SEC and Federal Reserve Board Update Bank-Broker Provisions With Adoption of Reg. R

When it comes to activities involving securities brokerage, banks have always operated in a tightly regulated environment. In an effort to clarify the securities powers of banks and provide a bit of breathing room to help them comply with federal regulations, the Securities and Exchange Commission and the Federal Reserve Board voted on Sept. 19 and 24, 2007, respectively, to adopt a new Regulation R, a joint rule which makes it easier for banks to engage in activities that tread the line between traditional banking and securities brokerage.

The updated regulation was designed to accommodate the business practices of modern banks and protect investors. It provides exceptions that allow banks to engage in some securities activities—under limited conditions—without subjecting themselves to regulation as broker-dealers, as they had previously been required to do. Banks do not have to start complying with the rules until the first day of their fiscal year commencing after Sept. 30, 2008.

Background

The separation between the commercial banking and securities industries dates back to the tumultuous years following the Stock Market Crash of 1929. The Banking Act of 1933 (also known as the Glass-Steagall Act) imposed a clear separation between the two sectors, and shortly thereafter, the Securities Exchange Act of 1934 completely excluded banks from broker-dealer regulation.

That changed in 1999, when the Gramm-Leach-Bliley Act repealed most of the separation provisions in the Glass-Steagall Act. However, it also enacted a new Section 3(a)(4) of the Securities Exchange Act, which limits the exclusion of banks from broker-dealer regulation to various securities-related activities traditionally provided by banks. The Gramm-Leach-Bliley Act required the SEC to provide much of the detail regarding the traditional bank activities excluded from broker-dealer regulation.

The SEC made little progress with this charge. It adopted Interim Rules in 2001 (which were ultimately extended into 2004), and then in 2004 it replaced the Interim Rules with proposed Regulation B. Reg. B was met with overwhelming criticism within the banking industry and never became effective.

Reg. R was prompted by a mandate in the Financial Services Regulatory Relief Act of 2006, which directed the SEC and the Board of Governors of the Federal Reserve System jointly to issue within 180 days a single set of proposed rules to facilitate banks’ compliance with Section 3(a)(4).

Reg. R provides guidance with respect to broker-dealer regulation exceptions for banking activities relating to:

• third-party networking arrangements;


• trust and fiduciary activities;


• sweep activities;


• safekeeping and custody activities;


• foreign securities transactions;


• securities lending transactions conducted in an agency capacity; and


• the execution of transactions involving mutual fund shares.

Reg. R also provides a limited "safe harbor" with respect to certain customer claims to banks that act in good faith and have in place reasonable policies and procedures designed to ensure compliance with Section 3(a)(4) of the Securities Exchange Act and Reg. R.

Networking Exemption

Section 3(a)(4)(B)(i) of the Securities Exchange Act permits a bank to avoid being considered a broker if, in entering into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to bank customers, the bank satisfies a number of conditions. One important condition is that bank employees may not receive incentive compensation for brokerage transactions unless those employees are also registered representatives of a broker-dealer. Bank employees may receive referral fees from a broker-dealer so long as the fees may be characterized as "nominal one-time cash fee[s] of a fixed dollar amount." Reg. R presents several alternative ways to meet the statutory "nominal" fee requirement. One alternative defines a "nominal" fee as one that does not exceed twice the employee’s actual base hourly wage. Another alternative treats as "nominal" a fee that does not exceed twenty-five dollars, which amount will be adjusted for inflation on April 1, 2012, and every five years thereafter.

In addition to the exception for payment of "nominal" fees, Reg. R includes a conditional exemption that will permit a bank to pay an employee a contingent referral fee of more than a "nominal" amount for referrals of an institutional customer or high-net-worth customer with which the bank has a contractual or other written networking arrangement.

Exemption for Trust and Fiduciary Activities

Recognizing the traditional securities role banks have performed for trust and fiduciary customers, Section 3(a)(4)(B)(ii) of the Securities Exchange Act permits a bank, under certain conditions, to effect securities transactions in a trustee or fiduciary capacity without being registered as a broker. To benefit from this exemption, a bank must, among other requirements, determine that it is "chiefly compensated" based on certain types of fees, effect such transactions in its trust department or other department that regularly undergoes compliance examinations, refrain from advertising that the bank accepts orders for securities transactions for a custodial account (other than an employee benefit plan or individual retirement account or similar account), and refrain from providing investment advice or research to the account.

Perhaps the most complex of these conditions is the requirement that banks be "chiefly compensated" based on certain enumerated fees referred to as "relationship compensation." Relationship compensation includes: (1) an administration or annual fee; (2) a percentage of assets under management; (3) a flat or capped per-order processing fee that does not exceed the cost the bank incurs in executing such securities transactions; or (4) any combination of such fees. Reg. R specifically states that Rule 12b-1 fees that are paid on the basis of a percentage of assets under management are to be considered relationship compensation.

The determination of whether a bank is "chiefly compensated" based on relationship compensation can be made in one of two ways. The first alternative is to determine, on an account-by-account basis over a two-year rolling average comparison, that the "relationship-total compensation percentage" for each trust or fiduciary account of the bank is greater than 50 percent of total compensation. The second alternative is for the bank to calculate the compensation it receives from all of its trust and fiduciary accounts on a bank-wide basis. To use this bank-wide methodology, the bank will have to ensure that the "aggregate relationship-total compensation percentage" for the bank’s trust and fiduciary business as a whole is at least 70 percent. The bank-wide alternative would simplify compliance, alleviate concerns about inadvertent noncompliance, and reduce the costs and disruptions banks likely would incur under the account-by-account approach.

Exemption for Cash Sweep Transactions

Securities Exchange Act Section 3(a)(4)(B)(v) provides that a bank will not be considered a broker to the extent it "effects transactions as part of a program for the investment or re-investment of deposit funds into any no-load, open-end management investment company registered under the Investment Company Act that holds itself out as a money market fund." Reg. R defines various terms under the exception, including the key term "no-load." A fund cannot be described as "no-load" if it has a front-end or deferred sales charge or sales-related expenses, and/or service fees exceeding 25 basis points per annum.

Reg. R also includes a new exemption permitting banks, without registering as a broker, to effect transactions on behalf of a customer in securities issued by a money market fund under certain conditions. To qualify for this exemption, the class or series of money market fund securities provided to the customer either would have to be no-load, or, if it is not no-load, the bank could not characterize or refer to the class or series of securities as no-load. For securities that are not no-load, the bank must provide the customer, not later than at the time the customer authorizes the bank to effect the transactions, a prospectus for the securities.

Safekeeping and Custody Exemption

Section 3(a)(4)(B)(viii) of the Securities Exchange Act provides banks with an exception from the "broker" definition for certain bank custody and safekeeping activities, allowing banks, subject to certain conditions, 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. To benefit from the exception, banks must satisfy several conditions, including accepting orders for securities transactions from only certain types of accounts, such as employee benefit plan accounts, individual retirement accounts or similar accounts.

With respect to other kinds of accounts for which the bank acts as custodian, Reg. R allows banks to accept securities orders as an accommodation to the customer subject to certain conditions designed to help ensure that these services continue to be provided only as an accommodation to customers and that the bank does not provide investment advice or research concerning securities to the account, make recommendations concerning securities to the account, or otherwise solicit securities transactions from the account.

Safe Harbors

In general, a contract entered into by an unregistered broker-dealer and a customer is voidable at the election of the customer under Section 29 of the Securities Exchange Act.

Reg. R provides that no contract entered into by a bank before 18 months after the effective date of Reg. R will be voidable by reason of Section 29 of the Securities Exchange Act simply because the bank should have been, but was not, registered as a broker-dealer under the Securities Exchange Act.

Of greater ongoing significance, however, is an additional safe harbor that is not subject to this time limit. It provides that no contract entered into by a bank will be voidable by reason of Section 29 of the Securities Exchange Act simply because the bank should have been, but was not, registered as a broker-dealer under the Securities Exchange Act, as long as (a) at the time the contract was created, the bank acted in good faith and had reasonable policies and procedures in place to comply with Section 3(a)(4)(B) of the Securities Exchange Act, and the rules and regulations, thereunder; and (b) 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.

This safe harbor reflects the SEC’s view that a bank that is acting in good faith and has reasonable policies and procedures in effect at the time a securities contract is created should not be subject to rescission claims as a result of an inadvertent failure to comply with the requirements under Section 3(c)(4) of the Exchange Act if customers are not significantly harmed.

Extension of Time and Transition Period

Reg. R extends the time afforded to banks to comply with the Securities Exchange Act’s provisions relating to the definition of "broker." A bank will be exempt from the definition of "broker" under Section 3(a)(4) of the Securities Exchange Act until the first day of its first fiscal year commencing after Sept. 30, 2008.

Next Steps

The new Reg. R contains detailed rules which cannot be fully summarized in the context of this article. Please consult with your investment management and/or banking counsel regarding the full impact of Reg. R on your business.