investment management and fiduciary services insight

- Fall 2001 -

SEC Guidance on the Gramm Leach Bliley Act

By William T. Harvey, Esq.

Prior to the passage of the Gramm Leach Bliley Act (“GLB Act”), banks were excluded from the definition of broker and dealer under the Securities Exchange Act of 1934 (“1934 Act”) and were exempt from the Securities and Exchange Commission’s (“SEC”) regulation of brokers and dealers. The GLB Act removes the blanket exemption from the definition of broker and dealer and replaces it with exemptions based on specific bank activities.  If a bank’s operations are within the activities described in the GLB Act’s revisions to the 1934 Act, the bank would not be required to register as a broker-dealer.  Activities outside those described in the GLB Act would require registration.  Since the GLB Act’s changes in this area are actually amendments made to the 1934 Act, which is administered by the SEC, the SEC is the appropriate agency to render interpretive guidance on the changes.

Exemptions Under the GLB Act

     Under the GLB Act, banks are permitted  to engage in the following types of securities activities without registering as a broker:

• Third-party brokerage arrangements.

• Certain trust and fiduciary activities.

• Transactions in certain exempted securities (such as government securities).

• Effecting securities transactions for certain stock purchase and employee benefit plans.

• Sweeping bank deposits into no-load, open-end money market funds.

• Effecting securities transactions for certain bank affiliates.

• Private placements of securities for banks that do not have securities affiliates.

• Safekeeping and custodial activities.

• Activities relating to municipal securities.

• Transactions in “identified banking products.” These include bank accounts, banker’s acceptances, letters of credit, bank loans, certain loan participations, credit card debit accounts, credit and equity swaps sold to a qualified investor (other than equity swaps to retail customers), and other instruments as determined by the SEC.

• Other securities transactions not in excess of 500 transactions per year.

A bank is also permitted to enter into  certain purchases and sales of asset-backed securities without registering as a dealer.

If a bank is involved in securities related transactions which are not listed above, the bank will be required to either cease those activities, register as a broker-dealer or “push out” the activity into a broker-dealer affiliate or subsidiary.

This article discusses the proposed rules adopted by the SEC and also provides the viewpoint of the Federal Reserve Board, the Office of the Controller of the Currency and the Federal Deposit Insurance Corporation (the “Banking Agencies”) on the rules.

SEC Rule and Banking Agency Comments

In Release No. 34-44291, the SEC issued an interim final rule interpreting the GLB Act’s specific exemptions from the definition of “broker” and “dealer” (the “SEC Rule”). 

After the SEC Rule was released theBanking Agencies issued a letter of com-ment on the SEC Rule. The SEC Rule focuses on just five of the exemptions set forth in the GLB Act.  Four of the exemptions relate to a bank’s activities as a broker: third party brokerage arrangements, trust and fiduciary activities, effecting “sweeps” into no-load open ended money market funds and safekeeping/custodial activities. One exemption relates to a bank’s activities as a dealer: transactions in asset backed securities. 

Statutory Exemption for Trust and Fiduciary Activities

The Trust and Fiduciary Exemption of the GLB Act permits a bank, without registering as a broker-dealer, to effect securities transactions in its capacity as a trustee or in a fiduciary capacity so long as the bank is “chiefly compensated” for such transactions on the basis of an administration or annual fee, a percentage of assets under management or a flat or capped per order processing fee which does not exceed the cost to the bank of executing securities transactions for its trust customers. In addition the bank must not publicly solicit brokerage business.

Definition of “Chiefly Compensated”

The SEC Rule defines the type of “permissible” compensation described in the GLB Act as “relationship compensation” and defines the type of compensation which is to be compared to the relationship compensation as “sales compensation.” It further provides that a bank meets the statute’s “chiefly compensated” requirement only if, on an annual basis, the amount of relationship compensation received by the bank from each trust and fiduciary account exceeds the sales compensation received by the bank from that account.

The Banking Agencies do not believe an account-by-account calculation of compensation is consistent with the wording or purposes of the GLB Act.  The Banking Agencies’ comment states that the GLB Act requires that in order to determine that a bank’s trust activities are chiefly compensated through relationship compensation, one should measure the type of compensation received by the bank for all of its trust and fiduciary activities, in the aggregate.

The SEC has adopted a related exemption that permits a bank to avoid calculating its compliance with the “chiefly compensated” requirement on an account-by-account basis if the bank demonstrates that the total “sales compensation” received from its trust and fiduciary accounts during the year does not exceed 10 percent of the “relationship compensation” received from such accounts during the year, and the bank maintains procedures designed to ensure that relationship compensation on each account is greater than 50 percent of the account’s total compensation.

View of the Banking Agencies

The Banking Agencies believe that the 10 percent requirement and the other requirements set forth in this exemption make it virtually unattainable and further believe that it fails to relieve the unnecessary burden created by the account-by-account measurement requirements of the SEC Rule.

Investment Adviser Exemption

The GLB Act includes those activities of a bank acting as an investment adviser if the bank receives a fee for its investment advice.

The SEC Rule provides that a bank will be deemed acting in an investment advisory capacity for purposes of the Trust and Fiduciary Exemption only if the bank is paid for providing continuous and regular investment advice to the         customer’s account and owes a duty of loyalty to the customer.

The Banking Agencies believe that there is no basis for the provision of the SEC Rule which requires that a bank provide “continuous and regular” investment advice to a customer in order to be within the “fiduciary” exception, nor is there a requirement that the bank have a duty of loyalty to the customer.  The Banking Agencies urge that any compensation for investment advice should cause such activity to be brought within the definition of “fiduciary,” and subject to the provisions of the fiduciary exemption.

Where Should Security Transactions Take Place?

The GLB Act requires that securities transactions effected by a bank under the Trust and Fiduciary Exemption be housed in the bank’s trust department or in another department that is regularly examined by bank examiners.

Areas subject to such examination include any area that identifies potential purchasers of securities, screens potential participants in a transaction for creditworthiness, solicits securities transactions, routes or matches orders, facilitates the execution of a securities transaction, handles customer funds and securities, or prepares and sends confirmations for securities transactions.

The Banking Agencies believe that the SEC Rule requiring all aspects of securities sales be within the trust department or similar department is not consistent with how banks operate or the Banking Agencies’ supervisory and examination programs, and that imposing these requirements by rule will artificially constrain normal business activity and prevent many banks from taking advantage of the Trust and Fiduciary Exemption granted by Congress.

Defining Relationship Compensation

The SEC Rule tracks the language of the GLB Act by defining “relationship compensation” to mean an administration or annual fee, a “percentage of assets under management” fee, a flat or capped per order processing fee or any combination of such fees.

The SEC Rule further provides that such fees may be included in permissible “relationship compensation” only to the extent they are received directly from a customer or beneficiary or directly from the assets of the trust or fiduciary account.  The Banking Agencies believe that the GLB Act places no limit on the source of payment for the statutorily enumerated fees, so long as the fees are of the type specified. The Banking Agencies do not agree that a type of fee expressly permitted by the GLB Act ceases to be permissible simply because the fee is paid by a third party.

In addition, under the SEC Rule, a per order processing fee may be included impermissible relationship compensation only if the fee does not exceed the amount charged by the broker-dealer for executing the transaction, plus the costs of any resources the bank exclusively dedicated to the execution of securities transactions for trust and fiduciary customers.

The Banking Agencies believe the definition of a permissible “flat or capped per order processing fee” in the SEC Rule is narrow and inconsistent with the terms of the Act.  They believe the plain language of the Act allows a per order processing fee to include any cost incurred by a bank in connection with executing securities transactions for trustee and fiduciary customers, and that the GLB Act does not require that the bank’s costs arise exclusively from resources the bank had dedicated solely to executing transactions for trust and fiduciary customers.

Defining Sales Compensation

The SEC Rule defines sales compensation to include fees received from an investment company under a plan adopted pursuant to Rule 12b-1 under the Investment Company Act of 1940 (“Rule 12b-1 fees”), “service fees” that a bank receives from an investment company (other than a Rule 12b-1 fee) for providing personal service or the maintenance of shareholder accounts, and finders’ fees, other than referral fees paid pursuant to the statutory networking exception.  The banking agencies believe that service fees and any Rule 12b-1 fees for providing non-distribution shareholder services to its customers also should be considered permissible administration fees and included in “relationship compensation.”

Statutory Exemption for Custody and Safekeeping Activities    

The GLB Act’s “Custody and Safekeeping Exemption” permits a bank, without being considered a broker, to engage in a variety of custodial-and safekeeping-related activities “as part of its customary banking activities.”  The activities expressly permitted by the statute include providing safekeeping or custody services with respect to securities, including the exercise of warrants and other rights on behalf of customers and engaging in other activities as part of their customary safekeeping and custody operations.

Defining Administrative Service

The SEC Rule provides that the language “other related administrative services” set forth in the GLB Act does not include securities brokerage services.  Therefore the SEC Rule provides (with certain exceptions) that this statutory exception does not permit banks to accept securities orders for their IRA customers, for 401(k) and benefit plans that receive custodial and administrative services from the bank, or as an accommodation to benefit plan customers.  The Banking Agencies do not believe that such an interpretation is consistent with the Act. The agencies comment that the excep-tion permitting the banks to perform administration services for employee benefit plans would not have been included in the act if “administrative services” is interpreted to exclude brokerage services.

Exemption for Third Party Arrangements

The GLB Act permits banks to enter into arrangements with registered broker-dealers to offer brokerage services to bank customers provided the “networking” arrangement meets certain requirements specified in the GLB Act.  One of the requirements is that bank employees are prohibited from receiving “incentive compensation.” However, the GLB Act does provide that a bank employee may receive compensation for the referral of any customer “if the compensation is anominal one-time cash fee of a fixed dollar amount and the payment of the fee is not contingent on whether the referral results in a transaction.” 

Defining “Nominal Fee”

The SEC Rule has interpreted the words “nominal one-time cash fee of a fixed dollar amount” to be limited to payments that do not exceed one hour of the gross cash wages of the bank employee making the referral; or points in a system or program that covers a range of bank products and non-securities related services where the points count toward a bonus that is cash or non-cash if the points (and their value) awarded for referrals involving securities are not greater than the points (and their value) awarded for activities not involving securities.

In addition, the SEC Rule states that the employee’s referral of customers to the affiliate broker or the amount of revenue generated by the affiliated broker-dealer cannot be a factor in determining the size of year-end bonuses paid to bank employees. 

The Banking Agencies do not believe it is necessary or appropriate for the SEC to define the upper limits of permissible referral fees.   

Exemption for Sweep Accounts

The GLB Act allows banks to sweep deposit funds into “no-load” money market mutual funds.  The SEC Rules generally adopt the definition of “no-load” that the National Association of Securities Dealers (“NASD”) has adopted in its Rule 2830(d)(4).  This rule prohibits a fund of an investment company from being advertised as “no-load” if  the investment company has a front end or deferred salescharge or imposes total charges against net assets to provide for sales related expenses and/or service fees that exceed .25 of 1 percent of average net assets per annum.

The Banking Agencies believe that it is not necessary to interpret “no-load” to exclude funds that impose asset-based sales.

The GLB Act includes an exception that permits banks to continue issuing and selling asset-backed securities to qualified investors through a grantor trust or other separate entity without registering as a dealer.  Under the exemption, the securities must be supported by loans, receivables or other obligations that were “predominantly originated” by the bank, any of the bank’s affiliates (other than a broker-dealer), or a syndicate of banks of which the bank is a member if the obligations are backed by mortgages or are consumer-related receivables. 

Defining “Predominantly Originated”

The SEC Rule provides that a pool of obligations will be considered to be “predominantly originated” by the relevant syndicate of banks only if at least 85 percent of the obligations were originated by such banks. 

The Banking Agencies believe that this definition of “predominantly originated” is unduly restrictive.  They believe that the   relevant syndicate of banks could meet the statute’s “predominantly originated” standard if the value of the obligations originated by such banks exceeds the value of the obligations originated by entities outside such syndicates.

Defining “Syndicate of Banks”

As noted above, in the case of securi-ties backed by mortgages and other consumer-related receivables, the statute permits the obligations to be predominantly originated by a “syndicate of banks of which the bank is a member.”

The SEC rule defines a “syndicate” to mean “a group of banks that acts jointly, on a temporary basis, to loan money in one or more bank credit obligations.”

The Banking Agencies believe that this definition  reflects a fundamental misunderstanding of how syndicates for the saleof such obligations function in the banking industry. The requirement that such a syndicate only include a group which is formed to lend the initial money creating the obligations effectively precludes banks from taking advantage of the syndicate exception in the GLB Act.  The definition of “syndicate” should not include the requirement that the banks participate as a group in making the syndicated loans, only in selling them.

Implementation Dates

The SEC Rule originally gave banks until October 1, 2001 to comply with the exceptions from the definition of broker and dealer in the Exchange Act, and delayed until January 1, 2003 the ability of private parties to sue banks under section 29(b) of the Exchange Act on the basis that the bank is not in compliance with the broker-dealer registration exceptions included in the Exchange Act.

The Banking Agencies believe that the SEC should seek public comment on a revised rule and should further extend the effective date of the GLB Act’s broker-dealer provisions until after that rulemaking is completed.  They also believe that the SEC should provide banks with at least a one-year transition period to implement the systems and make any other changes necessary to comply with the revised rule.

Partly in response to the urgings of the Banking Agencies, the SEC subsequently extended the comment period until September 4, 2001 and extended the compliance date until May 12, 2002.

Bill Harvey, a shareholder in the Investment Management and Fiduciary Services Group, may be reached at 412/594-5550 or via e-mail at wharvey@tuckerlaw.com.

In each issue, we will introduce a member of our Investment Management  & Fiduciary Services Group.

In this issue, we spotlight...

WILLIAM T. HARVEY

Mr. Harvey, a shareholder in the group, focuses his practice on business and securities law.  He counsels private and public companies on federal and state securities regulation, including private and public offerings of debt and equity securities.

Bill advises banks and other financial institutions in connection with mergers and acquisitions, establishing non-banking subsidiaries, securities regulatory matters, conversion from mutual to stock ownership and related ongoing banking matters. 

In 20 years of practice, Bill has handled various corporate and business matters, including the purchase and sale of corporate stock and assets, debt and equity financing, and the purchase and sale of various small to medium sized enterprises.  He has extensive experience with shareholder disputes, minority shareholders’ rights, directors’ and officers’ liability and other corporate law issues.  He has advised both publicly owned and privately held businesses on securities filings, proposed mergers, drafting and amendments to articles and bylaws and other corporate and securities issues.

Bill graduated from Yale University, then obtained a Masters Degree from Duquesne University. Bill graduated from the University of Pittsburgh School of Law. 

Bill may be reached at 412/594-5550 or via e-mail at wharvey@tuckerlaw.com.

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