United States: Financial Services Alert

Prior to the Act, banks were specifically exempt from registration or regulation as a broker-dealer under the federal Securities Exchange Act of 1934 (the "Exchange Act"), and thus were not subject to SEC registration, regulation or examination (collectively, "SEC Oversight") when effecting transactions in securities. Effective May 12, 2001, the Act changes the characterization of "broker" and "dealer" in the Exchange Act, replacing the current, general bank exemption with targeted exceptions for certain enumerated bank securities activities (discussed in Section A.1., below). As Section A.2. details, except in very unusual circumstances, we believe banks will find it undesirable to themselves become subject to SEC Oversight, and thus close evaluation will be necessary to determine if it is appropriate to establish a Securities Affiliate to conduct non-exempt securities activities.

While removing the general bank exemption, the Act provides certain enumerated exceptions to the general definition of "broker" under the Exchange Act. A bank generally will not be considered to be a broker (and thus will not become subject to SEC Oversight) because the bank engages in any one or more of the following activities: (1) Third Party Brokerage Arrangements (subject to certain conditions which are generally similar to the requirements in the Interagency Statement on Retail Sales of Nondeposit Investment Products); (2) Trust Activities (when acting in a trustee or fiduciary capacity, with restrictions on advertising, fees, and trade execution ("publicly traded" U.S. securities must be (i) directed to a registered broker-dealer, (ii) conducted as a cross- or similar type- trade within the bank, or (iii) conducted in some other manner authorized by the SEC)); (3) Permissible Securities Transactions (including transactions in commercial paper, bankers acceptances or commercial bills, and exempted securities); (4) Certain Stock Purchase Plans (subject to restrictions on solicitation, the netting of certain buy and sell orders, and trade execution ¾ see "Trust Activities"); (5) Sweep Accounts (only for the investment or reinvestment of deposit funds into any no-load, open end mutual fund that holds itself out as a money market fund); (6) Affiliate Transactions (for any affiliate other than a registered broker-dealer or merchant bank); (7) Private Securities Offerings (subject to restrictions if the bank is affiliated with a broker-dealer that engages in underwriting, market-making or dealing in securities, and limitations on the aggregate amount of the placement); (8) Safekeeping and Custody Activities (when acting in a custodial capacity and subject to restrictions on trade execution ¾ see "Trust Activities," with additional limitations if acting as a carrying broker); (9) Identified Banking Products (including deposit and savings accounts, bankers acceptances, letters of credit issued or loans made by the bank, bank debit accounts, loan participations (subject to certain qualifications) and certain swap agreements); (10) Municipal Securities; and (11) De Minimis Transactions (for banks effecting fewer than 500 transactions in securities in a calendar year, and such transactions are not effected by an employee who is also an employee of a broker-dealer).

The Act also contains certain enumerated exceptions to the general definition of "dealer" under the Exchange Act, including certain types of securities transactions; investment, trustee and fiduciary transactions; asset-backed transactions; and identified banking products.

As the foregoing makes clear, to determine whether it will remain exempt from broker-dealer registration, a bank must carefully evaluate each securities activity in which it engages. The SEC has stated informally on several occasions that it intends to construe the statutory exemptions described above narrowly against the banks; thus banks seeking to avoid SEC Oversight must ensure their activities fall squarely within those exemptions. If those exemptions do not fully cover a bank's current and contemplated securities activities, then the bank must determine whether it will continue to perform the activities and itself become subject to SEC Oversight, or conduct those activities through a Securities Affiliate. In this regard, we believe that a bank should be very reluctant to subject itself to SEC Oversight. Such oversight would require the bank to register under the federal, and in most cases, state, securities laws. One practical adverse effect of such registration is that, in addition to examination by its federal and state bank regulators, the bank would also become subject to ongoing review by the SEC and state securities authorities. In addition to registration under federal and state laws, a broker-dealer must become a member of a Self-Regulatory Organization, such as the National Association of Securities Dealers, and its employees must be appropriately tested and licensed for the activities to be conducted. As a result, it appears that the most practical means for a bank to engage in non-exempt securities activities will be through a Securities Affiliate. It should be re-emphasized, however, that a Securities Affiliate will be subject to SEC Oversight, and establishing a new broker-dealer could require several months. Consequently, it is critical that a bank determines promptly whether a Securities Affiliate is desirable, so that, if necessary, there will be sufficient time to establish a Securities Affiliate in an orderly manner.

Unlike the Act's broker-dealer exemption, evaluating whether a bank still is exempt from investment adviser registration under the Investment Advisers Act of 1940 (the "Advisers Act") is fairly straightforward. A bank that acts as an investment adviser (including sub-adviser) to registered investment companies (i.e., mutual funds and unit investment trusts) will no longer be exempt from the definition of "investment adviser" in the Advisers Act, and thus after May 12, 2001 will be required to register with the SEC under the Advisers Act. All other types of advisory activities, including trust activities and advisory activities for unregistered funds, will remain exempt. It should be noted, however, that if a bank loses the investment adviser exemption by providing investment advice to registered investment companies, then all of its investment advisory activities (not just those related to the mutual fund advisory services) will become subject to SEC Oversight. If a bank is conducting mutual fund advisory services, then, as with broker-dealer activities, the bank may avoid SEC Oversight by establishing a Securities Affiliate. However, the Act provides another alternative with respect to these activities. Specifically, banks may elect to conduct their mutual fund advisory and related activities in a separately identifiable department or division, and thereby limit the regulatory impact to only that portion of the bank. In this manner, the separately identifiable department or division, and not the bank itself, will need to register as an investment adviser under the Advisers Act.

The Act purports to codify in most respects the existing standards regarding the securities law exemptions for bank common trust funds ("CTFs"). However, the Act codifies the standard for CTFs inside the Investment Company Act, thus for the first time giving the SEC express statutory jurisdiction to evaluate whether a bank's arrangement satisfies the criteria to be qualified as a CTF. A disqualified CTF could result in the bank engaging in impermissible securities activities, and thus banks should review the compliance of their CTFs with the federal standards prior to May 12, 2001. Unlike CTFs, collective investment funds ("CIFs") have not been affected by the Act.

The Act also contains several provisions that affect the status of federal savings banks under the federal securities laws. In particular, the Act amends the Securities Act of 1933 and the Investment Company Act. The Investment Company Act will provide that a "bank" includes a "depository institution," as defined in the Federal Deposit Insurance Act, which means that a federal savings bank should be considered a "bank" for purposes of the Investment Company Act and its exemptions for bank maintained CTFs and CIFs. As a result, subject to certain limits, thrifts should be able to establish CTFs and CIFs. However, the Act does not change the definition of "bank" for purposes of the Exchange Act or the Advisers Act. Thus, a federal savings bank still generally must register under the Advisers Act if it provides investment advisory services, and also is not exempt from broker-dealer registration. In fact, thrifts generally establish subsidiaries to engage in brokerage activities.