For many banks, thrifts and trust companies, January 1, 2009 not only marks the first day of the new fiscal year, but also the date by which they must comply with Regulation R, which implements the Gramm-Leach-Bliley Act (GLBA).¹

The GLBA removed the blanket exemption from registration for securities activities conducted in banks, providing instead a set of specifically enumerated exceptions for banks from the definition of "broker" and "dealer" under Section 3(a)(4) of the Securities Exchange Act of 1934 (the Exchange Act). All non-conforming securities activities that do not fit into a statutory exception or regulatory exemption will need to be "pushed-out" to a registered broker-dealer. Regulation R implements certain of the GLBA broker exceptions for banks, including the exceptions related to trust and fiduciary activities, third-party networking arrangements, deposit "sweep" activities, and custody and safekeeping activities. Regulation R also includes certain exemptions related to foreign securities transactions, securities lending transactions, the execution of transactions involving mutual fund shares and variable annuities, and the potential liability of banks under Section 29 of the Exchange Act.²

The underlying purpose of the GLBA was to encourage competition in the financial industry under the rubric of "functional regulation," separating banking products, which would be offered through a bank subject to banking regulations from securities products, which would be offered through a broker-dealer subject to SEC regulations. Ironically, the financial industry's response to the new regulation combined with the current market turmoil has led a number of banks to acquire broker-dealer firms, joining these types of brokerage services under a single bank holding company umbrella in an unprecedented manner. For these new bank-brokerage conglomerates and other financial market participants, the upcoming Regulation R compliance deadline represents an important turning point. We review here the key regulatory considerations shaping banks' compliance efforts with Regulation R.

I. Trust and Fiduciary Exception

Without doubt, the most critical exception provided in the GLBA and Regulation R for banks engaged in securities activities is the trust and fiduciary exception.³ A bank may effect securities transactions in a trustee or fiduciary capacity without registering as a broker-dealer if the bank is "chiefly compensated" for those transactions on the basis of specific types of "relationship compensation."⁴ Regulation R provides two separate tests to determine how a bank is "chiefly compensated," either to be performed bank-wide or on an account-by-account basis.

Both compensation tests use a two-year rolling average of the compensation attributable to either the specific trust or fiduciary account for the account-by-account test, or the bank's trust and fiduciary business for the bank-wide test. Thus, banks with a fiscal year based on the calendar year will first need to demonstrate compliance with these compensation tests on January 1, 2011. It is expected that most banks will rely on the bank-wide test, which requires the quotient of relationship compensation divided by total compensation to be at least 70 percent. These banks will be required to provide documentation of the type of income earned from the accounts, which make up the 70 percent of relationship compensation. It is expected that guidance from the bank regulators on the record-keeping requirements of banks relying on the trust and fiduciary exception will be published in the near future.

II. Networking Exception for Non-Conforming Securities Activities

For non-conforming securities activities that do not meet the requirements for a statutory exception or regulatory exemption, two basic options are available for banks under the networking exception⁵: (1) maintain a single point of customer contact by requiring those activities to be conducted through bank employees who are "dually registered" as brokers in a "dual hat" arrangement; or (2) require bank customers to conduct those activities through other brokers employed by an affiliated broker-dealer or a third party brokerage firm in a "referral" arrangement.

A. Dual Hat Arrangements

Dual hat arrangements involve bank employees who, in addition to their bank responsibilities, act as "registered representatives" of a broker-dealer (typically, affiliated with the bank) and perform the non-conforming securities activities under the supervision of the broker-dealer.⁶ Practically, this arrangement can be onerous in the case of bank employees who need to pass the applicable qualification examination. In addition to practical hurdles, dual hat arrangements also present certain regulatory risks, principally that there may be inappropriate blurring of the identities of the bank and broker-dealer, and that the securities regulators may attempt to examine the activities of the bank. These risks are greater where an employee is dual-hatted because (i) it is more difficult to maintain separation when the same individual is in a customer-facing position offering both bank and broker-dealer products, and (ii) the broker-dealer is more likely to be perceived as having residual supervisory responsibility over the dual-hatted employee's sales practices, even if they are taking place away from the broker-dealer through another regulated entity. In May 2008, FINRA sought to clarify the supervisory responsibility of a broker-dealer over so-called "dual employees" by proposing certain rule changes as part of its Consolidated FINRA Rulebook.⁷In particular, proposed Consolidated FINRA Rule 3110(b)(3) would enable the broker-dealer to rely on the supervision of such employees by the bank, subject to certain conditions. It is not clear if or when the proposed rule changes will be adopted.

Maintaining separation presents day-to-day challenges, especially if a business culture is accustomed to thinking in terms of functional line of business, not legal entity. These risks should be managed through rigorous employee training and other controls to maintain a clear separation of bank and broker-dealer products and services and disclosure to the customer of the separate identities of the bank and broker-dealer.

B. Referral Arrangements

In a referral arrangement, bank employees refer out customers interested in broker-dealer products and services to registered representatives of an affiliated broker-dealer or third party brokerage firm. In this regard, the term "referral" is defined under Rule 700(e) to mean the "action taken by one or more bank employees to direct a customer of the bank to a broker or dealer for the purchase or sale of securities for the customer's account." A poorly managed referral program could present risks similar to those of the dual hat arrangement. If the bank employee making referrals does not properly "hand off" the customer to the broker-dealer's representatives, there is a risk of potential blurring between the bank and broker-dealer as well as a risk that the broker-dealer could be held liable for unsuitable sales of its investment products and services attributable to the bank employee. To guard against any such potential misconduct by bank employees, Regulation R imposes very specific limitations on their compensation arrangements.⁸

III. Conclusion

Whichever model a bank chooses to follow for complying with Regulation R and pushing out its non-conforming securities activities, the bank and the broker-dealer participating in the dual hat or referral arrangement should have a carefully drafted written agreement that addresses the legal and regulatory requirements and ensures compliance with the GLBA networking exception and related customer disclosure requirements. In particular, given the current regulatory environment, especially with the continuing business trend toward consolidation of financial services, it is important to observe the distinction between the bank's products and services and those offered by the broker-dealer in order to avoid any adverse enforcement action.

¹ See Exch. Act Rel. No. 56501, 72 Fed. Reg. 56514 (Oct. 3, 2007) (Regulation R adopting release). Regulation R was adopted jointly by the Board of Governors of the Federal Reserve System (Board) and Securities and Exchange Commission (SEC), and has been codified for the Board in Title 12 part 218 of the Code of Federal Regulations, and for the SEC, in Title 17 part 247. For ease of reference, we refer to the final rules comprising Regulation R without title and part designations.

² For a more detailed discussion of the provisions of Regulation R, See Final Broker Push-Out Rules for Banks--At Long Last, WilmerHale Publication (Sept. 24, 2007).

³ Exchange Act Section 3(a)(4)(B)(ii).

⁴ Rules 721 and 722.

⁵ Exchange Act Section 3(a)(4)(B)(i).

⁶ See NASD Rule 1031 (registration requirements) and Rule 3010 (supervision).

⁷ See FINRA Regulatory Notice 08-24 (May 2008).

⁸ See Rule 700 (definition of "incentive compensation" and certain other terms used in the networking exception).