The Securities and Exchange Commission (“SEC”) recently proposed amendments to Rule 15a-6 under the Securities Exchange Act of 1934 (the “Exchange Act”), which provides limited exemptions to foreign broker-dealers to engage in activities with U.S. investors, including hedge funds, private equity funds and other investors in foreign securities. The proposed amendments to Rule 15a-6 would expand the category of U.S. investors that foreign broker-dealers may contact for the purpose of providing research reports and soliciting securities transactions.

Current rule

Rule 15a-6 permits an unregistered non-U.S. broker-dealer to engage in certain activities without being “chaperoned” by a registered broker-dealer, including:

• Effecting “unsolicited” securities transactions with U.S. persons. However, the SEC has interpreted “solicitation” very broadly, thereby limiting its usefulness.
• Effecting and soliciting transactions for eligible investors.
• Providing research reports to certain large institutional investors.

The pace of internationalization of securities markets has been significant since the adoption of Rule 15a-6 in 1989. The industry has, however, advocated the liberalization of Rule 15a-6 to expand cross-border access for market investors. The SEC proposal addresses a number of specific areas under Rule 15a-6, including:

1. Persons who can be contacted by a foreign broker-dealer;
2. Dissemination of quotes by foreign broker-dealers;
3. Distribution of research by foreign broker-dealers;
4. Execution of trades by foreign broker-dealers;
5. Counterparties and specific customers; and
6. Providing information to U.S. customers regarding foreign option exchanges.

Expansion to qualified investors

The proposed rule would expand the range of U.S. investors with which a foreign broker-dealer could interact to include “qualified investors” as defined under Section 3(a)(54) of the Exchange Act. The proposal would allow additional investors to interact with foreign broker-dealers by lowering the threshold for participation from major institutional investors with $100 million in total assets to qualified investors with $25 million in investments. The SEC believes that the lower threshold reflects recognition of investors with the skills necessary to independently assess foreign broker-dealer’s integrity and competence to access markets.

Unsolicited trades on quotation systems

The SEC has previously determined that it would not consider a solicitation to have occurred for purposes of Rule 15a-6 if there were a U.S. distribution of foreign broker-dealers’ quotations by third-party systems, such as those operated by foreign marketplaces or private vendors, that primarily distributes these quotations in foreign countries. The SEC has noted that its concerns are focused on the certain systems that are intended to induce trades due to the nature of the transactions referenced in such quotation systems. The SEC has acknowledged that since the adoption of the current rule, third-party quotation systems have become increasingly global in scope, such that there is no longer a meaningful distinction between systems that distribute quotations primarily in the U.S. and those that distribute quotations primarily in foreign countries. Under the revised rule, the SEC would no longer require that a foreign broker-dealer’s quotation system be primarily located in foreign countries to avoid being deemed a solicitation, in the absence of other contacts with a U.S. person.

Provision of research reports

The SEC proposes allowing foreign broker-dealers to distribute research reports to, and effect transactions in the securities discussed in such reports with, “qualified investors,” rather than restricting distribution of these reports to institutional investors and natural persons with $100 million or more in assets. All other restrictions with respect to the distribution of research reports would remain in effect under the proposed rule.

Solicitation transaction by foreign broker-dealers

The proposed rules are intended to reduce the role of U.S. broker-dealers, under the chaperoning rules, in transactions between foreign broker-dealers and qualified investors. The two proposed amendments require that the foreign broker-dealer be regulated by a foreign securities authority for conducting securities-related activities. Additionally, under the amendments, foreign broker-dealers will be required to disclose to U.S. investors that they are not subject to regulation by the SEC, U.S. bankruptcy law or any U.S. self-regulatory organization.

Proposed Exemption (A)(1) ― Foreign Broker-Dealers Conducting “Foreign Business”

Proposed Exemption (A)(1) would allow foreign broker-dealers to engage in full service brokering services to qualified investors. Exemption (A)(1) would be available to foreign broker-dealers that conduct “foreign business.” Foreign business would be defined to mean a business with qualified investors and foreign resident clients where at least 85% of the aggregate value of transactions over a two-year period is derived from foreign securities. Exemption (A)(1) would allow foreign broker-dealers to place in custody funds and securities of U.S. investors.

Foreign broker-dealers utilizing Exemption (A)(1) would be subject to the following requirements:

• A U.S. broker-dealer would be required to maintain the books and records for transactions, but could do so in accordance with the regulations of the foreign securities authority regulating the foreign broker-dealer.
• The foreign broker-dealer could maintain the books and records relating to transactions subject to Exemption (A)(1) if the U.S. broker-dealer had access to such books and records upon request of the SEC.

Proposed Exemption (A)(2) ― U.S. Broker-Dealers as Intermediaries

Proposed Exemption (A)(2) would be available to foreign broker-dealers that solicit transactions with qualified investors that have accounts, and place in custody their funds and securities, with U.S. registered broker-dealers. Under this exemption, the U.S. broker-dealer would be required to maintain the books and records relating to any transaction and to receive, deliver and safeguard funds and securities on behalf of clients in such transactions.

Sales activities

Both proposed Exemption (A)(1) and proposed Exemption (A)(2) would eliminate the requirement in current Rule 15a-6(a)(3) that foreign associated persons be accompanied by an associated person of a U.S. registered broker-dealer during in-person visits with U.S. investors. The proposed rule also would eliminate the current requirement that an associated person of a U.S. registered broker-dealer to participate in communications between foreign associated persons and U.S. investors, whether oral or electronic. These amendments would reduce the chaperoning rules contained in the current rule.

Qualification standards

Foreign broker-dealers intending to rely on proposed Rule 15a-6(a)(3) would need to meet certain qualification requirements. Under the proposed rule (as under the current rule), the foreign broker-dealer would be required to provide the SEC, upon request or pursuant to agreement between the SEC and any foreign securities authority, information or documents related to the foreign broker-dealer’s activities in inducing or attempting to induce securities transactions by qualified investors.

The proposed rule also would require the foreign broker-dealer to determine that its associated persons that effect transactions with qualified investors are not subject to a statutory disqualification under Section 3(a)(39) of the Exchange Act. This would be a change from the current rule, which requires the U.S. registered broker-dealer intermediating the transaction to make this determination. The SEC believes shifting the responsibility for making the statutory disqualification determination would be appropriate because the foreign broker-dealer is in possession of the relevant information regarding its foreign associated persons.

Foreign resident client and foreign options exchanges

The SEC’s proposal would allow foreign broker-dealers to solicit and effect transactions involving foreign resident clients. A foreign resident client would be defined as: (1) an entity not organized in the U.S. or engaged in a trade or business under U.S. tax laws; (2) a natural person who is not a U.S. resident under U.S. tax laws; or (3) an entity not organized in the U.S. and at least 85% owned by an entity or person that meets either of the first two definitions of a foreign resident client.

Under the proposal, a foreign broker-dealer would be permitted to effect transactions involving options on foreign securities on the foreign options exchange of which it is a member for a qualified investor, if the foreign broker-dealer did not solicit the investor. The proposal would also permit certain activities by a foreign options exchange representative or foreign office, which would include providing qualified investors with a disclosure document that describes the foreign options exchange and, upon request by the investor, providing a list of participants that can take orders for that exchange.

Impact on foreign broker-dealers and U.S. investors

The proposed amendments are an attempt to open the market for foreign securities and information regarding foreign securities markets to a broader spectrum of U.S. investors. Hedge funds and other alternative investment vehicles that operate in multiple jurisdictions should benefit from increased access. Transactions that involve foreign broker-dealers should incur lower transaction costs and streamline the process to avoid the involvement of unnecessary third-parties. U.S. broker-dealers may further alter their business dealings with foreign broker-dealers to provide more efficient service to their clients.

Timothy Spangler (tspangler@kayescholer.com) is a partner in Kaye Scholer's London and New York offices and head of the firm's Investment Funds group. He is a Research Associate with EDHEC-Risk.