On September 19 and 24, 2007, respectively, the Securities and Exchange Commission (the “SEC”) and the Board of Governors of the Federal Reserve System (the “Board”) voted to adopt new “Regulation R” to implement the “broker” exceptions for banks under Section 3(a)(4) of the Securities Exchange Act of 1934 (the “Exchange Act”).1 The SEC separately issued an accompanying proposal conforming certain other SEC rules to Regulation R.2
Regulation R is intended to define the scope of securities agency activities that banks may conduct without registering with the SEC as a “broker.” The press release issued by the SEC states that Regulation R is intended to give effect to the bank broker exceptions “in a way that accommodates the traditional business practices of banks, ... stimulate[s] greater competition in the financial services industry, and give[s] investors a wider array of services at lower prices.”3 The Board issued a statement by Board Governor Randall S. Kroszner in which he stated that “Congress recognized that banks had been providing securities services to their customers for decades without significant securities-related concerns ... [and] the Board and the other federal banking agencies have a long history of effectively supervising the securities functions of banks through regular on-site examinations, regulations and supervisory guidance.”4
This Clients & Friends Memo summarizes the adopted Regulation R, including: (1) the four exemptions implemented by the regulation; (2) related SEC rule amendments and proposals; and (3) relevant policy issues, including the dominant themes pursued by both the Board and SEC.5
Prior to adoption of the Gramm-Leach-Bliley Act of 1999 (the “GLBA”), a “bank” (as defined in Section 3(a)(6) of the Exchange Act) was exempt from registering with the SEC as a “broker.” Accordingly, banks were free to engage in securities brokerage activities to the extent permitted by U.S. banking law and their activities in this regard were solely subject to the regulatory authority of the Federal Banking Agencies.
Section 201 of GLBA eliminated banks’ complete exemption from SEC registration by establishing functional regulation, the theory of which is that securities activities should be supervised and regulated by the SEC, while banking activities should be supervised and regulated by the bank regulators. Nonetheless, banks had long performed many securities agency activities and such activities had become an integral part of their banking services. For example, banks traditionally had acted as a securities broker when serving as custodian or trustee of a client’s assets. Banks wished to continue to offer this mix of banking and securities services. Congress permitted the continuance of this mix of activities by granting banks a continued, albeit only partial, exemption from registration as securities brokers for those securities agency activities in which they had traditionally engaged.
Nonetheless, interpretative disagreement over the scope of Section 201 of GLBA arose immediately over the question of whether the GLBA exemptions should be (i) narrowly drawn, to push bank securities agency activities into SEC-regulated broker-dealers or (ii) broadly understood to allow the continuation of the banks’ traditional activities and ongoing customer relationships. Previous SEC proposals to adopt “Regulation B” narrowly interpreted these exceptions. These narrow interpretations met strong opposition from the banks and Federal Banking Agencies.6 Regulation R takes the broader approach.7
Now that Regulation R has been adopted, securities agency activities performed by banks within the exemptions will be considered “banking” activities, in that they will be performed by banks outside the scope of the securities laws and will be functionally regulated by bank regulators.8 Any discussion of Regulation R must then focus not just on the specifics of what activities can be done in which entity, but also on the future of the supervision and enforcement of the Regulation, including the following questions, among others: How will compliance with the exemptions be enforced? How will future interpretation of Section 3(a)(4)(B) of the Exchange Act be handled among the SEC and the Board and the other Federal Banking Agencies?9 Will the SEC aggressively seek to enforce compliance by banks with the specifics of the exemptions? Will the bank regulators actively share with the SEC the information gathered from their examinations of the banks?10
As well, those securities firms that are affiliated with banks or thrifts should now consider the proper placement among their regulated entities of those securities activities that may be performed either in a registered broker-dealer or a bank/thrift.
Regulation R offers interpretive guidance for four exemptions listed in Section 3(a)(4)(B) of the Exchange Act: (i) networking arrangements; (ii) trust and fiduciary activities; (iii) sweep activities; and (iv) safekeeping and custody activities. Each of these exemptions is discussed in detail below.11
Section 201 of GLBA permits a bank to refer customers to a registered broker-dealer, subject to various conditions.12 After the adoption of the GLBA, the specific conditions to be imposed were hotly disputed.
A bank may receive compensation in an unlimited amount from the broker-dealer under the networking arrangement. However, unless additional conditions are satisfied, the bank only may pay its own employees a “nominal one-time cash fee of a fixed dollar amount” that is not contingent on whether the referral results in a transaction for the broker. Employee compensation cannot be incentive compensation; that is, it can not be dependent upon the execution of transactions by the customer with the brokerdealer, or even on the opening of a brokerage account.13
However, this requirement that referral compensation be ”nominal” does not apply to referrals of institutional or high net worth customers.14
a. Nominal Fees and Customer Referrals
The definition of “nominal one-time cash fee of a fixed dollar amount” includes four methods by which a bank can compensate its employees for referrals.15 Under the first two methods, a fee may not exceed either twice the average of the minimum and maximum hourly wage or 1/1000th of the average of the minimum and maximum annual base salary of the employee (or a similar employee). Under the third method, a fee may not exceed twice the employee’s actual base hourly wage. Under the fourth method, a fee may not exceed $25, which will be adjusted for inflation every five years. The SEC and the Board determined that fees permitted under each of the alternatives “would be small in relation to the employee’s overall compensation and therefore unlikely to create undue incentives ... and that the multiple alternatives are designed to provide flexibility to banks ... to use different business models ...”.16
A fee may be paid for each referral, including separate referrals of the same individual or entity. All fees must be for fixed amounts and paid in cash; no noncash fees are be permitted. Any employee that personally participated in a referral is eligible to receive a fee. Any action to direct a customer of a bank to a registered broker-dealer can be a “referral.”17
b. Prohibition on Contingent Fees and Incentive Compensation
A referral fee may not be contingent on the successful completion by the brokerdealer of a transaction. Regulation R defines “contingent” to cover fees where payment of the fee is “dependent on whether the referral results in a purchase or sale of a security; whether an account is opened with a broker-dealer; whether the referral results in a transaction involving a particular type of security; or whether the referral results in multiple securities transactions.”18 For purposes of this exemption, fees are not considered to be contingent (that is they are permitted) if they are payable only if (i) the customer actually meets with a representative of the broker-dealer as a result of a referral and (ii) the customer satisfies any eligibility requirements applicable to the networking program (e.g., an income or net-worth test).19
Incentive compensation, which is prohibited as part of a referral fee, is defined as “compensation that is intended to encourage a bank employee to refer potential customers to a broker-dealer or give a bank employee an interest in the success” of a transaction.20
c. Permitted Bonus Programs
The SEC and the Board permitted various types of existing bank bonus programs to continue without regard to the limits on networking arrangements.21 Excluded from the definition of incentive compensation are discretionary, multi-factor bonus plans, on the theory that such programs are not likely to give bank employees a promotional interest in the broker-dealer’s success, such as compensation generally paid by banks under bonus programs that are discretionary and based on a multiple of significant factors or variables that do not include the referral. Each factor of the bonus must be material to the employee’s compensation to be a significant factor.
Regulation R also provides a “safe harbor” for bonus plans based on overall profitability or revenue. Banks can factor into a bonus the total amount of business that an employee has generated for the bank and its partner broker-dealers.22
d. High Net Worth and Institutional Customers
Banks can pay fees that are both contingent and larger than nominal to employees in connection with a referral of a high net worth or institutional customer. This exemption recognizes both that such customers are capable of understanding the relationships among the employees, banks and broker-dealers.23
“Institutional customer” is defined as any corporation, partnership, limited liability corporation, trust or other non-natural person that has at least $10 million in investments or $20 million in revenues.24 However, an institutional customer may be referred solely for investment banking services if it has at least $15 million in revenues.25 These amounts are lower than those in proposed Regulation R, as the SEC and the Board modified the definition in partial accordance with many public comments stating that investors with fewer assets or revenues would have appropriate sophistication to be treated as an institutional customer by a bank.
“High net worth customer” is defined as any natural person having (individually or jointly with their spouse) at least $5 million in net worth, including certain trust assets but excluding a primary residence.26 These dollar amounts will be adjusted for inflation every five years.27 Either a bank or a registered broker-dealer may satisfy the customer eligibility requirements by having a reasonable belief that a customer so qualifies.
e. Limits on More than Nominal Fees
Contingent, referral fees that are more than nominal may be a dollar amount based on a fixed percentage of the revenues generated for investment banking services by the broker. The fee may also be predetermined in a dollar amount or a formula, so long as the fee does not vary based on (i) the revenue or profit from securities transactions, (ii) the quantity, price or identity of the securities purchased or sold, or (iii) the number of referrals made. Further, nothing in Regulation R prohibits a bank employee from receiving from the bank compensation as a bonus that would not be incentive compensation.28 Finally, nothing in the networking exemption prevents a bank employee from referring customers to other departments of the bank, and the rules do not apply to referrals not involving securities.
f. Procedural Requirements as to Higher Fees
Both the bank and any bank employee must meet certain other conditions before a more than nominal fee can be paid. A bank employee: (i) may not be registered or approved, or required to be so, under the rules of a self-regulatory organization (“SRO”);29 (ii) must be predominantly engaged in banking activities other than broker-dealer referrals; (iii) must not be subject to a statutory disqualification under the Exchange Act; and (iv) must encounter the customer as part of the employee’s ordinary course duties at the bank. The bank or the registered broker-dealer must provide certain written or oral disclosures about the employee’s interest in the referral prior to or at the time of the referral; the bank must also provide the employee’s details to the broker-dealer.30
Further, the bank must have in place a written agreement with the broker to which it is referring customers. This agreement must (i) require the broker to determine (A) that the bank employee is not subject to a statutory bar under the Exchange Act and (B) that the customer meets the criteria to be an institutional or high net worth customer.31 The written agreement must also require the broker to perform “a suitability or sophistication analysis of a securities transaction or the customer being referred.”32 For contingent fee arrangements, a suitability analysis must be performed for any securities transaction that triggers a portion of the contingent fee in accordance with applicable SRO rules as if the broker-dealer had recommended the securities transaction. For non-contingent fee arrangements, either a “sophistication” or a “suitability” analysis must be performed before the fee may be paid.33 Good faith failure of either the bank or the broker after following appropriate policies and procedures to comply with the terms of the written agreement will not cause the bank to become an unregistered “broker.” The broker-dealer should inform the customer if the customer or the transaction does not meet required standards.34
These procedural requirements, looked at somewhat closely, seem to reflect the very different attitudes and view of the Federal Banking Agencies and the SEC towards Regulation R -- and perhaps to the entities that they regulate. That is, (i) banks are permitted an exemption and (ii) broker-dealers are subject to the responsibility of determining the availability of the exemption, even as to bank employees. Further, the determination that the broker-dealer must make; e.g., that a transaction is “suitable” for a customer is potentially a judgment call that would not ordinarily be necessary if the customer entered into a transaction that was not recommended by the broker-dealer.
II. Trust and Fiduciary Activities
Section 201 of the GLBA permits a bank to effect securities transactions in a trustee or fiduciary capacity for bank customers.35 Such transactions must be effected from a trust department (or a department regularly examined by bank examiners for fiduciary compliance). The bank may be “chiefly compensated” for such transactions on the basis of (i) an administrative or annual fee; (ii) a percentage of assets under management; (iii) a flat or capped per-order fee not to exceed the bank’s execution cost; or (iv) any combination of these fees (collectively, these are “Relationship Compensation”).36
A bank may only advertise its securities services in this field as part of its fiduciary services, and it must execute the trade through a registered broker-dealer or as otherwise permitted in Regulation R.37
a. Chiefly Compensated
Regulation R provides that a bank meets the chiefly compensated test if the “relationship-total compensation percentage” is more than 50 percent. The percentage is calculated on an account-by-account basis by (i) dividing the Relationship Compensation attributable to each account during each of the two prior years by the total compensation attributable to the customer account over the prior two years; (ii) translating the quotient for each of the two years into a percentage; and (iii) averaging the percentages.38
Alternatively, a bank may calculate the compensation it receives from all of its trust and fiduciary accounts on a bank-wide basis. While this procedure simplifies compliance efforts for the bank, it requires that the “aggregate relationship-total compensation percentage” of the bank’s trust and fiduciary business be at least 70 percent. This calculation is made based on the same analysis as the accountby- account calculation, but based on the bank’s aggregate business.39 Both of these calculations would begin on the first day of applicability of Regulation R to a bank claiming the trust and fiduciary exception; banks are required to have finished their calculations within 60 days of the end of their fiscal year. A trust or fiduciary account is one in which the bank acts as trustee or in a “fiduciary capacity,” as defined in Section 3(a)(4)(D) of the Exchange Act.
b. Relationship Compensation
To calculate either of the above percentages, a bank must be able to determine the Relationship Compensation attributable to its trust or fiduciary accounts. Regulation R provides examples of fees that are considered Relationship Compensation, including asset management fees and 12b-1 fees paid by investment companies. This inclusion of 12b-1 fees is a significant change from previous proposals, and is favorable to banks. Also included are (i) fees for personal service or the maintenance of shareholder accounts and (ii) fees for transfer agent and other administrative services.40 Fees from securities transactions for trust or fiduciary customers executed by a bank pursuant to a different exception under Regulation R are excluded from these calculations, as is compensation from non-trust or fiduciary services.
Further included as “administrative fees” are fees for personal services, tax preparation or real estate settlement services, or fees paid by investment companies for such services. These examples are only illustrative, and other fees may also qualify.41
c. Advertising Restrictions
Banks are limited in their ability to advertise their authority to execute securities transactions under this exemption, except as part of their broader advertisements of the banks’ trust or fiduciary services. However, only material distributed through public media would be advertisements subject to the restriction, and the restriction would only prohibit advertisements that list securities transactions more prominently than other trust or fiduciary services.42
d. Other Exemptions
Regulation R permits a bank to exclude certain other accounts for purposes of determining its compliance with the trust and fiduciary activities exception, in order to reduce administrative burdens and ease compliance for accounts that do not present a risk that the bank is operating as a securities broker through its trust department. These accounts include (i) accounts open for less than three months, and (ii) accounts acquired as part of a merger, acquisition, purchase of assets, or similar transaction, which may be excluded for up to 12 months after the date of the transaction. In doing an account-by-account measurement, any bank failing the “chiefly compensated” test may come into compliance by transferring accounts to a broker or any unaffiliated third party. Also, a de minimis exemption is provided.43 Finally, a bank using the bank-wide measurement approach may exclude for purposes of the chiefly compensated test accounts held at a non-shell foreign branch of the bank (a non-US branch providing local services), provided the bank has a reasonable belief that the accounts held by or for U.S. persons are less than 10% of the total trust or fiduciary accounts of the foreign branch.44
III. Sweep Accounts and Transactions in Money Market Funds
Section 201 of the GLBA permits a bank to effect transactions as part of a program for the investment of deposit funds into any no-load, open-end management registered investment company that holds itself out as a money market fund.45 Regulation R defines several important terms for banks using this exemption, such as “no-load,” which is defined as transactions in a security or a class of securities in which the bank does not charge a sales charge, and on which total charges do not exceed 0.0025 of the average net assets of an account annually.46 Certain charges would not be considered charges for purposes of this definition, consistent with National Association of Securities Dealers (“NASD”) Rule 2830. A bank may provide sweep services to other banks under this exception.
Regulation R also includes an exception that permits a bank to effect transactions in securities issued by a money market fund, so long as the bank provides the customer with another product or service that would not otherwise require the bank to register as a broker or a dealer under the Exchange Act, such as an escrow, trust, fiduciary or custody account, a deposit account or a loan or extension of credit. Further, the securities provided must be no-load, or if not no-load, must be so identified and the customer would have to be provided with a prospectus.47
IV. Safekeeping and Custody
Section 201 of the GLBA permits a bank to perform certain bank custody and safekeeping activities: (i) to provide safekeeping or custody services with respect to securities, including the exercise of warrants and other rights for customers; (ii) to facilitate the transfer of funds or securities, as custodian or clearing agency; (iii) to effect securities lending or borrowing transactions with or on behalf of customers as part of custodial services or cash collateral investment pledged as part of such services; (iv) to hold securities pledged by a customer or subject to a purchase or resale agreement if the bank maintains records separately identifying the securities and the customer; and (v) to serve as a custodian or provide similar administrative services to any benefit or similar plan.48
Regulation R provides an exception that permits a bank to accept orders for securities transactions from employee benefit plan accounts and individual retirement and similar accounts for which the bank acts as a custodian. The exception also allows a bank to accept certain orders for other types of accounts on an accommodation basis.49
a. Order-Taking for Employee Benefit Plan Accounts, Individual Retirement Accounts and Similar Accounts
Regulation R provides that if a bank executes securities transactions for any of these benefit accounts, no bank employee may receive compensation from the bank or any other person that is based on (i) whether a securities transaction is executed or (ii) the quantity, price or identity of the securities. Compensation is permitted if based on whether a customer establishes a custodial account with the bank, or the total amount of assets in the account, and the rule does not prevent payments under a bonus or similar plan that would be permissible under the networking exemption discussed above.50
A bank relying on this exemption may not advertise that it executes securities transactions except as part of its overall advertising of its custodial or safekeeping services. This restriction is similar to that of the trust and fiduciary exemption.51 Finally, a bank that acts solely as a record-keeper or administrator in a noncustodial role would not be covered by the push-out rules.52
b. Accommodation Transactions
Regulation R permits a bank to accept securities orders for custodial accounts subject to certain limitations. First, the order accepting function must be accepted solely as an accommodation to a custodial customer. The Federal Banking Agencies are developing examiner guidance to ensure compliance with this restriction.53 Second, bank employee compensation must comply with the same restrictions imposed on employee benefit and similar accounts, as described above. Third, the fees a bank may charge may not vary based on (i) whether the bank accepted the order for the transaction or (ii) the quantity or price of the securities at issue, though it can vary based on the type of security purchased or sold. Fourth, advertising restrictions apply, similar to those described above. Fifth, no investment advice, research or recommendations may be provided, or solicitations made, regarding securities transactions (outside of advertisements that comply with the restrictions or responses to customer inquiries). Finally, a bank may not rely on this exemption if it is acting in a fiduciary or trust capacity with respect to an account, even when the bank is providing custodial services.54
V. Other Final Exemptions
a. Exemption for Regulation S Transactions with Non-U.S. Persons
Regulation R contains an exemption for a bank to sell to non-U.S. persons securities that are covered by Regulation S without having to register as a broker if the bank effects a sale in compliance with the requirements of Securities Act Rule 903.55 The exemption extends to the resale of Regulation S securities held by non-U.S. persons to other non-U.S. persons in transactions compliant with Regulation S, if the bank has a reasonable belief that the initial sale was executed in compliance with the requirements of Securities Act Rule 903.56 Finally, the exemption permits a bank to resell an “eligible security” (generally, a security not being sold from a bank’s or a bank affiliate’s inventory or being underwritten by the bank or an affiliate) on behalf of a registered broker-dealer to a non-U.S. purchaser, again if the bank has a reasonable belief that the initial sale was executed in compliance with the requirements of Securities Act Rule 903.57
b. Exemption for Non-Custodial Securities Lending
Regulation R also contains an exemption for a bank to the extent that, as agent, it effects securities lending transactions or provides securities lending services to (i) a qualified investor as defined in Section 3(a)(54) of the Exchange Act or (ii) an employee benefit plan that owns and invests on a discretionary basis not less than $25 million in investments. This exemption applies where a bank does not have custody of the securities to be lent (or has custody for less than the entire loan term), and is intended to permit banks to continue these activities “without disruption.”58
c. Exemption for Transactions in Investment Company Securities and Variable Insurance Products
Regulation R includes an exemption for the way in which a bank may effect transactions in investment company securities, variable annuities and variable life insurance policies, as well as transactions involving mutual funds. This exemption permits a bank to use the networking exemption described above when it effects transactions under certain circumstances through the National Securities Clearing Corporation’s Mutual Fund Services (Fund/SERV) or directly with a transfer agent.59
d. Exemption for Certain Transactions Involving a Company’s Securities for its Employee Benefit Plans and Participants
Regulation R includes an exemption (not included in proposed Regulation R but adopted pursuant to certain comments) permitting banks to effect certain securities transactions involving the securities of a company for the company’s employee benefit plans and participants. Certain rules apply: (i) no commission may be charged; (ii) the transaction must be solely for the benefit of an employee benefit plan; (iii) the security must be obtained directly from the company or an employee benefit plan of the company; and (iv) the security must be transferred directly to such company or plan.60
e. Temporary and Permanent Exemption for Contracts
Regulation R contains two exemptions intended to protect contracts entered into by banks from being voidable under Section 29(b) of the Exchange Act due to an inadvertent failure by the bank to comply with Regulation R during a transition period. First, no contract entered into before 18 months after the effective date of Regulation R will be voidable for any reason related to the bank’s status as a broker when the contract was created. Second, a permanent exemption provides that no contract entered into will be voidable if the bank (i) was acting in good faith when the contract was entered into and has appropriate compliance policies in place to prevent non-compliance with these rules and (ii) any violation did not cause significant harm, financial loss or cost to the person seeking redress.61
f. Extension of Time and Transition Period
Regulation R extends the time that a bank has to come into compliance with Section 3(a)(4) of the Exchange Act until the first day after its fiscal year beginning after September 30, 2008.62 For most banks, the date of compliance will be January 2, 2008. As noted above, that would not require that contracts in violation of Regulation R would potentially become voidable if entered into in June 2008.
VI. Self-Implementing Exemptions
There are seven other exceptions for bank brokerage activities in Section 201 of the GLBA. While there was discussion in proposed Regulation R regarding whether these provisions needed regulatory implementation in order to be effective, final Regulation R is mostly silent on the role of these other exceptions. These self-implementing exceptions are for (i) permissible securities transactions; (ii) certain stock purchase plans; (iii) affiliate transactions; (iv) private securities offerings; (v) identified banking products; (vi) municipal securities; and (vii) de minimis securities agency transactions. Each is fully available to banks upon effectiveness of Regulation R.
VII. Separate SEC Proposal
On September 24, 2007 the SEC separately issued a final rule amending certain exemptions under Section 3(a)(5) of the Exchange Act related to the exemptions from registration a bank can claim when acting as a dealer of securities (“Final Dealer Rule”).63 In the Final Dealer Rule, the SEC finalized four changes to the previously adopted rules under Section 3(a)(5) in order to conform such rules to the provisions of Regulation R: (i) a conditional exemption to permit a bank to execute riskless principal transactions with non-U.S. persons pursuant to Regulation S; (ii) an exemption for a bank to engage in securities lending activities as a conduit lender; (iii) a limited amendment to Rule 15a-6 applicable to foreign broker-dealers; and (iv) withdrawal of a rule defining the term “bank” and other related terms.64
a. Regulation S Transactions with Non-U.S. Persons
The SEC adopted Exchange Act Rule 3a5-2, which provides a bank a conditional exemption from the definition of a “dealer” to engage in transactions with non-U.S. persons on a riskless principal basis. These transactions are limited to those in “eligible securities,” and re-sales are permitted on substantially the same terms as described above in the “broker” exemption related to Regulation S transactions.65 As under Regulation R, a bank may rely on its “reasonable belief” that a security was sold outside of the United States.66
b. Amendment to Rule 15a-6
The SEC adopted an amendment to Exchange Act Rule 15a-6 to conform this rule to Regulation R and to make clear that foreign brokers and dealers may rely on Rule 15a-6 when transacting with a bank that itself is relying on an exemption from registration found in Sections 3(a)(4) or (5) of the Exchange Act.67
c. Securities Lending by Bank Dealers
The SEC adopted a rule to permit a bank to engage in securities lending activities and related services as a conduit lender. This rule is essentially the same rule that was adopted by the SEC in 2003 as Exchange Act Rule 15a-11, and is now redesignated as Exchange Act Rule 3a5-3 and applies only to dealing activities. (Regulation R contains a provision exempting a bank from the definition of a “broker” for agency securities lending activities and services).68
VIII. Summary and Questions Looking Forward
Regulation R provides banks with significantly increased flexibility to act as brokers as compared with the two SEC proposals of Regulation B and even as compared to the initially proposed Regulation R. As a general matter, Regulation R also allows banks the ability to “get on with their lives” almost than eight years after adoption of the GLBA, and offers the SEC a chance to close the door on what was the final unimplemented provision of Title II of the GLBA. Notwithstanding this increased flexibility, the ultimate implementation of Regulation R next year will require, at a minimum, the adoption of a substantial additional compliance procedures by banks and by broker-dealers to the extent that they are conducting activities that implicate one of the banking exemptions.
While Regulation R is the result of compromise between the SEC and the Board, the proposal illustrates the separate and distinct policy views brought to the bargaining table by each regulator.
The dominant themes pursued by the SEC:
- No back door to securities brokerage. The Regulation R proposal and adoption releases, when coupled with comments made by SEC commissioners and SEC staff during the proposal and adoption processes, make clear the SEC’s concerns about preventing banks from exceeding their authority to engage in securities brokerage activities. This concern was manifest in two forms. First, the SEC repeatedly requested restrictions on exemptive activities in order to ensure that banks were not effecting securities brokerage activities separate and apart from their banking activities. In other words, the SEC appeared concerned that banks would be able to engage in securities brokerage activities, and to advertise and sell such activities to customers, outside of the provision of a traditional banking activity. It therefore sought limitations on bank activities to guard against such concerns. Banks will be subject to examinations by Federal Banking Agencies to ensure compliance with these restrictions. Second, the SEC in several parts of Regulation R voiced concern that persons barred from the securities business would be able to engage in securities brokerage activities at a bank. Several exemptions require banks, or the broker-dealers with which they transact, to guard against employing such people, as a person barred by the SEC for good reason should not be able to engage in the same activity at a bank.
- Investor protection. In several places in Regulation R, the SEC voiced concern that appropriate investor protection be provided to bank customers. The SEC considered important that equal customer protection be applied regardless of the entity in which the securities transaction was effected. Implicitly, these statements indicated a belief that bank customers were less protected than customers of registered broker-dealers.
- Shift of Compliance Burden to Brokers. Many of the changes from Regulation B to Regulation R, shift or introduce further burdens of recordkeeping and compliance to brokers, which will require such brokers to update and conform their policies and procedures. Several of the Regulation R exemptions will permit the SEC to judge compliance by the banks through the performance of their broker partners. This increased scrutiny will increase the cost and the risk to brokers of handling bank generated securities brokerage business.
The dominant themes pursued by the Board (and the other Federal Banking Agencies):
- Protection of Traditional Banking Activities and Relationships. The Board went to great lengths to “persuade” the SEC that the pushout provisions of GLBA (Sections 201 and 202) were intended to preserve, without disruption, much of banks’ traditional securities activities. The success of this effort is evident throughout Regulation R, especially when compared with the provisions of previously proposed Regulation B, and banks should be pleased that the bulk of their traditional securities brokerage business is still permitted.
- Easing of Administrative Burdens and Compliance Issues. Regulation R makes several references to eliminating restrictions on banks’ brokerage activities in order to ease administrative or compliance difficulties. A theme of banks’ comments on Regulation B (and proposed Regulation R) was that the use of the exemptions provided would cause them to incur significant new administrative burdens that would be costly and time consuming. Regulation R was responsive to this concern in some places; in others, significant burdens remain.
- Investor Protection. In distinction to the SEC, the Federal Banking Agencies expressed skepticism that the conduct of securities brokerage activities by banks resulted in any harm to investors. Board Governor Kroszner expressly rejected any assertion that bank securities activities create any additional customer risk.
Our view of the effect of the Regulation is as set out below:
- Functional Regulation. As ultimately implemented, Section 201 of the GLBA will do little or nothing to implement functional regulation of securities activities. For the most part; banks are permitted to conduct all of their traditional brokerage activities, albeit subject to increased procedural requirements. As far as dealer activities, taken as a whole, GLBA significantly increased the extent of banks’ permitted securities activities. Further, GLBA and the related regulations expanded the types of banking institutions that could qualify as “banks” under the Exchange Act; i.e., thrifts and savings and loans now may benefit from the bank exemptions (which may be particularly welcome to those large securities firms affiliated with thrifts). The net result of all of this would seem to be that “banks” (as now more broadly defined) have greater powers to conduct securities activities now than they did before GLBA.
- Enforcement. Enforcement of the limitations of Regulation R against banks will now be in the hands of the Federal Banking Agencies. Given that the Federal Banking Agencies were more inclined to an expansive view of the exemptions than the SEC and in general favor examination and supervision over enforcement, it will be interesting to see the extent to which on-the-ground implementation of the Regulation is shaped by the views of the Federal Banking Agencies. As a practical matter, the views of the SEC in this regard can only be expressed to the extent that they are accepted by the Federal Banking Agencies.
- Regulatory Cultures. The adoption of Regulation R, including the varying statements made by the regulators, makes clear the very different cultures under which the SEC and the Federal Banking Agencies act. To take but one example of this, in adopting Regulation R, the Federal Banking Agencies effectively amended Section 29(b) (the section that provides for rescission risk) of the Exchange Act to eliminate its in terrorem effect. It is very difficult to imagine the SEC or other securities regulators acting in an analogous fashion.
- Procedures Without Purpose. In order to continue their securities agency activities, banks (and the broker-dealers to which they refer business) must now establish some fairly detailed, and no doubt, time consuming and expensive compliance procedures. These procedures would not seem to have much effect on activities in the real world -- does it really matter whether a teller can be paid a referral fee only if a customer meets with a broker, but can not be paid one contingent on the opening of a securities account? Similarly, does it matter whether Relationship Compensation is 50% of revenues, not 40%? What is the substance of any of this?
- On the Bright Side (for Cadwalader). In order to continue their securities agency activities, banks (and the broker-dealers to which they refer business) must now establish some fairly detailed, and no doubt, time consuming and expensive compliance procedures.