The Gramm-Leach-Bliley Act of 1999: Banks That Engage in Securities Activities Face New Challenges
Editor's Note: This is the fifth in a series of article on slected parts of the Gramm-Leach-Bliley act of 1999.
Glass-Steagall Act Repealed
The Gramm-Leach-Bliley Act of 1999 (GLB Act) repeals those provisions of the Glass-Steagall Act that prohibit banks from affiliating with companies "engaged principally" in specified securities activities (section 20) and restrict officer, director or employee interlocks between banks and securities companies (section 32). Prior to enactment of the new law, bank affiliates were permitted to underwrite and deal in bank-ineligible securities provided the gross revenue derived from those activities did not exceed 25 percent of the total gross revenue of the affiliate. The GLB Act now allows financial holding companies to underwrite and deal in securities, including mutual funds, without limit. In addition, banks and securities firms are permitted to own each other (as well as insurance companies). The new law also permits personnel interlocks between a bank and a securities underwriting firm.
The GLB Act provides for the "functional regulation" of insurance and securities activities conducted in banks. This means that bank insurance activities will be regulated by state insurance regulators, and bank securities activities will be regulated by the Securities and Exchange Commission (SEC). The insurance provisions of the Act were discussed in an earlier WWR Supplement. This article addresses the sale and brokerage of securities in banks.
The practical effect of functional regulation of securities activities in banks is that many banks that engage in significant securities activities in the bank itself will probably choose to "push out" those activities to a financial subsidiary or a holding company affiliate in order to avoid imposing SEC regulation on the entire bank.
Broker/Dealer Exemption Repealed (Effective Date: May 12, 2001)
The Securities Exchange Act of 1934 specifically exempted banks from the definitions of "broker" and "dealer." Thus, prior to enactment of the GLB Act, securities activities in banks were exempt from SEC regulation and from registration with the National Association of Securities Dealers (NASD) as a broker/dealer. The GLB Act, however, re-defines "broker" and "dealer" to include banks engaged in securities activities, subject to exceptions for the following activities and products:
- Third-party brokerage arrangements, either on- or off-premises, if -
- the broker/dealer is clearly identified as the person performing the transaction;
- broker/dealer services are offered in a clearly-marked area of the bank, preferably physically separated from the deposit-taking functions;
- all promotional materials clearly indicate that the services are being provided by the broker/dealer, and not the bank;
- all promotional materials must comply with federal securities laws; bank employees perform only clerical or ministerial functions;
- bank employees not associated with the broker/dealer do not receive incentive compensation for any brokerage transaction (except nominal one-time referral fees);
- the services are provided by the broker/dealer so that all customers that receive services are fully disclosed to the broker/dealer;
- the bank does not carry a securities account for the customer except in connection with its trust or safekeeping and custody activities; and
- the bank, broker or dealer fully informs each customer that the brokerage services are not being provided by the bank and that the securities are not deposits or other obligations of the bank and are not guaranteed by the bank and are not FDIC-insured.
- Trust activities, provided the bank operates in a trust or fiduciary capacity and
- is "chiefly" compensated on the basis of i) an administration or annual fee, ii) a percentage of assets under management, iii) a flat or capped per order processing fee, or iv) any combination of the above; and
- does not solicit brokerage business other than advertising that such activities are performed in conjunction with its other trust activities.
- Permissible securities transactions, including commercial paper, bankers acceptances or commercial bills; exempted securities; certain qualified foreign obligations.
- Certain stock purchase plans, including employee benefit plans (pension, retirement, profit-sharing, etc.), dividend reinvestment plans and issuer plans (for the purchase or sale of the issuer's shares).
- Sweep accounts under which deposit funds are invested in no-load, open-end mutual funds registered under the Investment Company Act.
- Affiliate transactions.
- Private placements.
- Safekeeping and custody activities.
- Identified banking products, including deposit accounts, savings accounts, CDs; a banker's acceptance; a letter of credit issued or loan made by a bank; a debit account arising from a credit card or similar arrangement; a loan participation; or a swap agreement, including a credit or equity swap, if the swap is sold only to a qualified investor (retail swaps are excluded).
- Municipal securities.
- De Minimis Exception. A bank will not be deemed to be a broker/dealer if it effects not more than 500 transactions a year (not including the exceptions listed above), and such transactions are effected by an employee of the bank who is also an employee of the broker/dealer.
"Dealer" Exemption Also Eliminated
Under the GLB Act, "dealer" is defined as "any person engaged in the business of buying and selling securities for such person's own account through a broker or otherwise." The blanket exemption for "dealer" activities in banks is repealed. However, there is a specific exclusion for a person who buys or sells securities for the person's own account, either individually or in a fiduciary capacity, but not as part of a regular business. In addition, the GLB Act includes exceptions for exempted securities transactions, asset securitization transactions, investment, trustee and fiduciary transactions, and "identified banking products" (see list above).
"Hybrid" products - products that are not "securities" under current law nor are "identified banking products" under the GLB Act - are not considered securities and therefore are not subject to SEC regulation. . . unless the SEC imposes such a requirement by rule or regulation. If the SEC determines that a hybrid product should be classified as a security, it must initiate a rulemaking proceeding after first consulting with the Federal Reserve. Any "new hybrid product" rule adopted by the SEC may be challenged by the Federal Reserve under an expedited review process in the federal appeals court. However, neither the Fed's views nor those of the SEC will be accorded judicial deference under this review process, making the determination process a "jump ball."
Mutual Fund Exemption Repealed
The GLB Act also amends the Investment Company Act of 1940 to eliminate the exemption from that Act for bank "investor adviser" services. The GLB Act also addresses potential conflicts of interest in bank mutual fund activities. This means that banks that provide advice to mutual funds would be required to register with the SEC as "investment advisors" and be subject to SEC examination of their mutual fund activities. If the bank sets up a "separately identifiable department" for this purpose, only that department would have to register and be subject to SEC examination.
The GLB Act also requires banks that sell mutual funds to clearly disclose to their customers that the mutual funds are not guaranteed by the bank nor covered by FDIC insurance.
Effect on Community Banks
The effect the new law will have on securities activities in community banks depends on a number of factors, including the extent of the securities activities provided, the kinds of products and services offered, and where these products and services are handled. Banks with significant securities activities may choose to push these activities out into a financial subsidiary of the bank or an affiliate of the holding company to avoid having their banking operations come under SEC jurisdiction. Many banks may not have to register as a broker/dealer if most of their brokerage activities are covered under the excepted activities. For transactions that are not excepted, banks can still fall back on the de minimis level of 500 transactions per year. Banks with more extensive securities departments may choose to affiliate or contract with a third party provider rather than offer securities products in the bank itself and have to register and be regulated by the SEC and the NASD. Clearly, the rules are changing, and every bank should examine the options carefully, and with appropriate advisers, before committing to any course of action.