As of the close of trading in Amsterdam today (April 19, 2023), the AEX Index will transition from a broad-based to a narrow-based security index within the meaning of applicable US law. More specifically, today marks the end of a three-month grace period following an earlier three-month period during which for more than 45 business days the AEX Index was narrow-based. As a result, as of open of trading tomorrow, AEX Index futures will become futures on a foreign narrow-based security index – which is to say, they will become "foreign security futures" within the meaning of the SEC's 2009 exemptive order relating to such transactions. But – because the AEX Index does not satisfy the "primary trading market" test under that order – it will not be eligible, consistent with the terms of the 2009 Order, to be executed or cleared by any customer (including any customer otherwise eligible under the Order) of a registered broker-dealer/FCM. (For additional background on the order and the AEX Index's transition, see here.)
So what's a US investment manager that wishes to continue trading AEX Index futures to do? That manager might reason as follows: "Some of the funds I manage are 'offshore clients' – they're organized under the law of a jurisdiction other than the United States and substantially all of the investors in those funds are neither US residents nor businesses located in the US for federal income tax purposes. And the AEX Index futures look to me like 'foreign securities' – that is, their issuer is organized outside the US, and they are listed on non-US exchanges. Why can't I do this trade under the Seven Firms Letter?"
The Seven Firms Letter is a no-action letter issued in 1996 by the SEC's Division of Trading and Markets that is widely relied on to this day. Penned in response to a petition from seven registered broker-dealers, the Seven Firms Letter says that non-US affiliates of such broker-dealers may effect transactions in "foreign securities" with a "US Resident Fiduciary" (i.e., our US investment manager) for "offshore clients," without the non-US affiliate either registering with the SEC or effecting the transactions in accordance with Rule 15a-6.
Rule 15a-6 under the Securities Exchange Act of 1934 provides conditional exemptions from broker-dealer registration for foreign broker-dealers that engage in certain specified activities involving US investors, including (i) effecting unsolicited securities transactions; (ii) providing research reports to US institutional investors, and effecting transactions in the securities covered in such reports for those investors; (iii) soliciting and effecting transactions for US institutional investors through a "chaperoning broker-dealer"; and (iv) soliciting and effecting transactions for registered broker-dealers, banks, certain international organizations, foreign persons temporarily present in the US, US citizens resident abroad, and foreign branches and agencies of US persons. The advantage conferred by the Seven Firms Letter is that it carves out a sphere within which US managers with offshore clients transacting in foreign securities may deal directly with non-US broker-dealers, free of the burden of compliance with the conditions in Rule 15a-6.
The SEC's 2009 Order on foreign security futures also includes a conditional exemption from 15a-6 – but that exemption is unavailing to our US manager looking to execute AEX Index futures, since it is only available where the foreign security futures contract is otherwise eligible under the Order. At any rate, the 15a-6 exemption in the 2009 Order requires foreign broker-dealers relying on it to comply with several conditions set forth under the rule, including effecting transactions through a registered broker-dealer (again, which the broker-dealer cannot do for a contract that is not eligible under the product eligibility conditions of the Order).
So why can't our US investment manager rely on the Seven Firms Letter instead – that haven from the cumbersome conditions of 15a-6 for transactions that are "entirely" offshore of the US but for the nexus of the investment manager's residence?
It's a good question. Indeed I used to think that the transaction our US manager wants to do is in scope of the Seven Firms Letter. But I have come to rethink that position on further consideration. Here's why.
Consider the full definition of "foreign security" in the Seven Firms Letter:
"(1) a security issued by an issuer not organized or incorporated under the laws of the United States when the transaction in such security is not effected on a US exchange or through Nasdaq system; or (2) a debt security (including a convertible debt security) issued by an issuer organized or incorporated in the United States in connection with a distribution conducted outside the United States. For purposes of this definition, the status of over-the-counter ("OTC") derivative instruments would be determined by reference to the underlying instrument."
A footnote adds: "For purposes of this definition, a depository receipt issued by a US bank would not be considered a Foreign Security unless it is initially offered and sold outside the United States in accordance with Regulation S under the Securities Act of 1933."
So the critical question for our US manager is this: can a foreign security future that fails the primary trading market test count as a "foreign security" under the Seven Firms Letter? On first blush the answer appears to be, sure. Take the AEX Index futures. They are securities issued by a clearinghouse (Euronext Clearing) that is "not organized or incorporated" under the laws of any US jurisdiction, and transactions in AEX Index futures are "not effected on a US exchange."
Case closed – is our US manager good to go?
On reflection, I've come to conclude that the answer is no. Yes, on the face of the definition any foreign security futures contract would appear to qualify. But the footnote referring to ADRs is a telling clue to the contrary. US ADR volume is the main reason why certain foreign security futures fail the primary trading market test – the names in the underlying index often have ADR volume that is significant enough to make what appears to be a foreign security that is primarily traded offshore, a US security that is primarily or predominantly traded in the US. The 2009 Order makes clear that the policy basis of the Order is that protections US investors enjoy for transactions in US capital markets do not necessarily extend to transactions in securities issued by foreign issuers in foreign markets, especially by sophisticated investors. This rationale is undermined where transactions in "foreign securities" transacted under a more lenient investor protection regime are in fact transactions in US securities (or securities in which there is significant trading volume on US exchanges).
Accordingly, in determining whether the Seven Firms Letter applies to AEX Index futures (and other foreign security futures that fail the primary trading market test), and specifically whether they are "foreign securities" under the Letter, the standard should be the primary trading market itself. As the Order states: the purpose of the primary trading market test is "to prevent this exemption from being used to avoid US federal securities laws or facilitating a secondary market in the US in securities that may not have been registered under the Securities Act or the Exchange Act." Presumably the SEC and Staff would have no less interest in preventing the Seven Firms Letter from being used to that end, as well – and to ensure that it's not, market participants should not force the definitions of the Letter to fit transactions clearly at odds with foundational policy objectives.
This doesn't mean our US manager is entirely without options. Swaps on the AEX Index or on AEX Index futures contracts may be executed by the manager on behalf of any eligible contract participant, subject to applicable swap or security-based swap regulations. And if the US manager has an offshore affiliate operating entirely outside the jurisdiction of the US, that manager can trade with non-US broker-dealers on behalf of offshore clients free of US regulatory constraints all together.
The text of Rule 15a-6 is available here. The Seven Firms Letter is here. The 2009 Order is here.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
