The Securities and Exchange Commission (“SEC” or “Commission”) has released a proposal to amend Exchange Act Rule 3b-16, Regulation ATS, and Regulation SCI.¹  Criticized by SEC Commissioner Hester Peirce as “too wide-ranging” and “unwieldy” with too short of a comment period,² the proposed rule, which actually includes amendments to three separate SEC regulations, spans 654 pages, contains 224 separate requests for comment (not including subparts), allows only 30 days for public comment, and seeks to bring about a significant expansion of the SEC’s regulatory authority.  In addition to extending Regulation ATS’s and Regulation SCI’s reach to Alternative Trading Systems that trade in government securities,³ the proposed rule includes amendments to Exchange Act Rule 3b-16 that could subject currently unregulated trading venues to SEC jurisdiction by redefining “exchange” for purposes of § 3(a)(1) of the Securities Exchange Act of 1934.⁴  Under the proposed amendments to Rule 3b-16,

• exchanges are defined in terms of buyers and sellers with trading interest as opposed to orders; 

• exchanges include organizations, associations, or groups of persons that simply make available—rather than use—established, non-discretionary methods that allow for interaction and agreement on the terms of trades; and 

• exchanges include, not only organizations, associations, or groups of persons that provide trading facilities or set rules, but also include organizations, associations, or groups of persons that merely provide communication protocols.  

These proposed amendments, which deformalize the criteria for being an exchange, have clear and potentially profound implications for decentralized finance (“DeFi”).  Under the proposed definition of exchange, an organization, association, or group of persons that passively makes available a communication protocol under which buyers and sellers with trading interest can interact and agree on the terms of trades is an exchange.  The new definition of exchange, if adopted as proposed, could sweep in currently unregulated blockchain-based cryptocurrency platforms and subject them to all of the regulatory requirements that flow from being an exchange.  In short, the SEC is proposing a potentially transformative regulatory change that could create existential risks for DeFi platforms or, at the very least, fundamentally change the way they operate.  

This Client Alert details:

• the proposed amendments to the definition of exchange in Rule 3b-16; and

• the potential avenues for challenging the proposed amendments to Rule 3b-16—either through public comment or litigation.  

The Proposed Redefinition of Exchange 

Currently, Rule 3b-16(a) contains the following definition for exchange:

(a) An organization, association, or group of persons shall be considered to constitute, maintain, or provide ‘a market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,’ as those terms are used in section 3(a)(1) of the Act, (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons:

1. Brings together the orders for securities of multiple buyers and sellers; and
    
2. Uses established, non-discretionary methods (whether by providing a trading facility or by setting rules) under which such orders interact with each other, and the buyers and sellers entering such orders agree to the terms of a trade.⁵

The SEC is proposing significant amendments to subsections 1 and 2 of Rule 3b-16(a).  The new regulatory text proposed by the SEC reads:

(a) An organization, association, or group of persons shall be considered to constitute, maintain, or provide a ‘market place or facilities for bringing together purchasers and sellers of securities or for otherwise performing with respect to securities the functions commonly performed by a stock exchange,’ as those terms are used in section 3(a)(1) of the Act (15 U.S.C. 78c(a)(1)), if such organization, association, or group of persons: 

1. Brings together buyers and sellers of securities using trading interest; and
    
2. Makes available established, non-discretionary methods (whether by providing a trading facility or communication protocols, or by setting rules) under which buyers and sellers can interact and agree to the terms of the trade.⁶

In addition, the SEC is proposing to add a new subsection (e) to Rule 3b-16 to define trading interest:

(e) For the purposes of this section, the term trading interest means an order as the term is defined under paragraph (c) of this section or any non-firm indication of a willingness to buy or sell a security that identifies at least the security and either quantity, direction (buy or sell), or price.⁷

The shift to non-firm trading interest and the addition of communication protocols are intended to reach Communication Protocol Systems because “[i]n the Commission’s experience, Communication Protocol Systems . . . generally offer the use of non-firm trading interest and establish protocols to prompt and guide buyers and sellers to communicate, negotiate, and agree to the terms of the trade without relying solely on the use of orders.”⁸  Similarly, “makes available” is substituted for “uses” because “[i]n contrast to the term ‘uses,’ the Commission believes the term ‘makes available’ would be applicable to Communication Protocol Systems because such systems take a more passive role in providing to their participants the means and protocols to interact, negotiate, and come to an agreement.”⁹

Although “the proposed amendments to Exchange Act Rule 3b-16(a) would scope Communication Protocol Systems into the definition of ‘exchange,’”¹⁰ the SEC never defines Communication Protocol Systems.  Instead, in the proposed rule’s preamble, the SEC provides only “a non-exhaustive list of some Communication Protocol Systems.”¹¹  The SEC’s examples include Request-for-Quote systems that allow participants to obtain quotes by sending messages to other participants, “stream axe” systems that electronically display firm or non-firm trading interest in a security or type of security, conditional order systems that allow participants to post trading interest that may not be executable without some further action by the participants, and negotiation systems that allow participants to display non-firm trading interest and then engage with other participants to negotiate trades.¹² 

In addition, the SEC provides an example of which systems are not Communication Protocol Systems: “systems that passively display trading interest, such as systems referred to in the industry as bulletin boards, but do not provide means for buyers and sellers to contact each other and agree to the terms of the trade on the system would not be encompassed by Rule 3b-16(a) as proposed to be amended.”¹³  Beyond the examples, the SEC indicates only that “the Commission would take an expansive view of what would constitute “communication protocols” under . . . Rule 3b-16(a)”¹⁴ and “the determination of whether the system meets Rule 3b-16(a)(2) would depend on the particular facts and circumstances of each system.”¹⁵

Options to Challenge the Redefinition of “Exchange” 

The Commission provided the public with only 30 days to comment on the proposed redefinition of exchange.  The comment period will close 30 days after the proposed rule’s publication in the Federal Register, although commenters may begin submitting comments before the proposed rule’s official publication.  Thirty days is an exceedingly short comment period but unfortunately is becoming the norm for SEC rulemaking.¹⁶

Despite the brevity of the comment period, “broad public input through a transparent regulatory (not enforcement) process” is vital.¹⁷  Indeed, studies of agency responsiveness have found that agencies are influenced by public comment.¹⁸

Notwithstanding how impactful public comment can be, legal challenges to federal rules are commonplace and often necessary.¹⁹  The proposed redefinition of exchange—given the brevity of the comment period relative to the size and scope of the proposed rule in which the redefinition appears—may be vulnerable to challenge under the Administrative Procedure Act (“APA”).²⁰ 

Under the APA, federal agencies are required to provide the public with adequate notice of a proposed rule followed by a meaningful opportunity to comment on the rule’s content.²¹  Although there is no minimum period of time during which a federal agency—here, the SEC—is required to accept public comment, the executive branch has recommended that federal agencies provide comment periods of at least 60 days.²²  Moreover, the legislative history of the APA suggests that “[matters] of great importance, or those where the public submission of facts will be either useful to the agency or a protection to the public, should naturally be accorded more elaborate public procedures.”²³ 

Here, despite the breadth and scope of the proposed rule in which the redefinition of exchange appears, the Commission has determined that it is appropriate to provide the public with only 30 days to read, understand, consider, consult, identify, model, assess, and discuss the proposed rule, which includes significant amendments to not only Rule 3b-16, but also to Regulation ATS and Regulation SCI.  Indeed, trading venues never before regulated by the SEC will be subject to SEC regulation if the proposed rule is adopted.  Further, as noted by Commissioner Pierce in her Dissenting Statement on the Proposal to Amend Regulation ATS, the Commission faces “no emergency in these markets that compels us to limit comments to 30 days.”²⁴  By providing only 30 days for public comment, a court could determine that the Commission acted arbitrarily and capriciously by failing to provide a meaningful opportunity for public participation, under the Executive Branch’s own standards.

Tellingly, Chair Gensler acknowledged during the open meeting at which the rulemaking was considered that there is currently a publication backlog in the Federal Register, ranging between six to eight weeks.  Consequently, he suggested that interested persons should initiate the comment process before the proposed rule’s publication in the Federal Register, thereby creating a de facto comment period of closer to 60 days or more.  The proposed solution may not withstand judicial scrutiny, however, given the APA’s clear command that the comment period should begin only after notice of the proposed rulemaking is published in the Federal Register.²⁵  Given the text of the APA, a court may find dubious the proposition that a comment period should be determined based on a backlog in the Federal Register.  

Further, when initiating and conducting a rulemaking proceeding, an agency uses its policymaking discretion, and the federal agency can alter or abandon a pending rulemaking proceeding at any time before the final rule is published.²⁶  And federal agencies routinely take advantage of this flexibility, abandoning rulemakings for myriad reasons.²⁷  Thus, comments submitted in advance of the proposed rule’s official publication in the Federal Register may be premature and may neglect, albeit unwittingly, to address the Commission’s most current proposal. 

The proposal also may be susceptible to legal challenge on the ground that the amendments exceed the SEC’s statutory jurisdiction.  As noted above, the proposal is exceedingly broad and dramatically expands the Exchange Act’s statutory definition of “exchange.”  When an agency adopts rules that exceed its statutory jurisdiction, a reviewing court is required to vacate the rules.²⁸ 

FOOTNOTES

¹ Securities and Exchange Commission, Amendments to Exchange Act Rule 3b-16 Regarding the Definition of “Exchange”; Regulation ATS for ATSs That Trade U.S. Government Securities, NMS Stocks, and Other Securities; Regulation SCI for ATSs That Trade U.S. Treasury Securities and Agency Securities, Release No. 34-94062, File No. S7-02-22, (Jan. 2022).  The proposed rule seeks to amend Exchange Act Rule 3b-16, which currently defines exchange for the purposes of the Exchange Act, see 17 C.F.R. 240.3b-16; Regulation ATS, which sets forth regulatory requirements and obligations for alternative trading systems not registered as exchanges or otherwise exempted, see 17 C.F.R. § 242.301; and Regulation SCI, which monitors and strengthens the technology infrastructure underpinning the securities markets, see 17 C.F.R. § 242.1000 et seq.

² Commissioner Hester M. Peirce, Dissenting Statement on the Proposal to Amend Regulation ATS, U.S. Securities and Exchange Commission (Jan. 26, 2022), available at https://www.sec.gov/news/statement/peirce-ats-20220126 (stating that while “[t]he proposal we are considering today is certainly not sloppy [rulemaking], [ ] at the same time it is too wide-ranging and, given its length, too unwieldy to facilitate careful consideration” but noting that she “could have voted for the proposal had the Commission provided a period long enough to enable market participants” to undertake a considered analysis of the rule changes proposed.)

³ See supra note 1; see also Securities and Exchange Commission, Investor Protections in Communication Protocol Systems and ATSs, available at https://www.sec.gov/files/34-94062-fact-sheet.pdf (detailing additional changes in the proposed rule). 

⁴ See supra note 1, at 9-10.  

⁵ 17 C.F.R. § 240.3b-16 (emphasis added).  

⁶ See supra note 1, at 557.

⁷ Id. (emphasis added). 

⁸ Id. at 18-19.

⁹ Id. at 40.

¹⁰ Id. at 46.

¹¹ See supra note 1. at 19.

¹² Id. at 19-20.

¹³ Id. at 45.

¹⁴ Id. at 44.

¹⁵ Id.

¹⁶ Jennifer L. Schulp and Nicholas Anthony, The SEC Short-Changes Public Comment, Cato At Liberty Blog (Jan. 14, 2022), available at https://www.cato.org/blog/sec-short-changes-public-comment. 

¹⁷ Commissioner Hester M. Peirce, Lawless in Austin, U.S. Securities and Exchange Commission (Oct. 8 2021), https://www.sec.gov/news/speech/peirce-2021-10-08.

¹⁸ See, e.g., Susan Webb Yackee, Sweet-Talking the Fourth Branch”: The Influence of Interest Group Comments on Federal Agency Rulemaking, 16 J Pub Admin Res & Theory 103 (2005) (concluding that “the formal participation of interest groups during rulemaking can, and often does, alter the content of policy within the ‘fourth branch’ of government” and “those who voice their preferences during the notice and comment period rulemaking are often able to change government policy outputs to better match their preferences”); see also, Andrei A Kirilenko et al., Do U.S. Regulators Listen to the Public Testing the Regulatory Process With the RegRank Algorithm, Robert. H. Smith Sch. of Bus. Research Paper Series, (Mar. 28, 2014), available at http://papers.ssrn.com/sol3/paperscfm?abstract_id=2377826 (developing and applying an algorithm called RegRank, which found that a financial regulatory agency developed final rules that took into account “comments that reflect organized public efforts.”).

¹⁹ See Federal Judicial Caseload Statistics, available at https://www.uscourts.gov/statistics-reports/federal-judicial-caseload-statistics-2020 (noting rise in administrative agency appeals).  

²⁰ See Prometheus Radio Project v. FCC, 652 F.3d 431, 453 (3d Cir. 2011) (noting that 90 days is the “usual” amount of time allotted for a comment period.); see also Am. Water Works Ass’n v. EPA, 40 F.3d 1266, 1274 (D.C. Cir. 1994) (stating that a reviewing court will ask “whether the purposes of notice and comment have been adequately served” when assessing whether the public was adequately and fairly apprised of a new rule).

²¹ See 5 U.S.C. § 553(c).

²² See Exec. Order No. 12,866, 58 Fed. Reg. 51,735 (Oct. 4, 1993) (“[E]ach agency should afford the public a meaningful opportunity to comment on any proposed regulation, which in most cases should include a comment period of not less than 60 days.”); see also Exec. Order No. 13,563, 76 Fed. Reg. 3,821 (Jan. 18, 2011) (“To the extent feasible and permitted by law, each agency shall afford the public a meaningful opportunity to comment through the Internet on any proposed regulation, with a comment period that should generally be at least 60 days.”); Memorandum for the Heads of Executive Departments and Agencies, 86 Fed. Reg. 7,223 (Jan. 20, 2021) (“This memorandum reaffirms the basic principles set forth in [Executive Order 12866] and in Executive Order 13563 ....”).  

²³ Administrative Procedure Act: Legislative History, S.Doc. No. 248, at 259.

²⁴ Cf. N.C. Growers’ Ass’n., Inc. v. United Farm Workers, 702 F.3d 755, 768 (4th Cir. 2012) (holding that shortened comment period was arbitrary and capricious in part because agencies failed to demonstrate any exigency necessitating quick agency action); see also Prometheus Radio Project, 652 F.3d at 453 (noting that 90 days is the “usual” amount of time allotted for a comment period.). 

²⁵ See 5 U.S.C. § 553(c) (“After notice [in the Federal Register] required by this section, the agency shall give interested persons an opportunity to participate in the rule making through submission of written data, views, or arguments with or without opportunity for oral presentation.”) (emphasis added).

²⁶ See Ass’n of Oil Pipe Lines v. FERC, 83 F.3d 1424, 1432 (D.C. Cir. 1996) (internal quotations omitted) (“An agency is free to adjust or abandon its proposals in light of public comments or internal agency reconsideration without having to start another round of rulemaking.” (internal quotations omitted)).

²⁷ See Anne Joseph O’Connell, Agency Rulemaking and Political Transitions, 105 Nw. U. L. Rev. 471, 507–12, 519–25 (2011) (analyzing wide range of uncompleted rulemakings, and the influence of presidential and congressional transitions, judicial decisions, and other possible factors).  

²⁸ See 5 U.S.C. § 706(2)(C); see also Securities and Exchange Commission v. Chenery Corporation et al., 318 U.S. 80, 95 (1943) (“administrative order cannot be upheld unless the grounds upon which the agency acted in exercising its powers were those upon which its action can be sustained”); American Bankers Association v. Securities and Exchange Commission, 804 F.2d 739 (D.C. Cir. 1986) (Rule 3b-9 under the Exchange Act held unlawful because the Commission lacked authority to regulate banks as “brokers”).