With considerable fanfare, the Securities and Exchange Commission has proposed new bank "pushout" rules under the Securities Exchange Act. These are the rules that implement the Gramm-Leach-Bliley Act's replacement of the broad Exchange Act exemptions from broker-dealer registration for banks with a series of activity-specific exemptions.
The agency suspended its original rules, published in May 2001, after the banking industry, federal and state bank regulators, and some members of Congress complained that they would disrupt a variety of established bank activities. Since then the SEC has reconfigured its bank "dealer" rules, which went into effect last fall, but has struggled to develop a regulatory scheme for bank agency (brokerage) activities that would satisfy its investor-protection concerns in a way that banks and their regulators would accept.
Has the SEC succeeded in this task? Probably not. And it probably cannot, because it is being asked to fulfill its investor-protection responsibilities under the federal securities laws while not unduly disrupting longstanding banking practices. It is being asked to reconcile two competing considerations that might not be reconcilable to everyone's satisfaction.
Before Gramm-Leach-Bliley, banks were widely exempted from broker-dealer regulation. When it was enacted, the SEC conditioned its support for the legislation's new financial institution powers on its right to regulate banking organizations engaged in the securities business.
The banking industry and its regulators knowingly acceded to the SEC's position, with the understanding that the agency's regulation would not disrupt established banking practices.
This concept of "functional regulation" (which dates back to the mid 1980s) was one of the key concepts running throughout GLB and was embraced (in theory) by the banking and securities industries, their regulators, and the politicians as a workable compromise. In this case the compromise was embodied in an elaborate series of Exchange Act exemptions that carved out traditional bank securities activities as well as those involving "traditional bank products" (such as loan and deposit products) from SEC regulation.
Gramm-Leach-Bliley and its legislative history made clear that the SEC now had the right to regulate bank securities activities, but also made plain that the agency was supposed to avoid unnecessarily disrupting traditional bank securities-related activities. Its May 2001 rulemaking efforts, however, ran aground on the general perception that the SEC's rules failed adequately to consider how banks conducted business, and that its interim rules - particularly in the areas of networking services, trust activities, cash management, and custody/safekeeping - were overly technical, complex and would disrupt established banking operations.
The SEC's new rules try to address these concerns, but once again they have created a framework that the banking industry will find unwieldy and costly.
For example, the agency has proposed new "networking" rules that would implement the exemption allowing banks to pay "nominal" referral compensation to unlicensed employees who refer customers to a broker-dealer for securities services. The SEC, however, continues to insist that permissible incentive programs cannot be based on securities sales and should only result in nominal compensation for unlicensed employees ($25 or one hour's base compensation).
To support its position, the agency points to Gramm-Leach-Bliley, which indeed does limit unlicensed employees' compensation to nominal, non-sales-based compensation. The problem is that the new rules will disrupt many established bank incentive compensation programs, which often try to motivate bank employee behavior precisely in ways the SEC says are not permitted under Gramm-Leach-Bliley.
Similarly, the agency has tried to be more accommodating in codifying the GLB exception that lets banks conduct trust operations without broker-dealer registration. The overall difficulty facing the SEC here is that the availability of the bank trust exemption plainly revolves around a principal but undefined condition ("chiefly compensated") that bears only a partial resemblance to current realities in the bank trust business.
In addressing this the SEC has tried to build flexibility and safe harbors for errors into the trust exception rules, but the rules' elaborate requirements for computation of permissible "relationship" compensation, and the multiple record keeping and oversight conditions, again are likely to create substantial inefficiencies and compliance burdens for banks, and complicate existing compensation programs.
These types of issues pervade the new rule proposals' treatment of other established bank activities, including cash management (or "sweep") services, and custody and safekeeping activities. At the same time, the SEC has made some substantial concessions to the banking industry's concerns, so it is not for lack of trying that the agency's efforts may ultimately fall short.
What makes this process so difficult?
Probably the single biggest problem facing the SEC is that bank securities activities have evolved over a long period in an environment where these activities were not subject to SEC oversight, and therefore did not have to take into account and adapt to the substantial and elaborate body of SEC regulatory precepts underlying the federal broker-dealer regulatory scheme.
And while the SEC's most recent efforts reflect much thought, hard work, and willingness to receive input from the banking industry, in the end these efforts are not likely to satisfy bankers who will say - rightfully - that the rules are highly complex and will significantly raise compliance and business costs. Nor will this scheme fully satisfy the SEC, which believes - rightfully - that the Gramm-Leach-Bliley mandate requires the agency to regulate bank securities activities under its statutory mantle of investor protection. It is doubtful that another round of comment letters or meetings with the agency will solve the problems presented by the proposed push-out rules or functional regulation in general.
The end result here will inevitably be a compromise that satisfies no one, but probably is about all that will be possible. In practice, functional regulation has proven more difficult than many expected, and the SEC's proposed push-out rules are just the latest example of this.
