Regulation R: the beginning of the end or the end of the beginning of bank securities brokerage activities?

North Carolina Banking Institute, March, 2008 by Jerome J. Roche, Babback Sabahi

I. INTRODUCTION

Almost eight years following the enactment of the Gramm-Leach-Bliley Act of 1999 (GLBA), (1) Regulation R was jointly adopted by the Securities and Exchange Commission (SEC) and the Board of Governors of the Federal Reserve System (FRB) in September of 2007 to implement provisions of GLBA governing the regulatory status of banks engaged in securities activities. (2) Prior to passage of GLBA, U.S. banks (including U.S. branches and agencies of non-U.S. banks) (3) enjoyed blanket exception from the definitions of "broker" and "dealer" under the Securities Exchange Act of 1934 (the Exchange Act). (4) GLBA replaced this blanket exception for banks with eleven functional exceptions from the definition of broker and four from the definition of dealer--these functional exceptions are largely based on the capacity in which the bank acts or the type of security involved in the bank's activity. Securities activities of a bank failing outside these functional exceptions need to be "pushed out" of the bank to a registered broker-dealer subject to regulation by the SEC. Thus, the functional exceptions are often referred to as the push-out exceptions.

Although the SEC adopted final rules to implement the dealer push-out exceptions five years ago, (5) final rules to implement the broker push-out exceptions were not promulgated until September of 2007 due to substantial adverse reactions to previous proposals from the banking industry, banking regulators, and key members of Congress. (6)

Some of the core criticisms of the SEC's prior regulatory proposals regarding the push-out exceptions were that these proposals would unnecessarily intrude on long-established bank securities activities, disrupt existing and prospective bank customer relationships and operations, and increase compliance costs for banks active in trust, custody, and other securities-related lines of business that Congress intended to exclude under GLBA.

President Bush signed into law on October 13, 2006, the Financial Services Regulatory Relief Act of 2006 (the Regulatory Relief Act) (7) to break the regulatory impasse created by the SEC's repeated yet unsuccessful efforts to adopt broker push-out rules under GLBA and to assure active banking regulatory agency participation in the SEC rulemaking process. Section 101 of the Regulatory Relief Act effectively set aside the SEC's then outstanding rules relating to the broker push-out exceptions and required the SEC and the FRB, after consulting with the other federal bank regulatory agencies, to adopt joint rules to implement the broker push-out exceptions. The Regulatory Relief Act required proposed rules to be issued within 180 days. The SEC and the FRB issued a release proposing Regulation R in December 2006. (8)

The provisions of proposed Regulation R were a significant improvement over the rules previously proposed, and to a large extent addressed the concerns of the banking industry and the federal banking agencies. Final Regulation R substantially adopts the December 2006 proposal. (9) Regulation R defines key terms in some of the broker push-out exceptions for banks and provides certain related exemptions.

Although the regulation is now effective, (10) Rule 781 of Regulation R exempts banks from complying with the regulation during a transitional period that will last until the first day of a bank's fiscal year commencing after September 30, 2008, which gives banks time to conform their activities to the regulation and to request clarifications through formal or informal rulemaking or interpretive actions.

This Article highlights the key provisions of Regulation R, including the ongoing attempts to resolve those issues that created the greatest controversy in the SEC's prior rulemaking attempts. This Article also discusses transition issues, next steps, changes to the dealer rules, and complementary amendments to Exchange Act Rule 15a-6.

II. KEY ASPECTS OF REGULATION R

To implement the broker push-out exceptions under GLBA, Regulation R defines certain statutory terms and provides exemptions for banks in several areas, including: (i) third-party brokerage ("networking") arrangements; (11) (ii) trust and fiduciary activities; (12) (iii) safekeeping and custody activities; (13) and (iv) sweep accounts. (14) These particular aspects of bank securities activities were the subjects of the greatest controversy during the SEC's previous rulemaking proceedings. (15)

Regulation R also provides a number of conditional exemptions to accommodate other bank securities activities including certain mutual fund, insurance and employee benefit plan transactions, certain securities lending activities, and transactions in "eligible securities" involving non-U.S. counterparties conducted pursuant to Regulation S. Importantly, Rule 780 of Regulation R provides banks with an exemption from possible third-party rescission rights under Section 29 of the Exchange Act pursuant to contracts entered into by such banks in violation of the Exchange Act's broker-dealer registration requirements. (16) However, this exemption expires on March 31, 2009, after which date a permanent exemption from Section 29 of the Exchange Act will continue to be available with respect to any contracts entered into by a bank if, at the time the contract was entered into, such bank acted in good faith and had reasonable policies and procedures in place to comply with Regulation R and any violation of the registration requirements did not result in any significant harm, financial loss, or cost to the person seeking to void the contract.