United States: Proposed Regulation R Retains Bank Securities Functions

Article by Michael E. Bleier and Byron F. Bowman

The Securities and Exchange Commission ("SEC") (on Dec.13, 2006) and the Board of Governors of the Federal Reserve System ("Fed") (on Dec. 18, 2006) jointly proposed Regulation R, which would clarify the securities powers of banks under the Gramm-Leach-Bliley Act ("GLBA").¹ In contrast to regulations previously proposed solely by the SEC, Regulation R would enable banks to continue many securities activities in which they engaged prior to the enactment of GLBA, without significant disruptions in their operations. In addition, Regulation R grants banks additional flexibility in areas such as the referral of customers to affiliated brokers and the performance of mutual fund transactions for their customers.

Prior to GLBA, banks were entitled to a "status exemption" from regulation as brokers by the SEC; that is, the definition of "broker" in the securities laws explicitly excluded "banks" from inclusion in that definition. GLBA revoked this status exemption in favor of 11 functional exemptions from the definition of "broker"; to the extent that banks were engaged in one of these 11 functions, they were excluded from the definition of broker.

Immediately prior to the effective date of GLBA, the SEC adopted "interim final rules" which were intended in part to clarify certain provisions of the functional exemptions from brokerage regulation.² However, the banking industry strongly objected to what it perceived as a roll-back of bank securities powers to a time significantly prior to the enactment of GLBA. The SEC responded to these objections by delaying the effectiveness of the interim final rules and by proposing Regulation B.³ In turn, this proposal engendered objections not only from the banking industry, but from the federal banking regulators as well.⁴

There followed lengthy but unproductive consultations among the SEC and the banking regulators on the final content of the regulations—and the implementation of GLBA’s scheme of functional regulation. Finally, in October 2006, Congress forced the agencies’ hands by requiring the joint proposal of regulations implementing the functional exemptions by the SEC and the Fed within 180 days.⁵

The final proposal of Regulation R was prepared under the direction of SEC Chairman Christopher Cox and Federal Reserve Governor Susan Bies, with the participation of Federal Reserve General Counsel Scott Alvarez, former SEC Acting Director of Market Regulation Robert Colby, and SEC Chief Counsel of the Division of Market Regulation Catherine McGuire, along with many staff members of both the Fed and the SEC. In addition, both the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation were consulted in the preparation of the proposal.

As proposed, Regulation R would consist of two identical sets of rules, 12 CFR 218.100 through 218.781 and 18 CFR 247.100 through 247.781, as adopted by the Fed and the SEC, respectively. These rules would specifically address four of the functional exemptions granted to banks under GLBA, namely, networking, fiduciary activities, sweep transactions in money market funds, and custody. Additionally, the new rules would also extend exemptions previously adopted by the SEC with respect to transactions with foreign customers and securities lending. Finally, Regulation R would also enable banks to engage directly in certain mutual fund transactions that previously would have had to be referred to brokers.

The networking exemption permits banks to enter into contractual relationships with third-party brokers to whom the bank can refer customers for securities transactions.⁶ Regulation R would affect this exemption by clarifying the ability of banks to compensate their employees for making referrals to the third-party broker.⁷

Regarding typical referrals, the GLBA networking exemption does not permit banks to pay their employees "incentive compensation" for making referrals to a broker, but does permit "a nominal one-time cash fee of a fixed dollar amount." Regulation R would permit banks to pay (a) twice the average hourly wage for the employee’s "job family," (b) 1/1,000th of the average base salary for the employee’s "job family," or (c) $25 (adjusted every five years for inflation).⁸

Regulation R would also create a new opportunity for paying more than nominal compensation for the referral of institutional or high-net-worth customers.⁹ If the referral is made subject to conditions that resemble the investment adviser "cash solicitation rule," ¹⁰ the employee may be paid a fee based on the brokerage business generated by the customer or the number of referrals. Finally, the referral of brokerage customers may be taken into account as part of a bonus program which is based on multiple factors including non-brokerage factors or bank or bank-affiliate profitability.

GLBA permits a bank to engage in securities transactions for its trust and fiduciary customers, provided that the bank is "chiefly compensated" for its efforts by an annual fee, a fee based on a percentage of assets, or an at-cost transaction processing fee (sometimes referred to as "relationship compensation"). Under the SEC’s prior proposals, banks could not include as relationship compensation fees paid to the banks by mutual funds or their affiliates derived from Rule 12b -1, fees or fees paid by mutual funds for personal services or the maintenance of shareholder accounts ("shareholder services").¹¹ Furthermore, the "chiefly compensated" test would have had to be satisfied by examining the compensation paid by each individual account or by showing that 90 percent of the revenue received by the bank in all of its fiduciary accounts on an annual basis was "relationship compensation."¹²

Regulation R significantly relaxes the "chiefly compensated" test by including compensation derived from 12b-1 fees and shareholder service fees as "relationship compensation," and by allowing a bank to satisfy the "chiefly compensated" test on a line-of-business basis by showing that 70 percent of the bank’s fiduciary revenue was "relationship compensation" during a two-year rolling period.¹³

Under both Regulations B and R, banks could not advertise their ability to engage in securities transactions separately from advertising their broad fiduciary services.¹⁴

Another functional exemption under GLBA permits banks to sweep deposit accounts into no-load money market funds.¹⁵ Under both Regulations B and R, "no-load" money market funds could compensate banks up to 0.25 percent annually for shareholder services and additional fees for the seven sister services.¹⁶ Regulation R, however, enables a bank to also sweep deposit accounts into "load" money market funds (i.e., those assessing and paying banks 12b-1 fees), provided that the bank provides each customer with a fund prospectus and does not refer to the fund as "no-load."¹⁷

GLBA provides a functional exemption from broker status when a bank engages in safekeeping and custody activities.¹⁸ In Regulation B, the SEC proposed to severely limit a bank’s ability to perform securities transactions for many custody customers, including participants in employee benefit plans or IRAs for which the bank served as custodian.¹⁹

Regulation R permits a significantly broader application of the custody functional exemption. With respect to employee benefit plan accounts and IRAs, banks may accept securities transactions from plans and their participants, provided that (a) employees may not receive compensation based on the execution or size of securities transactions and (b) the bank does not advertise its ability to accept securities orders except in advertisements for the bank’s broader custodial services.²⁰ For non-benefit plan accounts, a bank may accept transactions as an accommodation to a custody account provided that (a) the same employee compensation restriction and similar advertising restrictions as for benefit plan trades applies, (b) any security transaction fee charged by the bank does not vary based on whether the bank accepted the order or the quantity or price of the securities, and (c) the bank does not provide investment advice or recommendations to its customers.²¹

Previously, transactions by banks under the fiduciary, stock purchase plan, and private securities offerings exemption had to be directed by the bank to a registered broker-dealer for execution;²² Regulation R would permit banks to execute such transactions in shares of mutual funds, as long as they are effected directly with the transfer agent of the mutual fund or through the FundSERV facilities of the National Securities Clearing Corporation ("NSCC").²³

Regulation R also contains provisions permitting banks to engage in "Regulation S" transactions for foreign customers and in securities lending on the same basis as under provisional regulations previously adopted by the SEC.²⁴

With respect to securities lending, banks will be able to continue to engage in securities transactions in the capacity of either broker or dealer under Regulation R and a related rule proposed by the SEC.²⁵ However, in either case, a bank will only be exempt from broker or dealer regulation when providing securities lending services to (a) an employee benefit plan that invests more than $25 million or (b) a "Qualified Investor" (primarily institutional investors or individual investors with more than $25 million in investments).²⁶

In one very important procedural detail, the federal banking regulators will be responsible—in consultation with the SEC—for the development and implementation of recordkeeping rules to enable banks to demonstrate compliance with Regulation R.²⁷ The implication here is that the banking regulators, not the SEC, will be primarily responsible for determining the banks’ compliance with Regulation R.

As proposed, each bank will become subject to Regulation R on the first day of its first fiscal year commencing after June 30, 2008.²⁸ To facilitate this extension of the current situation, the SEC has extended the implementation of the functional exemptions under the Exchange Act until July 2, 2007, by which time it is anticipated that Regulation R will be adopted by the Fed and the SEC.²⁹

Regulation R was printed in the Federal Register Dec. 26, 2006.30 The comment period extends for 90 days, ending March 26, 2007. Persons having concerns regarding the proposed rules may file their comments either with the Fed or with the SEC, in either paper or electronic format. (Commenters should be aware that all comments made to the SEC will be posted for review on the SEC’s website.) Given the participation of SEC and Fed personnel at the very highest levels in the development of Regulation R, it is not anticipated that significant changes will be made to the Proposed Rules as a result of the comment process; therefore, comments relating to narrow or technical issues are more likely to elicit a response than broad objections to the main thrust of the proposals.

This article is presented for informational purposes only and is not intended to constitute legal advice.