The Financial Services Regulatory Relief Act of 2006 ("Financial Services Act"), which President Bush signed into law on October 13, 2006,¹ may result in significantly different rules governing securities activities of banks, under the Gramm-Leach-Bliley Act of 1999 ("GLBA") than have been proposed thus far, including with respect to bank employee compensation. The Financial Services Act also codifies existing SEC policy that allows federally regulated savings banks and savings associations, and state-chartered savings associations with deposits insured by the Federal Deposit Insurance Corporation ("Federal Thrifts")² to offer securities services under the same general terms and conditions as banks. Specifically, the Financial Services Act:

• Requires the Securities and Exchange Commission ("SEC") and the Board of Governors of the Federal Reserve System ("FRB"), to jointly propose rules to implement the exception from the definition of "broker" available to banks under the Securities Exchange Act of 1934 ("Exchange Act"). This set of rules, which will supersede any other proposed or final rules issued by the SEC in this regard, must be proposed within 180 days of enactment (April 12, 2007), after consulting with and seeking the concurrence of the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation (together with the FRB, the "Banking Regulators") and the Office of Thrift Supervision.
• Provides for treatment of Federal Thrifts under the Exchange Act and the Investment Advisers Act of 1940 ("Advisers Act"), which equates to the treatment of commercial banks under those statutes.

The joint rulemaking by the SEC and the FRB will, in accordance with the Financial Services Act, supersede any prior proposed or final rules issued by the SEC since GLBA was enacted in 1999. Because prior proposals to implement GLBA were developed solely by the SEC, the joint rulemaking with the FRB, if successful, should result in proposed rules that better reflect the views of the banking industry and Banking Regulators. This may be significant because the Banking Regulators had an unusually negative response to the SEC’s prior proposals.³ Of course, another possibility is that, due to the sharp differences between the SEC and the Banking Regulators on how the bank exception from brokerage should be implemented, the agencies will not be able to come to agreement within the timeframe required by the Financial Services Act, and joint rules will not be proposed as required. Public statements by SEC Chairman Cox, however, indicate that the SEC is likely to go to great lengths to come to a timely agreement with the FRB.⁴

By providing parity to federally regulated savings banks and savings associations with commercial banks under the Exchange Act, the Financial Services Act largely codifies the Exchange Act treatment Federal Thrifts have enjoyed since May 2001. By providing parity under the Advisers Act, the Financial Services Act will also permit Federal Thrifts to offer services such as wrap fee programs under the same terms enjoyed by commercial banks.

Joint SEC-FRB Rules

Background

Until GLBA became effective in May 2001, banks enjoyed a blanket exemption from having to register with the SEC as broker-dealers. Under the functional regulation scheme put into place by GLBA, banks in the future will be required to limit their securities activities to one or more of a series of exceptions enumerated in the Exchange Act. The SEC first provided guidance on bank securities activities under GLBA in a May 2001 release adopting interim rules and providing banks with a temporary exemption from "broker" status to permit them to come into compliance with the interim rules. Because of a strongly negative reaction to its proposal, both by the banking industry and Banking Regulators, the SEC extended the temporary exemption to allow the SEC time to consider comments received on the interim rules, with the intention of amending those rules and permitting banks a reasonable amount of time to come into compliance. The temporary exemption has been extended until the present, with the most recent extension set to expire on January 15, 2007.⁵

The SEC re-proposed rules governing bank securities activities as agent in June 2004 as proposed Regulation B.⁶ The Banking Regulators responded to this proposal in unusually harsh terms, however, stating that proposed Regulation B would "not give effect to the Congressional purpose or the statutory language" of GLBA. With respect to networking arrangements, the Banking Regulators generally criticized the SEC’s attempt to prescribe limits to the nominal referral fee that unregistered bank employees may receive for referring customers to broker-dealers. They also expressed concern that the SEC’s discussion of the relationship between bank bonuses and income earned by broker-dealers sharing the same bank branch or division was overly broad, encroaching too far into the internal operations of banks and bank holding companies.⁷

It is because of these sharp divisions between the SEC and the Banking Regulators on how best to regulate bank securities activities, that the new requirement to propose joint rules within 180 days is so significant. Unlike the two prior attempts by the SEC to apply GLBA to bank securities activities as agent,⁸ any joint proposal by the SEC and the FRB should better reflect the views of the Banking Regulators. In particular, if joint rules are proposed, we should expect to see changes in the following areas:

Networking Arrangements and Bank Bonus Programs

GLBA permitted unlicensed bank employees to receive, in exchange for a referral to a broker-dealer, a nominal one-time cash fee of a fixed dollar amount that is not contingent on whether the referral results in a transaction. Based in part on data provided by the banking industry, in proposed Regulation B, the SEC proposed to limit the amount of the referral fees to: (1) the employee’s base hourly rate of pay, (2) twenty-five dollars, or (3) fifteen dollars in 1999 dollars, adjusted for inflation.⁹ Although not explicitly contemplated by GLBA, the SEC also proposed to permit as an alternative non-cash referral fees, provided they (1) were paid in units or points with a readily ascertainable cash value known before the employee makes a brokerage referral, (2) did not, together with any cash referral fees paid, exceed a nominal amount, and (3) were paid under a program involving a broad range of products designed primarily to reward non-securities activities. In discussing the "one-time" limitation on referral fees, the SEC also linked bank bonus programs to the payment of incentive compensation to unlicensed employees. The SEC stated that "a bank could not rely on the networking exception and use bonuses as a means of indirectly paying their unregistered employees brokerage-related incentive compensation based on the performance of a branch, department or line of business of the bank."¹⁰

     Definition of "Nominal"

The SEC and the Banking Regulators appear to have very different ideas on what constitutes a "nominal" fee. For example, in proposing Regulation B, the SEC discussed a 2003 meeting, in which Staff from the Banking Regulators suggested that fees as high as $100 for referrals of high net worth customers should be considered nominal.¹¹ Not surprisingly, in response to the SEC’s proposed definition of "nominal," the Banking Regulators stated that the proposal was a "highly complex, restrictive and inflexible definition of what constitutes a nominal cash referral fee", and suggested that the SEC should instead rely on bank examiners to review referral fees in light of the geographic location of the bank involved and other relevant factors during their supervisory and examination process.¹² Although the agencies should be able to come to agreement on this issue, we should expect a more loosely defined definition of "nominal" to be proposed as part of any joint SEC-FRB proposal, based more on a fact and circumstance test than the SEC has previously proposed.

     Non-Cash Referral Fees

The Banking Regulators had problems with the SEC’s proposal on non-cash referral fees also. Instead of requiring non-cash referral fee programs to reward employees in points or units having a readily ascertainable cash value known to the employee at the time of the referral, the Banking Regulators suggested that only the methodology for granting points must be fixed in advance, provided the ultimate value of those points with respect to a single referral was nominal. The Banking Regulators also saw no reason why the non-cash referral fee programs must include a broad range of products primarily designed to reward non-securities activities. Here too, although the agencies should be able to come to agreement on this issue, we should expect a joint SEC-FRB proposal to provide for significantly less restrictive requirements for non-cash referral fee programs.

     Bank Bonus Programs

With respect to bank bonus programs, the Banking Regulators commented that the language in the SEC’s proposal of Regulation B could be read as asserting "broad jurisdiction over the employee compensation programs of banks and bank holding companies, even where these programs are not used as a conduit for the payment of referral fees." Moreover, the Banking Regulators stated, they do not believe that Congress, in authorizing banks to have networking arrangements with broker-dealers, intended to grant the SEC such broad authority. The Banking Regulators further stated their belief that the most appropriate way to ensure that bank bonus programs are not used as a conduit for paying referral fees of more than a nominal amount is through the bank supervision and examination process.

The SEC Staff, by its own account, has historically construed exceptions from broker-dealer registration, including the bank exception, narrowly.¹³ In adopting the interim final rules implementing GLBA, the SEC cited the Staff’s view on this approvingly.¹⁴ The SEC is therefore likely to assert that its jurisdiction over the receipt of transaction-related compensation by unlicensed bank employees precedes GLBA and, as a matter of practice, should continue to prohibit incentive compensation to unlicensed bank employees, except as expressly permitted by GLBA.¹⁵ It is likely, however, that the Banking Regulators will disagree with that view, at least as it relates to a bank’s ability to determine how to compensate its own employees. Whether the SEC and the Banking Regulators will come to an agreement that removes the uncertainty in this area, however, may not be known until joint rulemaking is proposed by the regulators.

NASD Rule 3040/Registered Bank Employees

An additional issue that the Banking Regulators raised in their comment letter on proposed Regulation B, was the application of NASD Conduct Rule 3040 to dual bank/broker-dealer employees. Currently, Rule 3040 requires NASD member firms to treat transactions effected by dual employees through the bank’s trust department as "private securities transactions" that must be reported to and supervised by the broker-dealer. Thus far, the SEC and the NASD have resisted changing this application of Rule 3040, which they consider necessary for their supervision of brokerage employees. The Banking Regulators, however, asserted that this application of Rule 3040 is not consistent with the functional regulation that GLBA was intended to implement. This issue is likely to be hotly debated as the agencies grapple with the implementation of GLBA to bank securities activities.

Trust and Fiduciary Activities

GLBA generally required that bank trust activities be "chiefly compensated" on the basis of an annual or administrative fee, or on the basis of assets managed ("Relationship Compensation"). GLBA did not define chiefly compensated, and the definition of this term was a primary focus of discussions between the SEC Staff and Banking Regulators since interim rules were originally proposed by the SEC in May 2001.

Relying on the legislative history of GLBA, the SEC focused on Congress’s concern that a broad reading of the trust and fiduciary activities exception could lead a "bank to conduct a full-scale securities brokerage in the trust department that would be exempt from [SEC] regulation and the imposition of appropriate investor protections under the Federal securities laws." The SEC therefore interpreted the definition of chiefly compensated strictly so as to "limit a bank’s ability to receive incentive compensation or similar compensation that could foster a salesman’s stake in promoting securities transactions."¹⁶ Under proposed Regulation B, the SEC would have generally required bank trust departments that received more than ten percent of their fees through transaction-related compensation to review their trust department accounts on an account-by-account basis to ensure compliance.

The Banking Regulators responded that the SEC’s proposal "would not work for a variety of reasons" and would "force banks to either cease providing securities transaction services to many corporate and employee benefit plan customers or significantly restructure their trust and fiduciary operations."¹⁷ The Banking Regulators asserted further that under GLBA, banks should merely be required to receive the majority of their compensation from trust accounts in the form of Relationship Compensation, measured on a bank-wide basis.

Assuming the SEC and the Banking Regulators can come to agreement on this exception, we should expect any joint proposal to impose less burdensome requirements on banks to review their compliance with the Exchange Act’s limits on how they are compensated for trust activities than had been proposed by the SEC previously. The Banking Regulators are also likely to urge the SEC to rely on the "statutory prohibition on bank advertising" and bank examinations to help ensure that banks are not using their trust departments to operate a full scale brokerage business.

Bank Custodial Activities

GLBA permitted banks to provide custody as part of the ordinary banking services that had been provided by banks for centuries. While agreeing that banks should be permitted to offer custodial services generally, the SEC has proposed greatly limiting banks’ abilities to accept securities orders from their custodial IRA customers, and from 401(k) and employee benefit plans for which the bank acts as custodian. In particular, proposed Regulation B generally would not have permitted banks to accept customers’ securities orders, other than from certain grandfathered accounts or from "qualified investors" as that term is defined in Exchange Act Section 3(a)(54) (i.e., generally institutions and individuals with more than $25 million invested). In proposing Regulation B, the SEC explained that this strict standard was justified because under the federal securities laws, accepting general orders to buy and sell securities is not a clerical and ministerial activity.¹⁸ It is instead often cited by the SEC Staff as a function that may require broker-dealer regulation.¹⁹

In response, the Banking Regulators stated that the SEC’s interpretation was "flatly at odds with the customary practices and customer relationships of banks." Moreover, it was "not consistent with [GLBA], its legislative history, or the purposes of the Custody and Safekeeping Exception."²⁰ The Banking Regulators recommended that the SEC permit banks to accept securities orders from the custodial customers explicitly mentioned in GLBA,²¹ as well as from other custodial customers on an unsolicited basis.

Seeing how far apart the regulators were when Regulation B was proposed, 180 days is not much time for the SEC and the FRB to come to agreement on this exception.²² We should expect, however, that any joint SEC-FRB rules which are proposed to be far more liberal as to banks accepting orders and providing other securities services to custody accounts of retirement plans, including individual retirement accounts, and possibly also providing these services to retail custody accounts.

Regulatory Parity for Banks and Thrifts

Section 401 of the Financial Services Act amends the Exchange Act and the Advisers Act to provide Federal Thrifts with the same exemptions from registration as banks currently enjoy. Until now, although banks were excluded from the definitions of "broker" in the Exchange Act and of "investment adviser" in the Advisers Act, savings banks and savings associations were generally not included within the definition of "bank" in those statutes, and were therefore unable to provide many of those services without relief from the SEC or its Staff.

Parity Under the Exchange Act

Prior to GLBA, banks enjoyed blanket exceptions from the definitions of "broker" and "dealer" under the Exchange Act. GLBA repealed those blanket exceptions, replacing them with a series of limited exceptions, permitting banks to engage in securities activities without registering as broker-dealers. Savings banks and savings associations, however, were not included in these exceptions, but instead had to seek no-action relief from the SEC Staff in order to engage in securities networking and other activities.

The SEC has exempted commercial banks and Federal Thrifts from the Exchange Act definition of "broker" since May 2001. The amendment adding Federal Thrifts to the Exchange Act definition of "bank" therefore merely codifies the equivalent treatment with commercial banks they have enjoyed since then. Because proposed Regulation B would not have extended all of the proposed bank exemptions from broker-dealer registration to Federal Thrifts, however, the amendment could effectively permit Federal Thrifts to engage in securities activities to a larger extent than would have been permitted if Regulation B were adopted as proposed.²³

Prior to the Financial Services Act, securities issued by a collective trust fund established by a bank were exempted from registration under Exchange Act Section 3(a)(12), but securities issued by a collective trust fund established by a Federal Thrift were not. One additional effect of this legislation is that securities issued by a collective trust fund established by a Federal Thrift are also now exempted from Exchange Act registration.

Parity Under the Advisers Act

Historically, Section 202(a)(11) of the Advisers Act excluded commercial banks from the definition of "investment adviser" (other than banks that acted as investment advisers to registered investment companies). However, the term "bank" under Section 202(a)(2) of the Advisers Act did not include thrifts, and thrifts were, therefore, generally subject to investment adviser registration to the extent that they provided investment advisory services to their clients. The Financial Services Act amends the definition of "bank" under the Advisers Act to include Federal Thrifts and, as a result, Federal Thrifts are now excluded from the definition of "investment adviser" and the registration requirements of the Advisers Act.

As a result of the legislation, Federal Thrifts may now offer asset allocation programs, wrap fee programs and financial planning services without registering as an investment adviser under the Advisers Act or as a broker-dealer under the Exchange Act.

Prior to the Financial Services Act, if a Federal Thrift wanted to offer investment advisory services and it qualified for SEC registration as an investment adviser, the Federal Thrift would have been exempt from state regulation. If SEC-registered Federal Thrifts de-register because they are no longer required to register as a result of the Financial Services Act, they generally will also be excluded from state registration requirements.²⁴ Federal Thrifts that decide to de-register with the SEC should review the specific requirements of the states in which they are principally located and in which they do business to determine if the state has similarly adopted an exemption for thrifts or any other regulations that would apply.

Notably, the Financial Services Act did not provide similar relief for thrifts under the Investment Company Act of 1940 (the "1940 Act"). Under Section 3 of the 1940 Act, certain common and collective trust funds that are administered by banks are excluded from the definition of an investment company and therefore are not subject to the requirements of the 1940 Act. Since the Financial Services Act did not amend the definition of "bank" under the 1940 Act, Federal Thrifts will not be able to continue to engage in such activities without subjecting the pool of assets to regulations of the 1940 Act.

For more information on the application of GLBA to banks, broker-dealers and investment advisers, please contact: in Los Angeles, John F. Hartigan, 213.612.2630, jhartigan@morganlewis.com; and in Washington, D.C., Kathleen W. Collins, 202.739.5642, kcollins@morganlewis.com; Jack P. Drogin, 202.739.5380, jdrogin@morganlewis.com, or Karen A. Aspinall, 202.739.5355, kaspinall@morganlewis.com.

¹      Financial Services Regulatory Relief Act, Public Law No. Public Law No: 109-351 (2006).

²     The amendments to the Exchange Act and the Advisers Act place federally-chartered savings banks and savings associations, and state-chartered savings associations that hold deposits insured by the Federal Deposit Insurance Corporation on an equal posture with banks under the Exchange Act and the Advisers Act. State-chartered savings associations without federally insured deposits, however, are not included under the amended definition of "bank."

³     See letter from Alan Greenspan, Chairman, FRB, Donald E. Powell, Chairman, Federal Deposit Insurance Corporation, and John D. Hawke, Jr., Office of the Comptroller of the Currency to Jonathan G. Katz, Secretary, SEC (October 8, 2004) ("Banking Regulators Comment Letter"). See also letter from James E. Gilleran, Director, Office of Thrift Supervision to Jonathan G. Katz, Secretary, SEC (September 1, 2006) ("OTS Comment Letter").
Because the joint rulemaking supersedes all prior proposals by the SEC relating to GLBA, it may effectively nullify prior statements by the SEC on compensation of unregistered bank employees when proposing Regulation B. See Securities Exchange Act Release No. 49879 (June 17, 2004) (proposing Regulation B).

⁴     SEC Chairman Cox has stated that he is very confident that the SEC and the FRB will meet the legislative deadline. He predicted the agencies will propose joint rules by year-end. See SEC Press Release No. 2006-169, "SEC Announces Timetable for Enactment of Final Rules Under Gramm-Leach-Bliley Act" (September 29, 2006). Available at: www.sec.gov/news/press/2006/2006-169.htm. See also "Gramm-Leach-Bliley Seven Years Later" (September 21, 2006) (in which Chairman Cox told the Financial Services Roundtable that he expected to propose rules by year-end and adopt them within 180 days). Available at: www.sec.gov/news/speech/2006/spch092106cc.htm.

⁵     The SEC’s order extending the bank exemption from the definition of broker may be found at www.sec.gov/rules/exorders/2006/34-54544.pdf. The SEC’s press release may be found at www.sec.gov/news/press/2006/2006-169.htm.

⁶     See Securities Exchange Act Release No. 49879, supra n.3.

⁷     See Banking Regulators Comment Letter, supra, n.3. The Banking Regulators also stated that their "greatest concerns" would not occur if the SEC interpreted the exceptions for bank trust, fiduciary and custodial activities "in a way that gives meaningful effect to the language and purposes of the statutory provisions."

⁸     The SEC has previously adopted rules governing bank activities as principal. See Securities Exchange Act Release No. 47364 (Feb. 13, 2003).

⁹     See Securities Exchange Act Release No. 49879 (June 17, 2004) at fn. 55.

¹⁰     BISA played a significant role in educating the SEC on industry compensation practices. See Securities Exchange Act Release No. 49879, supra n.3, at fn. 55. See also letter from Richard D. Starr, Director — Government Relations, BISA to Jonathan G. Katz, Secretary, SEC (September 1, 2004) (BISA comment letter on proposed Regulation B). BISA should be well-positioned to continue that dialogue with federal regulators with respect to future rulemaking by the SEC and the FRB.

¹¹     See Securities Exchange Act Release No. 49879, supra n.3, at fn. 41.

¹²     SeeBanking Regulators Comment Letter, supra, n.3.

¹³     See Maine Securities Regulator (April 9, 2002) (stating that the exception does not apply to bank affiliates, unless required by another regulator).

¹⁴     See Securities Exchange Act Release No. 44291 (May 11, 2001).

¹⁵     Because the Financial Services Act makes clear that any joint rulemaking by the SEC and the FRB will supersede prior rulemaking by the SEC with respect to GLBA, the SEC’s statements, when proposing Regulation B, on how banks may compensate their employees are unlikely to remain in effect. See Securities Exchange Act Release No. 49879, supra n.3.

¹⁶     See H.R. Rep. No. 106-74, pt. 3, at 164 (1999).

¹⁷     See Banking Regulators Comment Letter, supra, n.3.

¹⁸     See Securities Exchange Act Release No. 49879 (June 17, 2004) (proposing Regulation B) at fn. 252. The SEC cited as support for their views Exchange Services, Inc. v. SEC, 797 F.2d 188, 189-90 (4th. Cir. 1986).

¹⁹     See, e.g., MuniAuction, Inc. (pub. avail. March 13, 2000).

²⁰     See Banking Regulators Comment Letter, supra, n.3.

²¹     Exchange Act Section 3(a)(4)(B)(viii)(ee) specifically permits banks to offer as part of customary banking activities, to serve as custodian or provider of other related administrative services to any individual retirement account, pension, retirement, profit sharing, bonus, thrift savings, incentive, or other similar benefit plan. See also OTS Comment Letter, supra n.3., providing largely similar comments.

²²     As mentioned above, Chairman Cox has stated his expectation that joint rules will be proposed by year-end. The SEC and the banking agencies apparently have been working diligently to come to agreement on their remaining issues for a number of months. See "Gramm-Leach-Bliley Seven Years Later," supra n.4 (in which Chairman Cox stressed the efforts to date by the agencies and his expectation that final rules would be adopted within 180 days).

²³     Proposed Regulation B would not have permitted or applied the custody and safekeeping exemptions or certain exemptions relating to administration of ERISA plans to savings banks and savings associations. See OTS Comments Letter, supra n.3, for a discussion of areas in which Federal Thrifts would not have received equal treatment to commercial banks under proposed Regulation B.

²⁴     As a result of The National Securities Markets Improvement Act of 1996, a state may not require the registration of an investment adviser that is excepted from the definition of an investment adviser under the Advisers Act. See Section 203A(b)(1) of the Advisers Act. A state may require such entities to comply with notice filing requirements and pay a fee to do business in the state.