The Securities and Exchange Commission recently issued proposed Regulation B to implement the bank exemptions from securities broker regulation provided by the Gramm-Leach-Bliley Act in 1999. Regulation B supercedes the SEC's final interim rules adopted in 2001 which were put on hold after banks, banking regulators, and members of Congress objected that those rules would disrupt traditional banking activities contrary to the intent of Congress.
Regulation B provides significant relief from the final interim rules, but is daunting in its complexity and includes a few traps for the unwary. Banks will need to carefully study the rule and be prepared to devote substantial compliance resources in order to continue their traditional brokerage activities without becoming subject to broker-dealer regulation under the securities laws.
The new regulation includes highly detailed provisions that build upon the framework of the earlier rules. For example, the intricate "chiefly compensated" test remains under which "relationship compensation" from trust and fiduciary accounts must exceed "sales compensation" in order for a bank to continue to effect securities transactions for such accounts. Regulation B softens the impact by allowing banks to apply the test on a line-of-business basis rather than an account-by-account basis if the bank's ratio of sales compensation to relationship compensation is no more than 1 to 9. The regulation also includes fail safe provisions for banks that fall out of compliance. Existing trust accounts are grandfathered--a significant benefit. Nevertheless, banks will need to devote substantial permanent resources to comply with the chiefly compensated test and applicable procedural conditions on an ongoing basis.
In another area, the SEC interpreted the exemption for sweep accounts narrowly, but created an important 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 and provides significant relief for cash management services offered by banks.
Regulation B creates 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. The allowable activities of such employees remain very limited, however.
While easing up in certain areas, the SEC tightened its grip on bank custodial activities. Under Regulation B, a bank 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 already exists. Banks can deal with this problem by changing IRA custodial accounts to trust accounts.
The SEC's general treatment of custodial accounts will create customer relations problems with bank customers who do not want their custodial accounts transferred to a broker-dealer.
In another significant revision, the SEC created a new exemption that allows a bank to effect transactions for employee benefit accounts and receive compensation from 12b-1 fees, provided the fees are used to offset administrative expenses at the account level. The exemption provides relief when a bank acts as a fiduciary for discretionary ERISA accounts and is required by Department of Labor rules to offset 12b-1 fees. No offset generally is required in the case of participant-directed accounts, however, and the SEC appears to have created a stricter rule than would otherwise apply under ERISA.
The SEC staff obviously devoted considerable time and attention to addressing the comments of banks and their regulators in Regulation B. The SEC has indicated that it will continue to make revisions to accommodate legitimate concerns of banks, and banks will need to carefully study the rule and provide meaningful feedback in those areas where the rule needs to be made more workable. The regulation will significantly affect the way that banks structure their activities for years to come, and this may be the last chance to influence the final contours of the rule.