Speech by SEC Commissioner:
The SEC's Role as Functional Regulator of Bank Securities Activities
Cynthia A. Glassman
U.S. Securities and Exchange Commission
June 18, 2004
Thank you, Melanie, for your kind introduction. Melanie Fein is an old friend of mine, so when she asked me to speak, I was happy to oblige. At the outset, let me make the standard disclaimer that the views I express today are my own, and not necessarily the views of the Commission or the staff.
I particularly appreciate the opportunity to speak to you today because I want to set the tone for what is hopefully the final phase of the very important dialogue among the banks, the banking regulators and the SEC regarding the implementation of the "push-out" provisions of the Gramm-Leach-Bliley Act. As you know, the Commission has published a proposed rules package, and the comment period will expire on August 1st. That deadline was set to give our staff sufficient time to analyze all the comments, make changes as appropriate, and get a recommendation to the Commission for action by the beginning of November.
When I joined the Commission in January 2002, Gramm-Leach-Bliley was one of my first assignments. Harvey Pitt, our then chairman, thought that, given my experience on the bank regulatory side, I might be able to help bridge the gap with the banking community and get a positive dialogue going again after the suspension of the Interim Final Rules. Working with the Market Reg staff, we decided to tackle the broker and dealer rules separately and to make the process more inclusive and more interactive.
For both the broker and dealer rule proposals, we held extensive discussions with legal and operational representatives of the banks as well as the banking regulators. Having the benefit of their thinking helped us throughout the process, and I want to thank them - including many of you here - for those efforts. Once preliminary rule proposals were drafted, we again met with the banks and banking regulators, and briefed Congressional staff. That led, in turn, to more fine-tuning of the proposals. When we voted to publish the proposals for comment on June 2nd, each Commissioner, including Chairman Donaldson and myself, specifically welcomed industry input. While we do not look on the comment period as a negotiation, we do believe that the final product can only be better with your continued active participation. I think I speak for all of my fellow commissioners when I say that we will be reviewing your comment letters very closely.
Discussions about Gramm-Leach-Bliley have a tendency to become mired in the complexities of statutory exceptions and regulatory exemptions. I recognize that everyone is interested to know which activities may remain in the bank under the proposed rules and which will need to be "pushed out" to a broker-dealer. But today I would like to turn your focus away from the details and look at some of the policy issues involved in our proposal to implement functional regulation for broker activities. In other words, in interpreting the statutory exceptions under Gramm-Leach-Bliley, why has the Commission proposed to draw the lines the way it has?
At the outset, let me dispel one basic misconception. Much has been made of the differences between banking and securities regulation - how banking regulation focuses on the "safety and soundness" of financial institutions, while securities regulation emphasizes the protection of investors. As someone with experience with both types of regulation, I know there is some truth to this comparison. Overall, however, I do not believe that disagreement over whether banking or securities regulation is the more protective of investors is very helpful. Congress gave the Commission responsibility for implementing the "push-out" provisions because it wanted to ensure that -- no matter which intermediary they use to purchase or sell securities -- investors get the same basic protections. So what investor protections did Congress have in mind?
Under the federal securities regulatory scheme, investor protection starts with the registration of the broker-dealers that sell securities and the people they employ to do the selling. Before it can engage in a securities business, a broker-dealer must become registered with the Commission, become a member of a self-regulatory organization ("SRO") such as the NASD or the New York Stock Exchange, and get licensed in the states in which it plans to conduct business. It must meet the initial and ongoing financial criteria and reporting requirements specified in rules under the Securities Exchange Act of 1934, disclose its principal officers and their disciplinary history, if any, provide information about its business and control relationships, and maintain and enforce compliance and supervisory procedures.
The salespeople who represent the broker-dealer in dealings with the public must also be registered with an SRO and the appropriate states. This involves taking securities exams and keeping up with continuing education requirements. Persons who have been enjoined or convicted of a securities-related offense or been barred by a securities regulatory authority may not work for a broker-dealer unless and until the broker-dealer's SRO and, in some cases, the Commission, has considered the past circumstances and determined that current supervisory controls are adequate to prevent future misconduct.
Once broker-dealers and their associated persons are appropriately registered, they become subject to a comprehensive body of federal, state and SRO rules and regulations. The core provisions of the federal securities laws make it unlawful for anyone to commit fraudulent or deceptive acts in connection with the purchase or sale of securities. The Commission's examinations and inspections of registered persons, along with its enforcement proceedings, give teeth to this statutory prohibition. Moreover, the securities laws impose liability on supervisors for failing to supervise the securities activities of their salespersons and on controlling persons for the securities law violations of persons they control. This also strengthens the federal laws' substantive investor protections.
Of course, federal requirements evolve as market practices and problems evolve. Under SEC Rule 10b-10, for example, broker-dealers must provide their customers confirmations disclosing such trade-specific information as the securities bought or sold, the price paid or received, and whether the broker-dealers received certain types of additional compensation. In light of the mutual fund scandals and evolving arrangements between mutual funds and broker-dealers, including revenue-sharing, the Commission recently proposed to expand confirmation disclosures to include information highlighting distribution-related costs and the conflicts that may arise when mutual funds pay brokers to sell their funds. Under the proposal, related disclosures would also have to be made at the point of sale. Since some funds pay more than others to get on brokers' recommended lists, a broker may have a financial incentive to recommend one fund over another - separate and apart from whether the recommendation is made in the best interests of the investor. The Commission's proposal is intended to help investors better understand the incentives, so they can take them into account in making investment decisions.
So far I've been talking primarily about SEC requirements. However, as you know, the SROs are also an integral part of the federal securities regulatory framework. Not only do NASD and NYSE rules make it a violation to engage in fraudulent activity, but they also require broker-dealers and their associated persons to adhere to ethical standards and just and equitable principles of trade. SRO rules govern the truthfulness of advertising, sales literature and other communications with customers; they prohibit excessive commissions and unfair mark-ups on transactions with customers; they impose suitability and disclosure requirements; and they impose supervisory requirements on broker-dealers and their principals and supervisors.
Of course, the states play an important role in overseeing broker-dealers too. States have registration and licensing requirements, and they carry out rigorous examination and enforcement programs. They're the "local cops on the beat."
While the SEC, the SROs and state securities regulators strive to ensure that securities markets are fair and free of fraud and deceit, there can always be problems. Investors aggrieved by the actions of their brokers may seek redress through the SRO arbitration process overseen by the Commission. In the event of a broker-dealer bankruptcy, customers of the broker-dealer may be entitled to recover cash and securities held with the broker-dealer from the Securities Investor Protection Corporation.
Viewed as a whole, the federal securities regulatory framework provides a comprehensive body of investor protections. In adopting Gramm-Leach-Bliley and a system of functional regulation, Congress sought to make these protections available to purchasers and sellers of securities, regardless of whether they effect transactions through a bank or a broker-dealer. At the same time, Congress crafted exceptions for many types of existing bank securities activity, implicitly recognizing the investor protections available to bank customers in these specific areas. The exceptions cover situations in which the bank is acting as agent, is dealing with particular securities products or has satisfied certain statutory conditions.
By including the push-out provisions of the Gramm-Leach-Bliley Act in the Exchange Act, Congress gave the SEC the primary role in implementing its vision of functional regulation. The staff approached this monumental task by analyzing the provisions of the law and making a determination of whether the law permitted particular activities to remain in the bank. Input from the banking industry permitted the staff to draw lines to separate the securities activity that is appropriate to remain in the bank from securities activity that needs to be "pushed out" of the bank and "pushed into" a broker-dealer.
In the trust and fiduciary area, for example, the staff looked at the variety of accounts handled by a trust department and how the bank was compensated for its services. Obviously, bank trust departments generally operate in accordance with fiduciary principles, which impose an affirmative duty to act in the best interests of the client and to make full and fair disclosure of all material facts. Trust departments must also comply with the terms of the trust agreement that creates the fiduciary relationship.
In some cases, however, accounts in the trust department have characteristics similar to those of a non-discretionary, and therefore, non-fiduciary, brokerage account. For example, banks receive compensation for their trust customers' mutual fund transactions through Rule 12b-1 distribution fees paid by the fund, and not received from the customer, beneficiary or the assets of the trust or fiduciary account. As we know from regulating both mutual funds and the brokerage industry, Rule 12b-1 fees vary in amount from fund to fund, and carry the potential to create conflicts of interest between the recipients (whether bank or broker-dealer) and the customer. Revenue-sharing arrangements under which mutual funds pay broker-dealers and bank trust departments to sell their funds also raise conflicts of interest between the broker or bank representative and the customer.
The Interim Final Rules characterized Rule 12b-1 fees as sales compensation and interpreted the requirement that a bank be "chiefly compensated" by relationship, as opposed to sales, compensation on an "account-by-account" basis. The proposed rules provide alternatives to the account-by-account calculation that are intended to make it less burdensome for banks to comply. We expect commenters to tell us whether they find the proposed rules more workable. We think they are, especially in view of the proposed exclusion of personal trusts and employee benefit accounts from the computation and the expansion of sales compensation to include non-securities management fees, but we want to hear from you. We have also asked for comment on whether there are other approaches that achieve our objectives in a less burdensome way.
In examining bank sweep activities, the staff noted the pervasiveness of compensation for sweep account services through Rule 12b-1 fees, some of which exceed minimal levels. In recognition of the meaning the term "no load" has to investors and to the mutual fund industry, the Interim Final Rules defined the term "no load" mutual fund to exclude a fund paying in excess of a minimal amount even where there is no front-end or deferred sales charges. The proposed rules do not alter this definition. However, they do include a new exemption that would permit banks to provide cash management services in money market funds that are not "no load" funds for certain customers, including qualified investors.
Turning to the custody area, the staff noted that bank custody departments operate on the basis of contractual relationships with customers and are not subject to the same fiduciary obligations as a trustee. Banks have traditionally accommodated their customers by accepting orders on an occasional basis, and they must comply with recordkeeping and confirmation requirements. The Interim Final Rules took the position that order-taking was a core broker-dealer function beyond the scope of the custody exemption. The current proposal retains this view, but modifies two custody exemptions. Most important, the small bank custody exemption has been expanded to include, with relatively few limitations, banks with up to $500 million in assets. This expanded exemption should cover a significant number of small banks serving many communities.
I have mentioned only a few of the statutory exceptions that required SEC interpretation, but the pattern should be clear. Separating out securities activity from existing banking business has been very difficult, especially with the dual goals of not unduly disrupting traditional bank business while maintaining investor protections. The factors we have considered include: the nature of the customer relationship, whether fiduciary or contractual, the type of compensation received for services to the customer, the potential for conflicts of interest, the disclosures made about these conflicts of interest, and the benefits of other regulatory requirements applicable to securities activities conducted through a registered broker-dealer.
At the same time, we continue to try to deal with banks' compliance burden concerns, and this is where we could use your help. In formulating the broker proposals, the staff has talked to people at banks who run the employee benefit programs, people at banks that sell securities to non-U.S., offshore investors, and people at banks who run escrow and indenture trustee businesses. As a result, the proposal includes exemptions for transactions with certain employee benefit plans, transactions in money-market funds that wouldn't qualify as "no-load," and transactions in non-U.S. registered securities sold to non-U.S. persons. The staff couldn't have drafted - nor could we have proposed -- any of these exemptions without input from you. So I'm here again - one last time -- to ask you to help us help you.
The Commission received few comments from those outside the banking industry on the Interim Final Rules, but we did receive a few comments from investors and their advocates. We welcome additional comments from investors on the new proposals. Investors' input would be very valuable to us.
Once the rules on the "push-out" provisions are adopted and take effect, the bank regulators will pick up the ball and draft recordkeeping requirements to demonstrate compliance with the exemptions, in consultation with the Commission. The NASD and the Commission will continue to be responsible for overseeing the activities that the banks "push out" to broker-dealers. It is the bank examiners who will be in a position to monitor the banks' day-to-day compliance with some of most controversial elements of the rules, including the "chiefly compensated" test, as adopted. The Commission will continue to have a role from time to time when it conducts inspections of broker-dealers with networking relationships or when enforcement action is warranted.
In conclusion, I want to underscore that we are all in this together. Gramm-Leach-Bliley has altered the regulatory landscape where the securities and banking worlds overlap. Change is never easy, and the process of implementing this statute has proved no exception. Yes, it has taken us a long time to come up with what I hope is a more workable proposal. But I think we have all needed time to come to terms with the certainty that the Commission is going to adopt rules to implement the "push-out" provisions.
I have no doubt that there are other ways the lines could have been drawn, and the Commission may ultimately drawn the lines differently. But the staff has worked hard to draft the proposed rules and rule amendments in a manner designed to carry out the intent of the statute. The Commission has issued them for comment, and commenters will have their say in the next few months. In the end, the Commission will decide how to proceed with the final rules. Once the rules are adopted, however, it is my hope that the securities and banking communities will continue to collaborate to make functional regulation a reality and to strengthen investor protection.