SEC Proposes New Regulation R to Implement GLBA

On December 13, 2006, the SEC voted to propose Regulation R, which would implement the Gramm-Leach-Bliley Act (GLBA) provisions governing bank brokerage activities. Regulation R results from the Financial Services Regulatory Relief Act of 2006 (Regulatory Relief Act), which directed the SEC and the board of governors of the Federal Reserve System (FRB) to propose rules to implement the GLBA provisions. The FRB is scheduled to vote on the proposal on December 18, 2006, with a 90-day comment period to follow publication.

The SEC indicated that proposed Regulation R would include four basic components: Networking Arrangements; Trust and Fiduciary Activities; Money Market Sweeps; and Safekeeping and Custody.

Regulation R represents the SEC’s third effort at implementing the GLBA bank brokerage exceptions, the most recent being proposed Regulation B in June 2004. The SEC and the FRB have not yet issued a formal release, although the SEC discussed various features of Regulation R in its press release:

Networking Arrangements:

• Institutional Referrals. Regulation R would include a new exception for institutional and high net-worth referrals, under which banks may pay employees higher-than-nominal referral fees that may be contingent on the execution of a securities transaction. However, bank employees providing an institutional referral would be prohibited from making transaction recommendations, and transactions resulting from a referral would be subject to a traditional self-regulatory organization suitability analysis by the executing brokerdealer, as if that broker-dealer recommended the transactions itself.
• Bank Bonus Programs. To accommodate banks’ customary bonus plans, Regulation R would specifically exclude “qualifying discretionary compensation” from its definition of “incentive compensation.” This indicates some flexibility to allow inclusion of brokerage revenues in determining bonuses paid to unregistered bank employees. The details of this apparent flexibility likely will become evident when Regulation R is published for public comment.

Trust and Fiduciary Activities: Regulation R lowers to 70% (from 90% in Regulation B) the bankwide ratio of relationship compensation to sales compensation that banks must meet to be considered “chiefly compensated” by relationship compensation. The SEC also proposed to include 12b1 fees as relationship compensation in computing the chiefly compensated ratio.

Money Market Sweeps: Regulation R would require that banks provide another banking service to the customer, beside the sweep, to ensure that a legitimate banking relationship exists. The SEC also proposed that banks may include as an additional sweep option money market funds that have higher costs than no-load funds.

Safekeeping and Custody: Regulation R would include an increase in the types of safekeeping and custody accounts from which a bank may accept orders to include employee benefit plans, individual retirement accounts, health savings accounts, and similar accounts for which the bank acts as custodian, administrator, or recordkeeper.  

Direct Investment in Investment Company Securities: Regulation R would permit banks to affect mutual fund transactions through NSCC’s Fund/SERV or directly with a transfer agent. 

Securities Lending Exemption: Regulation R would exempt banks from the definition of broker for noncustodial securities lending activities. This aspect of the proposal would reinstate a rule that otherwise would be voided by the Regulatory Relief Act. 

Regulation S: Regulation R would exempt banks from the definition of “broker” for agency transactions in Regulation S securities.

Section 29 of the Exchange Act: Regulation R would provide banks with a transitional 18-month exemption from their contracts being voided under Section 29 of the Securities Exchange Act of 1934 (Exchange Act) for sales by an unregistered brokerdealer. Regulation R would also provide banks with a permanent exemption from Section 29 of the Exchange Act where a bank acted in good faith and had reasonable policies and procedures in place to comply with the bank broker rules, and any violation of the registration requirements did not result in significant harm, financial loss, or cost to the person seeking to void the contract.

Proposed Compliance Date: The SEC proposes to provide banks until the first day of their first fiscal year beginning on or after June 30, 2008 to come into compliance with proposed Regulation R.The SEC also voted to separately publish proposed revisions to certain exceptions for bank dealer activities, including to relax a bank’s due diligence requirement in Regulation S resale transactions, and to provide technical amendments to Rule 15a6. 

After the FRB votes to propose Regulation R on December 18, the agencies will jointly publish the proposal, with a 90-day public comment period. In order to allow the agencies time to publish the proposal and to consider comments, the SEC also extended the existing temporary bank exemption from the definition of “broker” until July 2, 2007. 

Securities Industry FYI is a service of the BrokerDealer Practice of Morgan Lewis. If you have any questions concerning these important legal developments, please contact any of the following Morgan Lewis attorneys:

John Hartigan
Morgan, Lewis & Bockius LLP
300 South Grand Avenue
Twenty-Second Floor
Los Angeles, CA 90071
Telephone: 213.612.2630
Fax: 213.612.2501
jhartigan@morganlewis.com

Kathleen Collins
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004
Telephone: 202.739.5642
Fax: 202.739.3001
kcollins@morganlewis.com

Jack Drogin
Morgan, Lewis & Bockius LLP
1111 Pennsylvania Ave, NW
Washington, D.C. 20004 
Telephone: 202.739.5380
Fax: 202.739.3001
jdrogin@morganlewis.com