On July 18, 2018, the U.S. Securities and Exchange Commission (the “SEC” or “Commission”) voted to approve a final rule (the “Final Rule”) amending Regulation Alternative Trading System (“Regulation ATS”) to require alternative trading systems (“ATSs”) that trade national market system (“NMS”) stocks (“NMS Stock ATSs”) to file with the SEC new Form ATS-N to begin operations or, for currently operating ATSs, to continue operations.  Form ATS-N will provide for enhanced disclosures regarding the ATS’s operations and relationship with its broker-dealer operator relative to current Form ATS and will be publicly available.  Importantly, unlike under the November 2015 proposal (the “Proposed Rule”), the SEC would automatically deem the Form ATS-N submissions to be effective after the review period, unless the Commission found it to be ineffective.

Overview and Changes from the Proposed Rule

Form ATS-N.  The Final Rule requires an NMS Stock ATS to file Form ATS-N through the Commission’s EDGAR system, providing detailed disclosure information about the ATS.  Specifically, Form ATS-N requires disclosure of information regarding: broker-dealer operators, their business divisions and their affiliates’ relationships with the ATS; ATS subscribers’ relationships with the ATS and the broker-dealer operator; other products and services provided by the ATS; shared employees’ activities; protection of confidential trading information; eligibility and exclusionary procedures for the ATS; connectivity and co-location services offered; order types, attributes and sizes; trading rules; liquidity provider arrangements; segmentation; counterparty selection; display information and routing; fees; suspension of trading; trade reporting; clearance and settlement; market data sources; fair access; and aggregate platform data.

However, these disclosures are more limited in important respects than what the Commission originally proposed.  In particular a number of commenters expressed concerns that the Proposed Rule would require that the ATS provide potentially proprietary or commercially sensitive information about the ATS’s operations or the operations of the broker-dealer operator and its affiliates.  In response, the SEC eliminated the requirement that ATSs attach copies of any material currently provided to subscribers related to the operations of the ATS.  In addition, the SEC narrowed the scope of its questions on Form ATS-N by, among other changes, eliminating the requirement to provide information on all the affiliates of a broker-dealer operator and instead focusing on those with access to the ATS.

Ineffectiveness Review.  A Form ATS-N will become effective following a review period (or completion of the Commission’s review, if shorter) if the SEC does not otherwise declare the Form ATS-N ineffective, after notice and an opportunity for a hearing.  Commission review is not intended to evaluate the merits of the ATS or its operations, but rather to focus solely on whether the entity meets the definition of an NMS Stock ATS, the completeness and comprehensibility of disclosures provided by the ATS, and whether the operations of the ATS would violate the federal securities laws.  The Commission will have 120 days to declare a Form ATS-N ineffective, extendable by up to 120 days, depending on the circumstances.  During the review, the Commission and its staff will work with the ATS to ensure that it has an opportunity to amend its Form ATS-N to remedy any deficiencies identified in the review.  If a Form ATS-N is declared ineffective, the ATS must cease operations (or wait to start operating) until a newly submitted Form ATS-N is deemed effective.

Similarly, NMS Stock ATSs will be required to file amendments to Form ATS-N 30 days in advance of implementing the change, during which time the Commission will be able to declare the amended form ATS-N ineffective.  The amended Form ATS-N will be made public following the 30-day review period, although a brief summary may be made public in advance.

This ineffectiveness review clarifies the process for initial Form ATS-N filings in comparison to the Proposed Rule.  Under the Proposed Rule, the SEC was required to declare a Form ATS-N effective or ineffective before an ATS could begin operations.  This change will provide greater procedural certainty and help ensure that market participants are not harmed due to solely to delays in the review process.

Scope.  The Final Rule is only applicable to NMS Stock ATSs.  In the Proposed Rule, the SEC questioned whether it should expand the applicability of the rule to include ATSs trading other securities, such as U.S. Treasuries or other fixed income securities.  For the Final Rule, the SEC decided to limit applicability to NMS Stock ATSs because the agency wanted to “take an incremental approach” to applicability.  Going forward, in addition to comments received during the comment process, the Commission may also wish to consider the input and recommendations from the Fixed Income Market Structure Advisory Committee to ensure that any additional requirements on other types of ATS s are appropriately tailored.[1]

Place within the SEC’s Equity Market Structure Reforms

Because NMS Stock ATSs are responsible for approximately 11.4% of the market share of NMS stock trading volumes, the SEC is seeking to foster greater transparency in the market for NMS stocks and to enhance NMS Stock ATS oversight.  The Final Rule is designed to allow institutional investors in particular to compare operations and conflicts of interest among various NMS Stock ATSs and national securities exchanges used by their executing brokers.  The Final Rule will provide market participants information about how orders interact, match and execute on NMS Stock ATSs, along with details about the activities of the broker-dealer operator and its affiliates in order to further assess conflicts of interest and information leakage.

The Final Rule continues the SEC’s focus on enhancing transparency and addressing potential conflicts of interest in the equity markets and will in particular work hand-in-hand with the proposed amendments to Rules 605 and 606 under Regulation NMS, which would require additional disclosures by broker-dealers to customers – including new disclosures to institutional customers – about the broker-dealer’s routing decisions and executions.  Combined, the rule changes will shed light on the manner in which broker-dealers and trading centers execute, in particular, institutional customer orders, allowing institutional investors and other market participants to evaluate broker-dealers to more readily assess the quality of services offered by their brokers.

The amendments to Regulation ATS create a number of potential enforcement risks for failure to comply with the new regulations.  An ATS that meets the requirements of Regulation ATS is exempt from the definition of “exchange” pursuant to Exchange Act Rule 3a1-1(a)(2).[2]  Under new Rule 304(a)(4), after notice and an opportunity for hearing, the Commission may suspend for a period not exceeding 12 months, limit or revoke an NMS Stock ATS’s exemption from the definition of “exchange” if the Commission deems that such action is necessary in the public interest and consistent with investor protections.  For example, failure to disclose a material change in an ATS’s operations on Form ATS-N could result in the prohibition of engaging in the undisclosed activity until such time as the ATS properly amends Form ATS-N.  Such a process will allow the Commission to address non-compliance with Regulation ATS or other securities laws violations.  Moreover, because an NMS Stock ATS will be required to provide additional disclosures, ensuring that its operations comply with those disclosures will increase the compliance burden on the broker-dealer operator.  The fact that the Form ATS-N will be publicly available also increases the risk that private litigants may seek to use the new form as the basis for a fraud claim on account of misstatements or omissions in the form.

[1] The Fixed Income Market Structure Advisory Committee has a mandate to provide the Commission with diverse perspectives on the structure and operations of the U.S. fixed income markets, as well as advice and recommendations on matters related to fixed income market structure.  On July 16, 2018, the committee recommended that the “SEC, [Financial Industry Regulatory Authority] and [Municipal Securities Rulemaking Board] form a joint working group to conduct a review of the regulatory framework for oversight of electronic trading platforms used in the corporate and municipal bond markets.”

[2] Section 5 of the Exchange Act requires an organization that meets the definition of “exchange” under Section 3(a)(1) of the Exchange Act to register with the Commission as a national securities exchange and is required to comply with the regulatory requirements applicable to national exchanges and self-regulatory organizations unless otherwise exempt.  15 U.S.C. 78e.