory authority under the Exchange Act and being arbitrary and capricious.

The District Court granted the plaintiffs’ motion for summary judgment, ruling that the SEC had exceeded its statutory authority under the Exchange Act in adopting the Dealer Rule and vacating the rule in full. The court did not address the plaintiffs’ claim that the SEC’s rulemaking was arbitrary and capricious or rule on the Dealer Rule’s application to private funds specifically.

The court focused on whether being “engaged in the business” of buying and selling securities for one’s own account requires providing liquidity as a service to customers. It concluded that the Exchange Act’s history supports the view that a “dealer” facilitates transactions for customers. This interpretation has particular relevance for private funds and digital asset funds, which typically do not have customers in the traditional sense.

Although the SEC cited two Eleventh Circuit cases to argue that dealers do not require customers, the court distinguished these cases, stating they pertained to specific conduct and did not establish that regular securities transactions alone qualify as dealer activity.

The vacating of the Dealer Rule is a significant development for private funds and digital asset funds. These entities often engage in trading for their own accounts without providing liquidity services to customers. The District Court’s decision reinforces the distinction between dealers and traders, potentially reducing regulatory burdens for funds that do not meet the traditional dealer definition.

Market participants should continue to assess whether they might be deemed dealers under existing SEC guidance. For example, SEC guidance identifies activities indicative of “dealer” status, such as quoting a market (e.g., simultaneous bid and ask quotes), holding oneself out as willing to buy and sell securities on a regular basis, and trading securities for the benefit of others. Firms engaging in such activities should consider whether their trading counterparties might be viewed as “customers” and whether such arrangements could be interpreted as offering “dealer” services.

Additionally, the SEC has pursued enforcement actions in recent years against participants in the convertible debt market for operating as unregistered dealers. These actions were based on the statutory definition of “dealer” under the Exchange Act, not the Dealer Rule. The District Court referenced two such cases, finding their outcomes consistent with its rulings in the Dealer Rule litigation. While the SEC may continue enforcement actions related to convertible debt financing under the new administration, the scope of targeted activities is unlikely to expand significantly.