Federal and State Regulation of Securities Offerings

On August 22, 1997 the Board of Governors of the Federal Reserve System (the "Board") announced final regulations (effective October 31, 1997) which, among other things, remove three "prudential limits" (often referred to as "firewalls") which have restricted the ability of commercial banks to extend credit and offer credit enhancement products to customers of their Section 20 affiliates and to share nonpublic customer information with their Section 20 affiliates. The removal of these prohibitions should enhance the ability of commercial and investments banks within a holding company structure to offer new commercial, capital markets and hybrid financing products.

Section 20 of the Banking Act of 1933 (the "Glass-Steagall Act") prohibits any bank which is a member of the Federal Reserve System (including all national banks and state-chartered member banks) from being affiliated with any entity that is "engaged principally" in the "issue, floatation, underwriting, public sale, or distribution, at wholesale, retail, or through syndicate participation" of securities that the bank may not underwrite or deal in directly ("ineligible securities").

In a series of actions approved between 1984 and 1989, the Board adopted a two-pronged approach to define the scope of permissible activities for securities affiliates of member banks. First, the Board ruled that an affiliate of a member bank would be "engaged principally" in underwriting and dealing in ineligible securities, and therefore would be in violation of Glass-Steagall, if its gross revenues from such activities exceeded 5 percent (later increased to 10 percent) of its total gross revenues. Secondly, the Board imposed 28 firewalls, including rules governing exposure to individual customers, cross-marketing, fiduciary purchases of securities underwritten by a Section 20 affiliate, capital adequacy, loans to customers of a securities affiliate, board and officer interlocks and disclosure of customer information. Securities firms whose activities satisfied these limitations and who received Board approval to operate as an affiliate of a member bank became known as "Section 20 subsidiaries" or "Section 20 affiliates".

In two recent actions, the Board revised both prongs of its Glass-Steagall regulations to permit much broader affiliation and cooperation between commercial and investment banks. First, effective in Marc 1997, the Board raised the 10 percent revenue limit to 25 percent, thus opening the door to the possibility of affiliation between commercial banks and many if not all of this country s largest investment banks. Secondly, in an action announced on August 22, 1997 and scheduled to take effect on October 31, 1997, the Board recodified modified versions of nine of the 28 original firewalls into eight "operating standards"; the remaining 19 firewalls were eliminated as unnecessary and/or duplicative of other applicable regulations (including the Securities Act of 1933, the Securities Exchange Act of 1934, broker-dealer registration requirements and financial reporting, anti-fraud and financial reporting rules applicable to brokers and dealers and Sections 23A and 23B of the Federal Reserve Act).

Significantly, the August 22 pronouncement deletes three firewalls which previously have limited the ability of Fed-member banks to offer commercial banking services to customers of their Section 20 affiliates. Subject to the quantitative and market terms limitations of Sections 23A and 23B, normal bank capital requirements, loan-to-borrower rules and a requirement that commercial banks conduct independent and thorough credit evaluations before offering credit in tandem with a Section 20 affiliate, commercial banks will now be allowed for the first time to:

  • extend credit or issue or enter into stand-by letters of credit, asset purchase agreements, indemnities, guarantees, insurance and other facilities to enhance the creditworthiness or marketability of ineligible securities underwritten or distributed by a Section 20 affiliate;
  • extend credit to an issuer of such securities for the purpose of the payment of principal, interest or dividends on such securities; and
  • share nonpublic information (including evaluations of the creditworthiness of issuers or other customers of the commercial bank or Section 20 affiliate) with its underwriting affiliates without the consent of its customers.

After October 31, 1997, commercial and investment banks will be able to offer more flexible and varied deal structures comprised of both commercial and investment banking elements and to coordinate their respective services to benefit optimally both their customers and themselves. Businesses seeking credit enhancement for public or private debt issues or seeking a combination of bank financing, public and private debt financing and access to public and private equity markets will no longer be required to endure the inconvenience and incur the added expenses associated with approaching commercial and investment banks independently. Instead, a single organization having both commercial and investment banking subsidiaries may coordinate (for the most part invisibly to the customer) the efforts of these affiliates to serve as a single resource for corporate financial services.

This McGuire Woods article is intended to provide information of general interest to the public and is not intended to offer legal advice about specific situations or problems. McGuire Woods does not intend to create an attorney-client relationship by offering this information, and anyone's review of the information shall not be deemed to create such a relationship. You should consult a lawyer if you have legal matter requiring attention.