SEC’s Proposed Regulation B: Complex but More Flexible: What Bankers Need to Know to Comment and Eventually Comply

The Securities and Exchange Commission's newly proposed Regulation B includes highly detailed provisions that build on the framework created in the SEC's Interim Final Regulations issued in 2001. The Interim Regulations never took effect due to complaints from banks, banking regulators and members of Congress who criticized the regulations as unduly burdensome and inconsistent with the intent of Congress to avoid disrupting traditional banking activities. Regulation B incorporates the basic framework of the Interim Regulations but, through a series of complex provisions, provides significant relief from the earlier provisions.

For example, in response to complaints that the "chiefly compensated" test was too strict, Regulation B would allow banks to apply the test on a line-of-business basis. Regulation B also includes fail safe provisions for banks that fall out of compliance and grandfathers existing trust accounts. Compliance with the chiefly compensated test is the key requirement of the exemption for trust and fiduciary activities, and the proposed rule changes will help ensure that banks can continue those activities in the bank.

In another area, the SEC interpreted the exemption for sweep accounts narrowly, but created a significant new exemption that allows banks to effect transactions in money market mutual funds for trust and fiduciary accounts, escrow and other agency accounts, and large institutional investors. Unlike the sweep exemption, the new exemption for money funds is not limited to no-load funds.

The SEC created somewhat more flexibility in the exemption for retail networking arrangements with third party broker-dealers by broadening the amount and types of compensation that may be paid to unlicensed bank employees who refer customers to the broker-dealer.

In at least one area–custody activities–the Regulation is stricter than before. Banks may not effect any securities trades for custodial accounts, other than existing accounts or accounts of large qualified investors, unless the bank qualifies for the small bank exception. The Regulation defines a small bank as one with assets of $500 million or less, which will cover most community banks. Still, a small bank cannot be affiliated with a broker-dealer and cannot be owned by a holding company with consolidated assets of $1 billion or more in order to qualify for the exception.

Custodial IRA accounts are not exempt under Regulation B and must be pushed out of the bank into a registered broker-dealer, unless the bank qualifies for the small bank custody exemption or the account is already in existence.

The SEC created a new exemption that allows a bank to effect transactions for employee benefit accounts and receive all of its compensation from 12b-1 fees, provided the fees are used to offset administrative expenses at the account level. The exemption provides relief when the bank acts as a fiduciary for discretionary accounts, but not when the bank effects transactions for participant-directed accounts.

Regulation B is extremely complex and banks will need to devote substantial compliance resources in order to avoid becoming broker-dealers. The SEC has requested comments on numerous provisions of the proposed rule by August 2, 2004. Banks should carefully study the rule and provide comments on those areas where relief is needed to make the rule more workable.

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