After years of disputes, the SEC and the Federal Reserve recently adopted Regulation R – the final rules governing the broker-dealer “push-out” provisions of the Gramm-Leach-Bliley Act. The GLBA eliminated the blanket exemption for banks from registration as a broker-dealer. Recently adopted Regulation R provides a complex web of rules with which a bank must comply to avoid registration as a broker-dealer. Because so many years have elapsed since passage of the Act and because money center banks usually have broker-dealer affiliates, large banks conformed their activities to the web of rules long ago by pushing out many activities to their affiliated broker-dealers.

Regional and community banks may have looked at the rules after the SEC promulgated Regulation B, the SEC’s effort (subsequently overruled by Congress) to be the sole regulator of bank broker-dealer activities. With the adoption of Regulation R, we urge regional and community banks, especially those with trust departments, to carefully re-examine their current activities to ensure the activities fall within the limits of the new rules. The failure to comply with Regulation R limits may lead to SEC and bank regulatory investigations. Furthermore, violations will provide each customer with the right to void their contract with the bank if the contract involve securities activities.

Brief History

The SEC and the Federal Reserve voted on September 19, 2007 and September 24, 2007, respectively, to adopt Regulation R. Regulation R implements the bank broker provisions of the GLBA and replaces the SEC’s prior efforts in the area of bank broker activities, including the previously proposed Regulation B. On September 19, 2007, the SEC also voted to adopt a companion release to amend and supplement bank dealer rules that were issued by the SEC in 2003 to implement the bank dealer provision of the GLBA.

The Exchange Act requires the registration of securities brokers and dealers in order to regulate these types of entities. Until the adoption of the GLBA in 1999, banks had been completely excluded from broker-dealer registration and regulation. The GLBA limited the exclusion of banks from broker-dealer regulation by removing the global exception for banks from the definitions of “broker” and “dealer” under Sections 3(a)(4) and (5) of the Exchange Act. In place of this global exception, the GLBA provided a list of permissible securities-related activities that a bank could perform without qualifying as a “broker” or “dealer” under the Exchange Act. This list of permissible activities was intended to cover securities-related activities that were traditionally provided by banks. If a bank’s securities-related activity fell outside this list of permissible activities, that bank would either have to register as a broker-dealer or the activity would have to be contracted out to a registered broker-dealer. The GLBA required that the SEC implement new rules to provide further detail regarding these “permissible” activities. Regulation R and the new Bank Dealer Rules are the culmination of the SEC’s efforts to provide this detail.

Regulation R

Banks are permitted to engage in the following securities activities under Regulation R:

Third Party Networking Arrangements: Section 3(a)(4)(B)(i) of the Exchange Act allows banks to receive compensation for referring bank customers to broker-dealers and provides that banks may pay unregistered employees (i.e., bank employees who are not employed as registered representatives of a broker-dealer) “nominal” incentive compensation for making these referrals. Like the proposed rules, Regulation R provides that a fee will be considered “nominal” so long as it meets any one of the following three alternative standards: 

  • The payment does not exceed (i) twice the average hourly wage established by the bank for the “job family”* that includes the employee or (ii) 1/1000th of the average annual base salary established by the bank for the employee’s “job family”; 
  • The payment does not exceed (i) twice the employee’s actual base hourly wage or (ii) 1/1000th of the employee’s actual annual base salary; or 
  • The payment does not exceed $25 (to be adjusted periodically for inflation).

Regulation R also permits banks to pay more than nominal fees for referrals of certain institutional customers and high net worth customers to a broker or dealer so long as the bank and broker-dealer satisfy certain conditions that protect these customers. The final rules also clarify that more than one bank employee may receive payment for a single referral so long as the payments only go to employees personally involved in the referral.

Trust and Fiduciary Activities: Section 3(a)(4)(B)(ii) of the Exchange Act allows a bank to effect securities transactions in a trustee or fiduciary capacity without being registered as a broker. In order to qualify for this exception, the bank must determine that it is “chiefly compensated” based on certain fees referred to as “relationship compensation.” Relationship compensation includes: 

  • an administration or annual fee;
  • a fee based on the percentage of assets under management; 
  • a flat or capped per-order processing fee that does not exceed the cost incurred by the bank in executing the securities transactions in question; or 
  • any combination of such fees.

The final rules further define what it means to be “chiefly compensated” by providing a bright-line test – a bank has met the “chiefly compensated” standard if, using a two-year rolling average comparison: (1) on an account-by-account basis, the bank’s relationship compensation is greater than 50% of its entire compensation from an account, or (2) on a bank-wide basis, the bank’s relationship compensation is more than 70% of its total compensation from its trust and fiduciary accounts.

Sweep Activities: Section 3(a)(4)(B)(v) of the Exchange Act permits a bank, without registering as a broker, to effect transactions in securities as part of a sweep program that invests customer funds in a “no-load” mutual fund. Regulation R also permits banks, subject to certain conditions, to sweep customer funds to mutual funds that charge higher fees than no-load mutual funds.

Safekeeping and Custody Activities: Section 3(a)(4)(b)(viii) of the Exchange Act allows banks to perform certain custody and safekeeping activities without qualifying as a broker. For example, a bank may accept orders for securities transactions from employee benefit plan accounts and individual retirement accounts for which the bank acts as a custodian. Under Regulation R, a bank may also accept securities orders with respect to other kinds of accounts as an accommodation to its customer subject to certain conditions designed to help ensure that these services continue to be provided only as an accommodation. Specifically, the bank is not permitted to advertise securities order-taking, provide investment research or advice or make recommendations to the account concerning securities or otherwise solicit securities transactions from the account. In addition, the amount charged by the bank for facilitating a securities transaction for an account can not vary based on whether the bank accepted the order for the transaction or on the quantity or price of the securities to be bought or sold.

In addition, in a departure from the proposed Regulation R, the final rules provide guidance with respect to the specific circumstances under which a bank may or may not be considered to be acting as a “carrying broker” thereby disqualifying it from exemption under the safekeeping and custody activities exception. The final rule release states that banks may look to certain key factors to help distinguish permissible custodial activity from impermissible carrying broker activity, namely: 

  • the broker-dealer’s own regulatory obligations and 
  • whether the broker-dealer either makes formal or informal arrangements with the bank or structures its operations or offering to cause the broker-dealer’s customers generally to use the bank’s custody accounts instead of maintaining funds and securities in accounts at the broker-dealer (thereby avoiding the broker-dealer’s financial and related responsibilities).

The release goes on to state that the following activities would not cause the bank to be acting as a “carrying broker”: 

  • existence of a substantial number of common customers between a broker-dealer and a bank’s custody department in the absence of such a structure or arrangement that helps the broker-dealer to avoid its financial responsibilities 
  • the performance or sharing of systems that perform limited back-office functions on behalf of a broker-dealer, e.g., a broker-dealer may contract with an unregistered bank to send out transaction confirmations on behalf of the broker-dealer. (However, it should be noted that a broker-dealer may not delegate core functions to a bank or functions that would require an individual to pass a qualification exam or register with an SRO.)

The proposed rule has also been modified to allow a bank that acts as a directed trustee for an account to accept orders and effect transactions for the account under the custody exemption in lieu of relying on the trust and fiduciary exemption discussed above. A directed trustee is defined as “a trustee that does not exercise investment discretion with respect to the account.”

Foreign Securities Transactions: Rule 771 of Regulation R provides an exemption that permits banks to effect certain agency transactions involving Regulation S securities. Regulation S securities are securities that are offered and sold outside of the U.S. and, as such, are exempt from registration under Section 5 of the Securities Act of 1933. Banks may rely on Rule 771 so long as they have a reasonable belief that securities were initially sold in compliance with Regulation S.

Securities Lending Transactions Conducted in an Agency Capacity: The final rules adopt Rule 772, as proposed, which provides an exemption that allows banks to engage in noncustodial securities lending associated with banks’ brokerage activities. To qualify for this exemption, the bank must either (i) not have custody of the securities or (ii) have custody of such securities for less than the entire period of the transaction. In addition, this exemption applies only to securities lending activities with or on behalf of (i) a person that the bank reasonably believes to be a “qualified investor” as defined in the Exchange Act or (ii) any employee benefit plan that owns and invests, on a discretionary basis, not less than $25 million in investments.

Transactions in Company Securities for its Employee Benefit Plans and Participants: In a departure from the proposed rules, the final Regulation R adds an exemption to permit a bank to effect a transaction in the securities of a company in connection with such company’s employee benefit plans. The transaction must be made directly with a transfer agent acting for the company and four other conditions must be met: 

  • no commission may be charged with respect to the transaction; 
  • the transaction must be conducted solely for the benefit of an employee benefit plan; 
  • the security must be obtained directly from the company or an employee benefit plan of the company; and 
  • the security must be transferred only to the company or an employee benefit plan of the company.

Transactions Involving Mutual Fund Shares: The rules also include an exemption that allows banks to effect certain transactions in mutual funds and certain variable insurance products that are registered, and funded by a separate account, through the National Securities Clearing Corporation, directly with a transfer agent, or directly with an insurance company or a separate account that is excluded from the Exchange Act definition of transfer agent. In order to qualify for this exemption, the security in question may not be traded on a national securities exchange or through the facilities of a national securities association or an interdealer quotation system.

Safe Harbors Under Regulation R

Section 29 of the Exchange Act provides that any contract entered into by an unregistered broker-dealer and a customer is voidable at the election of the customer. Regulation R provides two safe harbors to banks to avoid the application of the general rule of Section 29:

First, Regulation R creates a transitional safe harbor which provides that no contract entered into by a bank within the 18 months after the effective date of Regulation R (December 3, 2007) will be voidable by reason of Section 29 simply because the bank was not registered as a broker-dealer when its activities fell outside the exempt list of activities described above.

The second safe harbor is not subject to a time limit. It provides that no contract entered into by a bank will be voidable by reason of Section 29 if the bank was not registered as a broker-dealer as long as (i) the bank acted in good faith and had reasonable policies and procedures in place to comply with Section 3(a)(4)(B) of the Exchange Act at the time the contract was created and (ii) any violation of the registration requirements by the bank did not result in any significant harm, financial loss or cost to the person seeking to void the contract.

Bank Dealer Rules

The SEC also voted to adopt new and amended bank dealer rules (“Bank Dealer Rules”) in a separate companion release. The following is a summary of the significant substantive changes effected by the Bank Dealer Rules.

Regulation S Transactions With Non-U.S. Persons

The SEC is adopting Exchange Act Rule 3a5-2 which provides a conditional exemption from the definition of “dealer” that allows banks to engage in certain transactions involving securities exempted from registration by Regulation S under the Securities Act of 1933. This exemption will permit U.S. banks to sell these securities overseas so long as the purchases and sales in question (i) only involve “eligible securities” (securities that are not inventory of the bank or an affiliate, and that are not underwritten by the bank or an affiliate on a firm commitment basis, apart from securities acquired from an unaffiliated distributor) and (ii) are made by the bank on a “riskless principal” basis (i.e., after receiving an order to buy from a customer, the bank purchased the security from another person to offset a contemporaneous sale to such customer or, having received an order to sell from a customer, the bank sold the security to another person to offset a contemporaneous purchase from such customer).

The exemption is available when a bank: 

  • Purchases a newly-issued eligible security from an issuer or broker-dealer and sells that security to a non-U.S. purchaser in compliance with Regulation S;
  • Purchases an eligible security from a non-U.S. person after its initial sale with a reasonable belief that the eligible security was initially sold outside of the U.S. in compliance with Regulation S and resells that security to a non-U.S. purchaser or to a registered broker-dealer; or 
  • Purchases an eligible security from a registered broker-dealer after its initial sale with a reasonable belief that the security was initially sold outside of the U.S. in compliance with Regulation S and resells that security to a purchaser who is not in the U.S. (Note that, in this instance, under the rules as initially proposed, a bank would not have been allowed to rely on its “reasonable belief” that the security was initially sold outside of the U.S.)

As compared to the bank dealer rules as proposed, the final rules, by addressing both the purchase and resale of these securities, were designed to better reflect the nature of banks’ riskless principal transactions involving Regulation S securities and to parallel the equivalent provisions of Regulation R regarding banks’ Regulation S transactions as agents.

Securities Lending by Bank Dealers

Rule 3a5-3 of the Exchange Act has been adopted as proposed to provide banks engaged in certain securities lending transactions with a conditional exemption form the definition of “dealer.” Under the rule, a bank will not qualify as a “dealer” to the extent that it engages in or effects certain securities lending transactions and services as a “conduit lender.” The exemption applies so long as the securities lending activities in question are undertaken with or on behalf of a person that the bank reasonably believes to be (i) a qualified investor or (ii) an employee benefit plan that owns and invests, on a discretionary basis, not less than $25 million in investments.

When Do Banks Have to Comply with Regulation R and the Bank Dealer Rules

The rules and amendments adopted in Regulation R will go into effect on December 3, 2007. However, unlike the rules as proposed, banks are provided transitional relief under the final rules which exempts them from complying with the new rules and the “broker” exemptions until the first day of their first fiscal year that commences after September 30, 2008.

The final Bank Dealer Rules will be effective on November 2, 2007.

Next Steps For the Client

Please note that Regulation R and the Bank Dealer Rules contain detailed rules which can not be fully summarized in this alert. Please feel free to contact us for more information concerning the potential effects of Regulation R and the Bank Dealer Rules on your business.