TESTIMONY OF ARTHUR LEVITT, CHAIRMAN U.S. SECURITIES AND EXCHANGE COMMISSION CONCERNING THE "FINANCIAL SERVICES COMPETITIVENESS ACT OF 1995" AND RELATED ISSUES BEFORE THE COMMITTEE ON BANKING AND FINANCIAL SERVICES U.S. HOUSE OF REPRESENTATIVES MARCH 15, 1995 Chairman Leach and Members of the Committee: I appreciate this opportunity to testify on behalf of the Securities and Exchange Commission regarding H.R. 18, the "Financial Services Competitiveness Act of 1995," introduced earlier this year by Chairman Leach.-[1]- I would like to thank you, Mr. Chairman, for holding these hearings and initiating the present dialogue on Glass-Steagall reform and financial services modernization. The Commission supports the principal purpose of H.R. 18, which is to permit banks to participate more fully in the securities business through affiliated companies. Glass-Steagall reform would provide banks with greater flexibility and new avenues for innovation. By bringing new bank competition to the market for securities services and products, Glass-Steagall reform could also benefit consumers and the financial markets as a whole. The Commission would welcome these developments. Much of the debate on Glass-Steagall reform and financial services modernization to date has focused on these bank-related issues. This is understandable. The special role of banks in the U.S. economy, the important safety and soundness issues linked to the solvency of the federal deposit insurance safety net, and the competitive benefits Glass-Steagall reform will bring to the banking industry, are all important issues that deserve serious consideration. As Congress considers how, and to what extent, to permit affiliations between the banking and securities industry, it is important also to remember that Congress' actions in this area will likely have a profound effect on investors and the securities markets generally, as well as banks. As the debate on Glass-Steagall reform moves forward, the Commission urges the Committee to keep in mind two important principles: First, the investors' perspective must be maintained. Investors benefit from a wide array of financial products and providers. Investors benefit more when they can be assured of -------- FOOTNOTES -------- -[1]- H.R. 18 was revised and reintroduced as H.R. 1062 on February 27, 1995. We refer to the revised bill as H.R. 18 for the purpose of this testimony. -------------------- BEGINNING OF PAGE #2 ------------------- the integrity of markets and when they can be assured they will receive a high level of investor protection. The Commission therefore urges Congress to make investor protection as much of a priority as bank safety and soundness. Second, the vitality of our capital markets must be preserved. The U.S. capital markets are the deepest, most liquid, and strongest in the world. In 1994 alone these markets raised $1 trillion in capital for companies, to support new industries and create new jobs. This capital was raised directly from private investors, without the benefit of federal deposit insurance. As Congress weighs expanding bank securities powers, it must be careful not to impose bank-style "safety and soundness" requirements or constraints on the securities markets that could impair their continued success. The Commission is pleased that H.R. 18 takes steps to address these issues. Specifically, the bill contains provisions that would enhance investor protection by promoting functional regulation of bank securities activities. The Commission strongly supports the principle of functional regulation; we have long maintained that Glass-Steagall reform must be accompanied by reforms to bring bank securities activities within the securities regulatory scheme. Such an approach would ensure that the securities and banking activities of all market participants -- regardless of the structure in which they are conducted -- would be subject to a single set of standards, consistently applied by one expert regulator. In addition, H.R. 18 contains important provisions that would facilitate regulatory coordination and information-sharing. These provisions recognize and build on the concept of functional regulation, and are intended to promote efficient regulation that does not unduly burden the operation of our capital markets. The Commission strongly supports the thrust of these provisions. However, we believe that additional attention to these areas is warranted. In particular, the Commission has concerns regarding the numerous exceptions in H.R. 18's functional regulation provisions, which would allow banks to engage in significant securities activities outside the securities regulatory scheme. Likewise, more can be done to clarify and strengthen the provisions aimed at achieving what FDIC Chairman Ricki Tigert Helfer described as "seamless" regulatory co-ordination.-[2]- The Commission fully appreciates the difficulty of the Committee's task. In reforming Glass-Steagall, the goals of safeguarding bank safety and soundness and maintaining a fair and competitive securities market must be harmonized. The Commission is convinced that adoption of a strong system of functional -------- FOOTNOTES -------- -[2]- Testimony of Ricki Tigert Helfer, Chairman, Federal Deposit Insurance Corporation ("FDIC"), on the "Financial Services Competitiveness Act of 1995" and Related Issues Before the House Committee on Banking and Financial Services, Feb. 28, 1995, at 11. -------------------- BEGINNING OF PAGE #3 ------------------- regulation will make it easier to strike the appropriate balance. Finally, the Commission recognizes that Glass-Steagall reform raises many other complex, related questions, such as how to provide a "two-way street" for securities firms that wish to acquire banks. The Commission believes that in order to preserve the vitality and fairness of our markets, financial reform must provide equal opportunities for all market participants. The Commission is pleased to assist the Committee as it considers this and other important issues, and looks forward to working with the Committee toward our shared goals. The remainder of this statement provides background information on the existing regulatory structure for bank securities activities and discusses functional regulation, the "two-way street," and related issues. More detailed comments on the securities-related provisions contained in H.R. 18 are set forth in the appendix to this testimony. I. The Existing Regulatory Structure and the Need for Regulatory Reform A. Background and recent market developments Before enactment of the Glass-Steagall Act, some sixty years ago, U.S. banks were significant participants in the nation's capital markets. Indeed, by 1930, bank affiliates were sponsoring over 50 percent of all new securities issues, and 41 percent of all commercial bank assets were invested in securities or securities-related loans.-[3]- Bank involvement in the securities markets came under close scrutiny after the 1929 market crash. The Pecora hearings of 1933, which focused on the causes of the crash and the subsequent banking crisis, uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest;-[4]- the underwriting of unsound securities in order to pay off bad bank loans; and "pool operations" to support the price of bank stocks. Revelations about these and other abuses reinforced concerns about the role that banks had played in the speculative fever of -------- FOOTNOTES -------- -[3]- See Susan E. Kennedy, The Banking Crisis of 1933 212 (1973); Donald Langevoort, Statutory Obsolescence and the Judicial Process: The Revisionist Role of the Courts in Federal Banking Regulation, 85 Mich. L. Rev. 672, 694 (1987). Banks and bank affiliates by 1930 also claimed a 61 percent market share of new bond issue participations. See Edwin Perkins, The Divorce of Commercial and Investment Banking, 88 Banking L. J. 483, 495, 527 (1971). -[4]- Congress was concerned, for example, about the use of bank loans to support bank affiliates and affiliate- underwritten securities, and about bank incentives (in giving investment advice) to promote affiliate- underwritten securities. -------------------- BEGINNING OF PAGE #4 ------------------- the 1920s. The hearing record also compounded fears that the securities activities of bank affiliates threatened bank safety and soundness. Ultimately, strong public reaction to the hearings prompted the enactment of the Glass-Steagall Act and the separation of commercial from investment banking.-[5]- At the same time, banks were excluded from the regulatory scheme enacted for securities brokers and dealers, based in large part on the assumption that the Glass-Steagall Act barred banks from engaging in most securities activities.-[6]- Much has changed in the six decades that have passed since the enactment of the Glass-Steagall Act. Economic expansion, new technologies, and innovative financial products have resulted in the striking growth of the U.S. capital markets. The $1 trillion raised in the U.S. capital markets in 1994 represents more than a 1500-fold increase over the $641 million raised in 1934. Regulatory changes, meanwhile, have allowed banks to play an ever-larger part in those capital markets. Over the last two decades, through expansive banking agency interpretations, banks have gained entry into a wide range of securities activities that were once thought to be foreclosed by the Glass-Steagall Act.-[7]- To offer just a few examples: -------- FOOTNOTES -------- -[5]- There is a broad spectrum of views on the degree to which the Glass-Steagall Act actually responded to the causes of the banking crash. See, e.g., ICI v. Camp, 401 U.S. 617 (1971) (Act was intended to protect bank safety and soundness by preventing abuses of securities affiliates); Langevoort, supra note 3 (Act reflects then-orthodox banking theory that banks should concentrate on commercial lending, combined with a need to respond to the public outcry that followed the Pecora hearings); William Isaac and Melanie Fein, Facing the Future -- Life Without Glass-Steagall, 37 Cath. U. L. Rev. 281 (1988) (no link was ever shown between securities activities and collapse of banking system; Act responded to public outcry rather than hard evidence). -[6]- See Stock Exchange Regulation: Hearings on H.R. 7852 and H.R. 8720 Before the House Comm. on Interstate and Foreign Commerce, 73d Cong., 2d Sess. 86 (Feb. 16, 1934) (statement of Thomas G. Corcoran, an administration spokesman and a principal drafter of the Securities Exchange Act of 1934). Later, the Investment Advisers Act of 1940 also excluded banks and bank holding companies from regulation as investment advisers. -[7]- At the same time, securities firms have entered into some aspects of the banking business. For example, recent reports state that Goldman, Sachs & Co. will join with four commercial banks in underwriting a $1.5 billion bank loan in connection with the acquisition of Santa Fe Pacific Corp. by Burlington Northern Inc. See S. Lipin, Goldman Sachs, Taking Unusual Role, Joins Bank Loan for Santa Fe Takeover, Wall St. J., Feb. 3, 1995, at A4. -------------------- BEGINNING OF PAGE #5 ------------------- * in 1994, 119 banks provided investment advice or other services to over $312 billion in mutual fund assets (representing approximately 15% of total mutual fund assets);-[8]- * in 1994, over 1800 banking firms sold mutual funds to their customers;-[9]- * as of January 1995, the Federal Reserve had authorized 36 bank holding companies to operate so-called "Section 20" underwriting affiliates;-[10]- * in the third quarter of 1994, the assets of Section 20 affiliates accounted for 16.6% of the assets of all broker- dealers doing a public business.-[11]- The statutory framework for bank securities activities has not evolved to keep pace with the dramatic changes that have taken place in U.S. financial markets in recent years.-[12]- On the one hand, the Glass-Steagall Act continues to limit the scope of permissible bank activities. On the other hand, the outdated bank exclusions still contained in the federal securities laws allow banks to conduct a wide range of securities activities outside the regulatory scheme established for all other broker- dealers and investment advisers. Clearly, the time has come to modernize the existing regulatory structure for banks. At the same time, it must be recognized that entry into the securities business involves its -------- FOOTNOTES -------- -[8]- See Lipper Bank-Related Fund Analysis (4th Quarter 1994). Commission records indicate that banks advise approximately 35% of all open-end fund portfolios (total: 4,899) or approximately 8% of all investment company portfolios (total, including closed-end funds and unit investment trusts: 27,764). -[9]- See Michelle Clark, Call Reports Show Surprisingly Few Banks Selling Funds, American Banker, Aug. 25, 1994, at 12. -[10]- Sixteen of these affiliates had received approval to underwrite both corporate debt and equity issues. -[11]- Section 20 affiliates also accounted for 7.7% of the total capital and equity capital, for 12.1% of total revenues, and for 15.6% of total proprietary trading. -[12]- Certain statutory changes have, however, addressed some of the problems identified in the Pecora hearings. For example, Federal Reserve Act sections 23A and 23B limit and set standards for transactions between banks and their affiliates. Moreover, the federal securities laws address the problem of inadequate disclosure, prohibit insider abuses and other forms of securities fraud, and provide for federal market oversight. -------------------- BEGINNING OF PAGE #6 ------------------- own risks.-[13]- Indeed, risk-taking is fundamental to the securities business.-[14]- Congress, therefore, in considering Glass-Steagall reform, will have to strike a careful balance between protecting bank safety and soundness and permitting the risk-taking that is central to capital markets activities. Banking regulation has traditionally limited bank risk-taking, in the interests of bank safety and soundness. But securities firms, and the securities markets generally, specialize in entrepreneurial and risk-taking activities.-[15]- Sometimes they misjudge: securities firms may have "bad years" (as in 1994) and may even fail. Nonetheless, it is through taking on market risks that securities firms are able to serve as a powerful engine for U.S. capital formation. B. Current regulation of bank securities activities Before turning to a discussion of how the existing regulatory structure should be reformed, it is important to review the current framework for bank securities activities and some of the more significant disparities that exist with respect to bank broker-dealer and investment adviser activities. -------- FOOTNOTES -------- -[13]- Lending and other banking activities, of course, also involve risk. See Testimony of FDIC Chairman Tigert, supra note 2, at 3-4. -[14]- Markets are by nature volatile; they go down as well as up. Thus, while 1993 was generally a profitable year for securities firms, 1994 was labelled "Wall Street's worst business environment in years." Salomon Inc, CS First Boston Co., Goldman Sachs, and J.P. Morgan & Co. (for example) suffered lower earnings or losses and subsequently announced layoffs and other cost-cutting measures. See Red Braces, Pink Slips, The Economist, Feb. 18, 1995, at 73. Only last month J.P. Morgan (the first banking firm approved to engage in corporate debt and equities underwriting through a Section 20 affiliate) lost its long-standing triple-A rating from Moody's Investors Service, Inc., due in large part to concerns regarding J.P. Morgan's move away from commercial banking and into investment banking. See S. Kleege, Moody's Lowers Rating for Morgan, Citing Focus on Investment Banking, Am. Banker, Feb. 15, 1995, at 24. -[15]- For this reason, securities regulation does not seek completely to insulate securities firms from the risks they incur in their business activities. Instead, the regulatory framework seeks to protect investors and maintain fair and orderly markets by imposing financial responsibility, training and competency, supervision, disclosure, antifraud and other requirements on securities firms. Within these parameters, risk-taking is largely left to market control, not to governmental management. -------------------- BEGINNING OF PAGE #7 ------------------- Today, banks engage directly-[16]- in a wide range of broker-dealer and investment advisory activities that are comparable to, and competitive with, the services of registered securities firms and investment advisers. They generally do so, however, outside the regulatory framework established under the federal securities laws.-[17]- Banking regulation -- which does apply to bank securities activities -- has not traditionally focused on investor protection and the maintenance of fair and orderly markets. The banking agencies are charged with protecting the viability of banking institutions, as well as the solvency of the federal deposit insurance system. In contrast, the Commission has as its focus disclosure, market discipline, and enforcement, with an overall mandate to protect investors and maintain fair and orderly securities markets. These different philosophical approaches affect the ways in which regulation and enforcement are undertaken.-[18]- Bank broker-dealer activities. Banks that engage directly in securities activities are excluded from the definitions of "broker" and "dealer" in the Exchange Act and are therefore exempt from broker-dealer regulation under the federal securities laws. Their activities are subject only to federal banking law and the antifraud provisions of the federal securities laws. Federal banking laws -------- FOOTNOTES -------- -[16]- Banks also may choose to engage in securities activities through a number of indirect routes. For example, a bank may conduct its sales or investment advisory activities through subsidiaries or affiliates registered with the Commission. This section of the Commission's testimony, however, focuses on the direct securities activities of banks. Such activities -- though subject to the antifraud provisions of the federal securities laws -- take place outside the federal regulatory scheme for securities activities. -[17]- The unique treatment afforded bank securities activities stands in contrast to the regulatory schemes for bank transfer agents and bank municipal and government securities activities, which are regulated under the federal securities laws. -[18]- For a discussion of the differences in philosophy and specific requirements between banking and securities regulation, see Testimony of Chairman Arthur Levitt Before the Subcommittee on Telecommunications and Finance of the House Energy and Commerce Committee Concerning H.R. 3447 and Related Functional Regulation Issues (April 14, 1994) at 2. For a detailed, side- by-side comparison of banking and securities laws and regulations, see Proposed Mellon-Dreyfus Merger: Hearings Before the Subcomm. on Oversight and Investigations of the House Comm. on Energy and Commerce, 103d Cong., 2d Sess. 906-72 (1994). -------------------- BEGINNING OF PAGE #8 ------------------- and regulations, however, do not specifically address important aspects of bank brokerage activities.-[19]- For example: * Banking regulations do not require banks to register or provide information regarding their securities activities, nor do they impose special financial responsibility requirements as a condition of engaging in direct securities activities. * Banking regulations do not establish specific qualification and continuing education requirements for bank securities salespersons. * Federal banking law does not provide for the statutory disqualification of bank securities salespersons with disciplinary histories. * The federal banking statutes and regulations do not comprehensively address sales practice issues, nor do they impose an explicit duty to supervise bank securities sales personnel. Finally, bank securities customers have no formal avenue of redress for complaints, and the federal banking laws do not generally contain private rights of action for investors.-[20]- Over the last two years, the federal banking agencies have issued guidelines and a subsequent Interagency Statement-[21]- designed to supplement their securities regulatory programs. While these guidelines represent an important forward step, they do not create a comprehensive securities regulatory scheme for banks. As "guidelines" rather than regulations, they are advisory rather than legally binding, and may not be legally enforceable by the bank regulators or by bank customers. Furthermore, the guidelines do not establish precise standards of conduct; banks are given wide latitude to establish procedures and policies to implement them. The guidelines, moreover, raise potential problems of regulatory overlap insofar as they apply to registered broker- -------- FOOTNOTES -------- -[19]- The federal banking laws do, however, contain limited recordkeeping and confirmation requirements relating to bank securities transactions. See, e.g., 12 C.F.R. 12.1-12.7, 12 C.F.R. 344.1-344.7, and 12 C.F.R. 208.8(k). -[20]- See, e.g., In re Fidelity Bank Trust Fee Litigation, 839 F. Supp. 318 (E.D. Pa. 1993); In re Corestates Trust Fee Litigation, 837 F. Supp. 104 (E.D. Pa. 1993). -[21]- See Board of Governors of the Federal Reserve System ("Federal Reserve Board"), FDIC, OCC, and Office of Thrift Supervision, "Interagency Statement on Retail Sales of Nondeposit Investment Products" (Feb. 15, 1994) (the "Interagency Statement"). -------------------- BEGINNING OF PAGE #9 ------------------- dealers that are affiliated or have contracts with banks for the sale of securities.-[22]- Since broker-dealers are already subject to comprehensive Commission and self-regulatory organization ("SRO") regulation under the federal securities laws, imposing an additional layer of banking regulator oversight and examinations is unnecessary. Bank investment adviser activities. A separate set of problems exists with respect to the regulation of banks that advise registered investment companies ("funds"). Banks are excluded from Commission oversight under the Advisers Act (although bank advisory relationships with funds are subject to the Investment Company Act of 1940). Because bank advisers are not required to register with the Commission as investment advisers, Commission examiners may not have access to all the books and records normally available when the adviser is registered.-[23]- In addition, banks are not subject to a number of substantive requirements applicable to other investment advisers, including regulation of performance fees, procedures to prevent misuse of non-public information, and the Advisers Act anti-fraud provisions. In other respects, bank-advised funds (like bank-affiliated broker-dealers) face the problem of overlapping regulation. Some of the banking agencies have recently indicated that they may expand their role to include oversight of funds advised by banks.-[24]- This move is likely to create new problems in the form of duplicative and potentially conflicting regulation, as bank-advised funds become subject to multiple regulators. As one commentator has noted, "we are heading toward a world of five federal mutual fund regulators -- the SEC and the four federal banking agencies."-[25]- II. The Case for Functional Regulation The existing regulatory framework for bank securities activities -- containing both gaps and redundancies -- plainly needs to be restructured. Investor protection must be made a priority, and the regulatory system must be made more efficient and more rational. The adoption of functional regulation, in our view, is necessary to achieve the following important objectives: -------- FOOTNOTES -------- -[22]- The OCC, for example, has recently begun to examine registered broker-dealers that sell securities in association with national banks. -[23]- Commission records indicate that approximately 61% of bank-affiliated investment companies are managed by investment advisers not subject to full Commission oversight. -[24]- See, e.g., S. Prakash, "Comptroller Drafts Guidelines for Mutual Fund Activities," American Banker, July 1, 1994, at 12. -[25]- M. Fink, "SEC Needs a Strong Hand in Regulating Funds," American Banker, March 31, 1994, at 13. -------------------- BEGINNING OF PAGE #10 ------------------- Investor protection. Functional regulation of bank securities activities would further investor protection by subjecting all securities activities to a single set of standards, consistently applied by one expert regulator -- in marked contrast to the fragmented system currently in place. Banks and broker-dealers alike would be subject to the same requirements with respect to training, supervision, sales practices, financial responsibility, and other important matters. Banks that advise investment companies, like all other registered investment advisers, would be fully subject to oversight and other requirements designed to guard against conflicts of interest. The Commission strongly believes that Congress should make these changes to close existing gaps in investor protection, whether or not broader Glass-Steagall reform is adopted. Elimination of duplicative regulation. Under existing law, bank-affiliated securities firms and investment companies must comply with overlapping and potentially inconsistent regulatory requirements. This duplication confuses the industry, imposes unnecessary costs, impairs industry competitiveness, and wastes scarce government resources. Replacement of the existing regulatory scheme with a system of functional regulation should relieve financial services providers (and the markets as a whole) from many of the burdens of duplicative regulation. Of course, with financial services reform and the expansion of bank securities activities, there will be an ever-greater need for cooperation among regulators.-[26]- III. Two-Way Street and Other Issues In addition to the issue of functional regulation, Glass- Steagall reform must address the need to provide for a meaningful "two-way street," whether to retain some form of consolidated regulation at the holding company level, and whether to relax the strict separation of banking and commerce. These are admittedly difficult issues. The Commission would like to take this opportunity to add its views to the current debate on this subject, as well as on related issues involving the structure of bank affiliations with securities firms. Subsidiaries vs. affiliates. -------- FOOTNOTES -------- -[26]- The Commission and its banking agency counterparts have already taken a number of steps toward improved regulatory coordination. For instance, Commission and OCC staff have held discussions on the subjects of (1) joint inspections of banks and their affiliated mutual funds, and (2) coordination of enforcement actions. The Commission is optimistic that this and similar initiatives will result in better working relationships. However, these steps will not correct the underlying flaws in the existing regulatory structure. -------------------- BEGINNING OF PAGE #11 ------------------- A threshold matter that is the subject of current debate is how bank affiliations with securities firms should be structured. Some have argued that banks should be free to choose between a subsidiary and a bank holding company affiliate structure. Others believe that banks, and ultimately the bank insurance fund, would be better protected if their securities activities were undertaken in bank holding company affiliates rather than bank subsidiaries. From a functional regulation perspective, use of either structure is preferable to directly conducting securities activities in a bank. The Commission does, however, prefer the affiliate structure.-[27]- In our view, it offers a greater separation and creates sharper distinctions between the bank and any related securities firm.-[28]- A clear separation between banking and securities functions guards against confusion, and makes it easier to build and enforce strong firewalls. Use of affiliates rather than subsidiaries also serves to limit the potential for conflicts of interest, such as abusive affiliate transactions.-[29]- Finally, the Commission generally has had a positive experience regulating Section 20 broker-dealer affiliates in the context of a larger holding company structure. "Two-way street." Nevertheless, as a general matter, the Commission believes that for financial modernization reform to be truly effective, it must allow for vigorous competition between all market participants. A meaningful "two-way" street must provide equal -------- FOOTNOTES -------- -[27]- In this regard, Commissioner Wallman believes that the Commission should have no preference as to whether the appropriate structure should be a subsidiary, affiliate, or some other structure. Federal regulatory agencies should apply the same set of rules to the same activity engaged in by any entity regardless of its particular form. Thus, in his view, if Congress 1) limited overlapping regulation by the banking and securities regulators and 2) ensured through a system of strong functional regulation that the Commission had appropriate authority to regulate the securities activities engaged in by banks and their related entities, the form of entity -- provided it was separate from the bank -- should be irrelevant to the Commission. -[28]- See Commission Testimony Concerning S. 543 and S. 713 Before the Senate Committee on Banking, Housing and Urban Affairs, May 7, 1991, at 22. -[29]- For example, at present, transactions between a bank and its affiliates are subject to restrictions contained in Sections 23A and 23B of the Federal Reserve Act; transactions between a bank and its subsidiaries, however, are not governed by those restrictions. -------------------- BEGINNING OF PAGE #12 ------------------- opportunities for market participation to banks and securities firms alike. Competition, moreover, should occur on the basis of market performance, not differential regulation. Within the context of the existing regulatory structure, repeal of the Glass-Steagall Act would allow banking organizations to acquire securities firms, but would not necessarily enable securities firms to acquire banks. A securities firm that sought to acquire even a small bank would have to submit to comprehensive regulation by the Federal Reserve as a holding company. Accordingly, those securities firms that could acquire banks (i.e., those unaffiliated with commercial entities) would have to accept a radical change in their regulatory supervision in order to do so. At a minimum, this would result in significant new regulatory costs. In expanding bank securities powers, Congress therefore needs to decide how to give securities firms a meaningful opportunity to enter into the banking business. This requires a more focused approach to bank safety and soundness than bringing all affiliates within the existing framework of consolidated bank-style regulation. Consolidated "umbrella" regulation. The term "umbrella" regulation refers to the type of consolidated holding company regulation that currently exists under the Bank Holding Company Act. Among other things, that model requires regulatory approvals before affiliates may enter a new line of business, as well as comprehensive supervision of the holding company and all of its affiliates. The Commission recognizes that bank affiliations with securities firms may raise bank safety and soundness issues (and, ultimately, issues related to protection of the deposit insurance fund). However, it would be misguided to seek to control these risks by imposing an overlay of bank-type "safety and soundness" regulation on nonbank affiliates -- as consolidated bank holding company regulation currently does. In particular, this approach is not well-suited for companies that seek to compete vigorously in new lines of business and fast-moving markets. In lieu of consolidated holding company regulation, the Commission would prefer an approach based on strong functional regulation, effective firewalls, and enhanced regulatory coordination. Under this approach, each entity in the holding company complex would be separately regulated by its expert regulator in accordance with the principle of functional regulation. The federal banking regulators (consistent with their special expertise) would be charged with containing any potential risks to bank safety and soundness that arise as a result of bank affiliations with other entities. The Commission and the SROs, consistent with our statutory mandate and particular expertise, would enforce investor protection and provide market oversight. In this manner, duplicative and potentially inconsistent regulation could be avoided. -------------------- BEGINNING OF PAGE #13 ------------------- In order to address issues of systemic risk, the functional regulator should be able to receive information concerning the activities and exposures of affiliates. This would enable the functional regulator to monitor the risks to which the regulated entity is exposed.-[30]- Thus, a bank regulator would have access to "risk-assessment" information about a securities affiliate or an information technology affiliate.-[31]- Firewalls. The Commission believes that Congress' efforts to protect bank safety and soundness should pay particular attention to the creation of appropriate "firewalls" designed to insulate banks from the risk of their securities affiliates. Although opinions differ regarding the details of the specific firewalls, and whether they should be statutory or discretionary in nature, the Commission believes that most of the parties to the Glass-Steagall debate acknowledge the importance of "firewalls" to protect the banking system and the solvency of the federal deposit insurance system in the context of Glass-Steagall repeal. To the extent that such firewalls are predicated on bank safety and soundness concerns, the Commission generally defers to Congress and the banking regulators. Firewalls addressing conflicts of interest and other matters are also important and should be imposed and enforced by -------- FOOTNOTES -------- -[30]- A model for such a system already exists in the federal securities laws. Pursuant to the Market Reform Act of 1990, the Commission adopted rules establishing a risk assessment program that requires broker-dealers to file quarterly reports on their affiliates within a holding company group whose business activities are reasonably likely to have a material impact on the financial and operational condition of the broker-dealer. Under the Commission's risk assessment rules, the Commission receives essentially the same information that an affiliated bank holding company of a registered broker- dealer is required to file with the Federal Reserve Board. We view the information gathered under the risk assessment program as a significant complement to the Commission's existing broker-dealer authority. -[31]- Another approach that merits consideration would build on the concept of a "broker-dealer holding company." Under this approach, the Commission would serve as the holding company regulator for firms whose aggregate revenues come primarily from the activities of securities subsidiaries -- even if those firms also control banks. The Commission's regulatory focus would be different from that of the Federal Reserve: the Commission would regulate the broker-dealer holding company according to a risk-assessment approach based on the securities regulatory scheme. A more detailed discussion of this model is set forth in Commission testimony Concerning Financial Services Modernization Before the Senate Committee on Banking, Housing and Urban Affairs, July 19, 1990. -------------------- BEGINNING OF PAGE #14 ------------------- securities, as well as banking, regulators.-[32]- For example, firewalls aimed at protecting broker-dealer capital would help ensure that bank-affiliated broker-dealers can meet their financial responsibility to customers. Other firewalls could protect investors against underwriting abuses, such as the use of underwriting proceeds to pay off bank loans. Conflicts of interest between banks and the investment companies they advise deserve particular mention. The Investment Company Act and the Advisers Act address conflicts that can arise when brokerage firms or their affiliates conduct investment company activities; but because the current role of banks in the investment company business was not contemplated when those Acts were adopted, new provisions are needed to address the conflicts that can arise between banks and affiliated investment companies. The Commission is aware of the current debate regarding firewalls, and their potential effects on "synergies" between banks and their affiliates. Without addressing this issue directly, we would simply note that the firewalls contained in the Federal Reserve's Section 20 orders do not appear to have kept Section 20 securities affiliates from competing successfully in the marketplace for securities services.-[33]- Commerce and banking. The issue of commerce and banking directly affects the viability of any "two-way street" proposal. Broker-dealers often are affiliated with insurance companies, and they may also hold equity investments in commercial firms as a result of merchant banking activities. These firms would be unable to take advantage of any "two-way street" if divestiture of such investments is required.-[34]- The Commission appreciates that this is a difficult issue from the banking perspective. Viewed from the securities perspective, however, the Commission has no objections to allowing commercial entities to engage in the securities business. The Commission has had considerable experience recently with the involvement of commercial entities in the securities business, and it has not been problematic for us. The Commission's ability to oversee the registered broker-dealers involved was not impaired and, from time to time, the commercial -------- FOOTNOTES -------- -[32]- In addition, we believe Congress should give consideration to maintaining existing prohibitions on inappropriate tying arrangements. -[33]- See figures cited supra at 6 and fn. 11. -[34]- One possible approach to this problem would be to alter (rather than remove completely) the separation between commerce and banking, so as to allow combinations of banking, insurance, and other financial activities. Under such an approach, it would also be appropriate to provide for regulatory coordination (along the lines discussed above) among banking, securities, and insurance regulators. -------------------- BEGINNING OF PAGE #15 ------------------- parents provided a ready source of capital to their affiliated broker-dealers.-[35]- IV. H.R. 18 H.R. 18 represents a significant contribution to the debate on Glass-Steagall reform and efforts to modernize our financial services regulatory structure. H.R. 18 would amend the Glass- Steagall Act to allow affiliations between banks and securities firms, through a bank holding company structure and subject to "firewalls" intended to protect bank safety and soundness. These affiliated securities firms would have to be separately incorporated and capitalized. The principle of functional regulation would apply to these affiliates: they would be registered with, and regulated by, the Commission just like any other registered broker-dealer.-[36]- H.R. 18 would make many other useful changes in the regulatory framework for bank securities activities. It would further the principle of functional regulation by repealing the blanket exclusion of banks from the definitions of "broker," "dealer," and "investment adviser" under the federal securities laws. It would amend various provisions of the Investment Company Act to take account of growing bank involvement in the fund business. The bill would also amend the Exchange Act to eliminate outdated restrictions on broker-dealer borrowing. Finally, H.R. 18 contains "two-way street" provisions designed to allow securities firms to acquire banks, as well as provisions permitting banks to acquire securities firms. The Commission supports many of the provisions contained in H.R. 18. We do, however, have three broad concerns about the bill. First, we believe investor protection may be undermined by the bill's provisions granting banks extensive exemptions from broker-dealer regulation. Second, we believe that more can and should be done to eliminate regulatory overlap (and potential regulatory conflict) in the oversight and examination of bank- affiliated securities activities. Third, we believe greater attention must be given to creating a regulatory structure that will permit the establishment of a meaningful "two-way street." A. Bank broker-dealer activities H.R. 18 would move toward functional regulation of securities activities by requiring that certain bank securities -------- FOOTNOTES -------- -[35]- For example, prior to its recent sale to Paine Webber, Kidder Peabody, a former registered broker-dealer, was controlled by General Electric. General Electric was instrumental in infusing capital at critical points. Similarly, Prudential Insurance Company of America was an additional source of funding for its securities affiliate, Prudential Securities, Inc. -[36]- H.R. 18 thus essentially ratifies the approach the Federal Reserve has followed since 1987 in approving limited underwriting activities for "Section 20" affiliates of bank holding companies. -------------------- BEGINNING OF PAGE #16 ------------------- activities be conducted in a broker-dealer separate from the bank, and by partially removing the exclusion of banks from the definitions of broker and dealer contained in the federal securities laws. This bank exclusion, as explained above, is a historical vestige from an era when banks were largely precluded from the securities business. The Commission strongly supports removal of the bank exclusion from the broker and dealer definitions. Removal of this exclusion would create a "level playing field" for all market participants, and would ensure that the securities regulatory scheme is consistently applied to all securities transactions, irrespective of how an entity is chartered. The Commission, however, has both general and specific concerns about the thirteen new exemptions that H.R. 18 would create for bank brokerage activities.-[37]- While the Commission does not necessarily object to the specific aims of some of H.R. 18's exemptions,-[38]- the inclusion of the numerous exemptions serves to undermine the principle of functional regulation that H.R. 18 otherwise seeks to promote. These exemptions would continue to split the regulation of functionally equivalent brokerage and dealer activities between the Commission and the bank regulators, and -------- FOOTNOTES -------- -[37]- The bill's thirteen limited exemptions from the definition of "broker" and four limited exemptions from the definition of "dealer" would permit banks to engage in many securities-related activities without being subject to securities regulation. Exemptions from the definition of "broker" are provided for: (i) banks that engage in brokerage activities in connection with "networking arrangements," (ii) certain trust activities, (iii) transactions in exempted and similar securities, including government securities, (iv) transactions in municipal securities, (v) transactions in connection with employee benefit plans, (vi) "sweep" transactions, (vii) affiliate transactions, (viii) private placements, (ix) a de minimis number of transactions, (x) safekeeping and custody services, (xi) clearance and settlement activities, (xii) securities lending, and (xiii) agency transactions involving repurchase agreements. Exemptions from the definition of "dealer" are provided for: banks that engage in transactions involving (i) exempted and similar securities, (ii) municipal securities, (iii) bank and trust department transactions for investment purposes, and (iv) (under limited circumstances) certain categories of asset-backed securities. As discussed in the testimony, the Commission is concerned that these exemptions may create an incentive for securities firms to transfer some of these activities to a bank and away from Commission oversight. -[38]- For example, the networking exclusion is consistent with existing Commission policies -- although incorporation of this exclusion into legislation would deprive the Commission of flexibility it would otherwise have to adapt the exclusion in response to changing circumstances. -------------------- BEGINNING OF PAGE #17 ------------------- would permit banks to conduct a significant volume of securities business outside the regulatory framework established under the federal securities laws. As a result, investors who buy securities through their banks would continue to receive a different standard of protection than other investors. In addition, the Commission is concerned that, as securities firms affiliate with banks, securities activities could "migrate" out of securities firms and into affiliated banks, thereby weakening the protections currently afforded investors.-[39]- In addition to these general concerns, the Commission has specific comments about the nature and scope of some of the exemptions. Those comments are set forth in detail in the appendix to this testimony. To the extent that H.R. 18 seeks to allow banks to continue engaging in traditional banking activities, it would be preferable to rely on Commission exemptive authority (as provided under Section 122 of the bill), rather than devising multiple statutory exclusions for banks. At a minimum, the Commission should be granted authority to impose additional safeguards or to create specifically tailored exemptions in consultation with the appropriate banking regulators to account for the continually evolving financial markets.-[40]- The Commission also could use such authority to adjust the exemptions to address any untoward movement of securities activities out of broker-dealers and into banks.-[41]- -------- FOOTNOTES -------- -[39]- The Commission also notes that it will be difficult to monitor and enforce the proposed exemptions. Although H.R. 18 suggests that monitoring such exemptions is appropriate, the tools to do so are not in place. Specifically, the bill allows, but does not require, bank regulators to obtain information from banks regarding the banks' use of the exemptions. Notably, the bill does not require a copy of such data to be provided to the Commission. [See sec 103 of H.R. 18] -[40]- Such authority would be similar to the authority H.R. 18 proposes to confer on the Federal Reserve, with respect to modification of the statutory "firewalls" provisions. -[41]- Alternatively, in the event the exemptions are retained, they should be revised (1) to prohibit the general solicitation of the securities services involved, and (2) to "expire" upon the affiliation of a bank with a securities firm. These limitations would be consistent with the assumption that underlies the exemptions, i.e., the idea that banks have traditionally provided securities services as an "accommodation to customers," and should be allowed to continue providing such traditional services so long as they are not conducting a general securities business. Notably, a prohibition against general solicitation is already contained in H.R. 18's exemption for bank trust activities, and a built-in "expiration" is included in H.R. 18's exemptions for municipal securities, affiliate transactions, private securities offerings, (continued...) -------------------- BEGINNING OF PAGE #18 ------------------- B. Bank investment advisory activities H.R. 18 would amend the Investment Company Act and the Advisers Act to address a number of issues raised when banks manage and provide other services to registered investment companies. Most importantly, the bill would amend the Advisers Act to remove the exclusion for banks and bank holding companies that provide investment advice to funds. As a result of this amendment, a bank or a holding company that serves as an adviser to a fund would be regulated in the same manner as any other investment adviser to a fund. The Commission strongly supports this change.-[42]- H.R. 18 also would add provisions to the Investment Company Act that are designed to address conflicts of interest and other potential abuses that may exist when banks advise registered investment companies. Because the Investment Company Act and the Advisers Act did not contemplate that banks would be active participants in the fund industry, the statutes do not specifically address these conflicts of interest. The Commission agrees that these statutes should be updated to reflect the greater involvement of banks in the fund business. We believe, however, that the Commission would be better able to address conflicts of interest involving funds and banks if it were given authority to define and deal with those conflicts by rule or order. This authority would allow the Commission to strike a balance between protecting investors from abusive conflict of interest situations and enabling funds to engage in transactions with affiliated banks that could be beneficial to shareholders. This approach would also permit the Commission to avoid time- consuming case-by-case applications for exemptions from outright -------- FOOTNOTES -------- -[41]-(...continued) and de minimis transactions. A built-in expiration would prevent securities firms from transferring dealer activities that are not traditional banking services, such as dealing in structured notes, to the affiliated bank and away from Commission oversight. -[42]- The bill would allow banks to segregate their fund investment advisory activities in a separately identifiable department or division ("SID"), and to register the SID (rather than the bank as a whole) as an investment adviser. The primary benefits of requiring banks and SIDs that advise investment companies to register under the Advisers Act would be the application of the following provisions: (1) the regulation of performance fees under Section 205; (2) the requirement under Section 204A to establish procedures designed to prevent the misuse of non- public information; and (3) the Section 206 anti-fraud provisions, which are somewhat broader than the anti- fraud standards under other applicable securities laws. Registration would also improve the Commission's ability to inspect bank-advised funds by requiring banks and SIDs to provide the Commission with additional information regarding the investment management of these funds. -------------------- BEGINNING OF PAGE #19 ------------------- prohibitions, which could become a drain on Commission resources.-[43]- Finally, H.R. 18 would address the issue of investor confusion by prohibiting funds and their affiliated banks from sharing common names.-[44]- The bill also would amend the Investment Company Act to require disclosures by bank-affiliated investment companies that securities issued by such companies are not deposits, are not insured by the FDIC, and are not otherwise obligations of the affiliated bank. In both these instances, the Commission supports H.R. 18's goals.-[45]- Again, however, we believe that a somewhat more flexible approach could be taken on these matters; our detailed comments are set forth in the attached appendix. C. The problem of regulatory duplication and overlap As described above, the Commission believes that H.R. 18 would make important progress toward a system of functional regulation. However, the Commission believes that H.R. 18 could go still farther than it does to reduce regulatory duplication. In part, the Commission is concerned that some of the -------- FOOTNOTES -------- -[43]- More detailed comments on some of the bill's specific provisions are set forth in the appendix to this testimony. -[44]- This issue has long concerned the Commission. Two years ago, the Commission staff advised investment companies that the use of common names is presumptively misleading. See Letter to Registrants from Barbara J. Green, Deputy Director, SEC Division of Investment Management (May 13, 1993). This letter noted that the presumption could be rebutted through appropriate disclosure. The letter requires bank-sold and bank- advised funds to prominently disclose in their prospectuses that fund shares are not deposits or obligations of, or guaranteed or endorsed by, the bank and that the shares are not federally insured by the FDIC, the Federal Reserve Board, or any other agency. -[45]- These provisions would respond to the issue (identified in articles and studies) of customer confusion about the uninsured status of bank-sold mutual funds. See, e.g., SEC News Release 93-55, "Chairman Levitt Announces Results of SEC's Mutual Fund Survey" (Nov. 10, 1993); "Banks' Fund Sales at Issue," New York Times, March 9, 1994, at D2. Recently, the NASD also took steps to address the customer confusion issue. A pending NASD rule proposal would establish requirements governing broker-dealers that sell securities on bank premises. See NASD Notice to Members 94- 94 (December 1994). The proposed rule would, among other things, specify where on bank premises a broker-dealer may provide securities services; limit the activities and compensation of unregistered personnel; require broker- dealers to implement supervisory procedures; and mandate specified disclosures to customers. This rule may be revised before it is filed with the Commission for approval. -------------------- BEGINNING OF PAGE #20 ------------------- inefficiencies and overlap inherent in today's regulatory structure for bank securities activities would carry forward under the bill. To the extent that H.R. 18 would require banks to conduct their securities activities in separate affiliates or departments, subject to Commission regulation, the bill would significantly improve the regulation of bank securities activities today. Moreover, certain provisions in the bill would facilitate coordination between bank and securities regulators in a way that would promote functional regulation. For example, Section 140 of H.R. 18 requires the appropriate agencies to provide each other with examination reports or other information related to the investment advisory activities of banks to the extent necessary for each to carry out its respective statutory responsibilities. This provision is intended to discourage duplicative examinations of banks, conserve governmental resources, and prevent inconsistent regulation of banks that engage in investment advisory activities. Other provisions of H.R. 18, however, appear to be inconsistent with these goals, and would leave room for continuing regulatory overlap and confusion. The Commission understands that the banking agencies have a valid interest in obtaining information about affiliates' operations to the extent that such operations affect a bank's safety and soundness. But proposed BHCA 10(f)(13)(D) suggests that the federal banking agencies have a role to play in evaluating the compliance of registered broker-dealers, investment advisers, and investment companies with the federal securities laws. This is the responsibility and function of the Commission, not of the banking agencies. Similarly, proposed BHCA 10(f)(13)(H) suggests, by negative implication, that the federal banking regulators may conduct independent inspections or examinations of any investment company affiliated with or advised by a bank. Such investment companies, of course, are comprehensively regulated by the Commission, and should not be subject to the possibility of dual examinations. The Commission believes that H.R. 18's enhanced information- sharing and coordination provisions should be strengthened and clarified. It would also be helpful if H.R. 18 modified existing banking law to clarify and limit the extent to which the federal banking agencies can impose bank regulation on registered securities firms affiliated with banks. D. Two-way street As noted above, repeal of the Glass-Steagall Act would not necessarily enable securities firms to acquire banks. In response to this problem, H.R. 18 would give securities firms two options. First, a securities firm could become a bank holding company by acquiring an insured bank. The bank holding company could retain certain "financial" activities that would not be permitted for bank holding companies generally. The barrier between banking and commerce would be retained, however, and the -------------------- BEGINNING OF PAGE #21 ------------------- securities firm would have to divest any nonfinancial business within a maximum of ten years. A second possibility for a securities firm would be to acquire or spin off a wholesale bank and become a new "investment bank holding company" ("IBHC") that could engage in activities financial in nature and that would have access to the FedWire and discount window.-[46]- As a result, securities firms (which often have affiliates that engage in activities otherwise impermissible under the Bank Holding Company Act) could become IBHCs. The Commission strongly supports efforts to promote a "two- way street;" however, we have a number of concerns regarding how these specific provisions would be implemented. As more fully described above, securities firms, already subject to Commission regulation, may be reluctant to submit to an additional overlay of Federal Reserve oversight. It is not clear, therefore, whether these options, as currently drafted, create a meaningful opportunity for many securities firms. In addition, the Commission is concerned that the IBHC proposal may inadvertently create incentives for securities firms to transfer some of their securities activities to a wholesale financial institution and away from NASD and Commission oversight. This could occur if an existing securities firm decided to take advantage of some of the numerous new exemptions for "traditional bank activities" in order to move securities activities into the wholesale bank. For example, a securities firm with a substantial government securities business could form an IBHC and transfer its government securities business to the bank in order to gain access to the Federal Reserve payments system and discount window. Shifting such activities out of a broker-dealer and into a bank would remove them from the well- developed investor protection requirements contained in the federal securities laws. Notwithstanding these comments, the Commission believes that H.R. 18's "two-way street" provisions do present securities firms with options that they do not have today. In particular, the IBHC vehicle, with the more limited form of bank-style regulation contemplated, offers a good foundation for a continuing dialogue. V. Conclusion The Commission supports the goal of financial services modernization, and believes that H.R. 18 represents a good first step in that direction. As the debate on Glass-Steagall reform goes forward, the Commission urges Congress to go beyond bank safety and soundness, -------- FOOTNOTES -------- -[46]- Such companies would be barred from controlling "retail" banks (i.e., banks that accept insured deposits); they could control only "wholesale financial institutions," defined as uninsured state banks that are regulated by the Federal Reserve. -------------------- BEGINNING OF PAGE #22 ------------------- and also to consider the needs of investors and the markets. In particular, the Commission urges Congress to keep these principles in mind: * Investor protection -- as well as bank safety and soundness -- must be a priority. * The vitality of the securities markets should not be undermined by cumbersome or inequitable regulation. The Commission looks forward to working with the Committee on these issues. ======================== APPENDIX =========================== This appendix supplements the general comments set forth in the Commission's testimony of March 15, 1995; it contains technical comments on specific provisions of H.R. 18. A. Bank broker-dealer provisions As noted in the March 15th testimony, the Commission has both general and specific concerns about H.R. 18's thirteen exemptions from the definition of "broker" and four exemptions from the definition of "dealer." Our specific concerns include: Private placements. The exemption for bank private placement activities excepts from functional regulation a traditional, and increasingly significant, broker-dealer activity. One aspect of this exemption would permit a bank (that has no securities affiliate) to sell securities to persons with at least $200,000 in annual income as part of a private placement, without being subject to regulation as a securities broker-dealer. We question why an important and growing area of securities activities should be excluded from a functional regulation approach based on the registration status of the securities in question: there is no rationale for why private placement activity should not be subject to Commission oversight merely because it is engaged in by a bank, when all others engaging in identical activities are be subject to Commission oversight. De minimis exemption. This exemption would permit a bank (that has no securities subsidiary or affiliate) to effect up to 1,000 securities transactions in a year -- 800 transactions in securities for which a ready market exists, plus 200 transactions in any security. Thus, a bank could advertise and actively market to any investor, without securities regulation, some of the same securities that have been subject to heightened Commission scrutiny in recent years for sales practice abuses, such as penny stocks and limited partnership interests. Safekeeping, clearing, and related services. -------------------- BEGINNING OF PAGE #23 ------------------- The Commission agrees that banks should not be considered broker-dealers solely by virtue of acting in their traditional and customary manner in providing safekeeping and custody services, clearance and settlement transactions in securities, securities lending, and collateral agency services. We emphasize, however, that any exemptions along these lines should be expressly limited to traditional and customary activities as currently performed by U.S. banks. Otherwise, the exemptions could create incentives for broker-dealers that currently engage in such businesses to move these activities into an affiliated bank and use them as an avenue to market their brokerage services away from Commission oversight. Furthermore, all activity in this area is not simply incidental to banking. Some banks, for example, currently are marketing their brokerage services to pension plans that have an existing relationship with their custody services departments by offering commission rebates on trades. Government securities. The Commission is particularly concerned by the exemption for activities in government (including government sponsored enterprise ("GSE") securities). The category of government securities encompasses a broad spectrum of instruments, ranging from Treasury bonds to GSE structured notes, such as the ones purchased by Orange County. As demonstrated by Orange County's recent investment in structured notes, investor protection concerns arise even with the most sophisticated investors.-[1]- The Commission recognizes that certain of these activities have historically been conducted in banks. Nonetheless, we believe that if a bank subsequently affiliates with a securities firm, the bank's government securities activities should be transferred to the securities firm.-[2]- The Commission is concerned that H.R. 18's exemption for exempted securities is too open-ended and creates an incentive to move government securities activities out of securities firms and into bank subsidiaries to gain access to the Federal Reserve Board payment system and discount window, thereby generating substantial savings in transaction costs. This would result in moving such activities away from Commission and NASD oversight, into affiliated banks. This would undercut the principle of functional regulation. -------- FOOTNOTES -------- -[1]- See Testimony of Arthur Levitt, Chairman, Securities and Exchange Commission, Before the Senate Committee on Banking, Housing, and Urban Affairs (January 5, 1995). -[2]- Banks already have an exemption for certain government securities dealer activities. For example, banks whose only government securities dealer activities are exempt activities, including sales and subsequent repurchases pursuant to a repurchase agreement, are exempt from complying with many of the regulatory requirements of Section 15C of the Securities Exchange Act of 1934. The Commission believes that these types of activities should continue to be conducted within the bank. -------------------- BEGINNING OF PAGE #24 ------------------- Moreover, creating an incentive for securities firms to transfer their government securities business to affiliated banks would serve to undermine the goals of the Government Securities Act Amendments of 1993 ("Amendments"). When Congress passed the Amendments, it was aware that non-banks did the bulk of government securities dealing.-[3]- In that context, Congress determined that it was desirable to grant the NASD authority over broker-dealers that are government securities dealers as a way of establishing sales practice requirements for government securities transactions analogous to those currently in effect for registered broker-dealers generally.-[4]- Solutions. As noted in the text of today's testimony, to the extent that H.R. 18 seeks to allow banks to continue engaging in traditional banking activities, it would be preferable to rely on Commission exemptive authority (as provided under Section 122 of the bill), rather than devising multiple statutory exclusions for banks. At a minimum, the Commission should be granted authority to impose additional safeguards or to create specifically tailored exemptions in consultation with the appropriate banking regulators to account for the continually evolving financial markets.-[5]- The Commission also could use such authority to adjust the exemptions to address any untoward movement of securities activities out of broker-dealers and into banks. The other route -- building a large number of inflexible exceptions into the statutory framework -- by contrast, is much more likely to result, over time, in a large number of bank securities -------- FOOTNOTES -------- -[3]- As of January 1995, 37 of the 38 primary dealers in government securities were registered with, and regulated by, the Commission. In addition, 2,156 registered broker-dealers dealt in government securities as part of a broader business. Only 310 banks -- a significantly smaller number when compared both with the number of registered broker-dealers that are government securities dealers and the total number of banks overall -- dealt in government securities. The Office of the Comptroller of the Currency is the primary regulator for the majority of banks (198) that are bank government securities dealers. -[4]- As a 1990 GAO report noted, "the absence of fair dealing . . . makes transactions in government securities by some individuals and smaller institutional investors potentially vulnerable to abusive dealer practices . . ." U.S. Government Securities: More Transaction Information and Investor Protection Measures Are Needed, GAO/GGD 90-114 (September 1990). -[5]- Such authority would be similar to the authority H.R. 18 proposes to confer on the Federal Reserve, with respect to modification of the statutory "firewalls" provisions. -------------------- BEGINNING OF PAGE #25 ------------------- activities being conducted outside of the broker-dealer regulatory scheme.-[6]- Alternatively, many of the exemptions (which are largely derived from the concept that banks traditionally provided securities services as an "accommodation to customers") could be revised to prohibit the general solicitation of the securities services involved. Such a prohibition is already contained in the exemption for bank trust activities: H.R. 18 provides that a bank will not be considered a "broker" by virtue of its trust activities unless the bank publicly solicits brokerage business (other than by advertising such services in conjunction with other trust activities). Inclusion of a comparable prohibition is particularly important with respect to the de minimis exception, which we understand is only intended to permit smaller banks to engage in accommodation transactions for their customers. Moreover, the Commission believes that most of the exemptions, if maintained, should "expire" upon the affiliation of a bank with a securities firm, after an appropriate transition period designed to minimize any potential disruption to a bank's business practice. Such an approach is already used in several of the exemptions (e.g., the exemptions for municipal securities, affiliate transactions, private securities offerings, and de minimis transactions). In particular, this limitation should be incorporated into the exemption for exempted securities, including government securities. Otherwise, securities firms will have an incentive to permanently transfer their government dealing activities to the affiliated bank and away from Commission oversight. B. Margin requirements H.R. 18 would amend the Exchange Act to eliminate outdated restrictions on broker-dealer borrowing. Specifically, the bill would remove the restrictions that prevent broker-dealers from borrowing against securities to finance their normal business operations.-[7]- -------- FOOTNOTES -------- -[6]- In addition, the Commission notes that it will be difficult to monitor and enforce the proposed exemptions. Although H.R. 18 suggests that monitoring such exemptions is appropriate, the tools to do so are not in place. Specifically, the bill allows, but does not require, bank regulators to obtain information from banks regarding the banks' use of the exemptions. Notably, the bill does not require a copy of such data to be provided to the Commission. -[7]- As currently written, Section 123 amends Sections 7(d) and 8(a) of the Exchange Act to permit broker-dealers to borrow from any person other than a broker-dealer to finance their ordinary business operations (other than to purchase securities for their own account). Although we understand the intention of H.R. 18 is to permit broker-dealers to borrow from any person for the purpose of purchasing or carrying securities, Section (continued...) -------------------- BEGINNING OF PAGE #26 ------------------- H.R. 18 also would permit broker-dealers to borrow against securities from any person that agrees to observe the rules of the Federal Reserve Board. The evolving nature of our financial markets, with greater reliance on non-bank sources of financing, has made the current limitation to bank sources of financing on securities unnecessary. We therefore believe H.R. 18 would appropriately (1) loosen the restrictions on borrowing to finance broker-dealer activities (including the purchase of securities for customers), and (2) restrict borrowing against securities to purchase for a broker-dealer's own account. C. Bank investment advisory activities The Commission supports H.R. 18's efforts to update the Investment Company Act and the Advisers Act in light of growing bank involvement in the investment company business. However, because this involvement is a relatively new development, we believe (as a general matter) that it would be advisable for many of the investment company provisions to be modified somewhat to give the Commission authority to deal with conflicts of interest and other issues as they arise. Customer confusion. H.R. 18 is intended to address potential customer confusion caused when investors purchase securities on bank premises or purchase shares of a mutual fund that has a name similar to that of a bank. We commend H.R. 18 for seeking to deal with this issue, which has long concerned the Commission.-[8]- First, the bill would amend the Investment Company Act to prohibit a bank-affiliated investment company from adopting a -------- FOOTNOTES -------- -[7]-(...continued) 7(d) of the Exchange Act governs the ability of persons other than broker-dealers to extend credit for the purchase or carrying of securities. Section 7(c), which is not amended in the current draft, governs the ability of broker-dealers to extend credit for the purpose of purchasing or carrying securities. The bill should amend Section 7(c) to clarify that broker- dealers may extend credit to other broker-dealers for use in the ordinary course of business (other than for the purchase of securities for their own account). -[8]- Because common names can be a source of customer confusion, the Commission has advised investment companies that the use of common names is presumptively misleading. See Letter to Registrants from Barbara J. Green, Deputy Director, SEC Division of Investment Management (May 13, 1993). This letter noted that the presumption could be rebutted through appropriate disclosure. The letter requires bank-sold and bank- advised funds to prominently disclose in their prospectuses that fund shares are not deposits or obligations of, or guaranteed or endorsed by, the bank and that the shares are not federally insured by the FDIC, the Federal Reserve Board, or any other agency. -------------------- BEGINNING OF PAGE #27 ------------------- name that is the same as or similar to the name of its affiliated bank.-[9]- The Commission believes that consideration should be given to recasting this important provision to authorize the Commission to adopt rules or issue orders to regulate this practice. In particular, the Commission recommends that the provision be revised to state that it is deceptive or misleading for an investment company to use a name similar to that of an affiliated bank in contravention of Commission rules or orders. This approach would avoid an outright prohibition of common names under all circumstances, and enable the Commission to respond to particular names it concludes are potentially confusing to investors. Second, H.R. 18 would amend the Investment Company Act to prohibit investment companies or sellers of investment company securities from implying or representing that the company or any security issued by the company is guaranteed by the U.S. government, insured by the FDIC, or guaranteed by a bank. In addition, the bill would mandate that the Commission adopt rules to require that bank-affiliated investment companies and persons selling bank-affiliated investment company securities prominently disclose that the investment company or any security issued by the company is not FDIC-insured and is not otherwise an obligation of the affiliated bank. The Commission agrees that such disclosure is necessary, but would recommend a more flexible approach. In particular, we recommend that the provision be revised to require bank-affiliated investment companies, and persons who sell securities issued by such companies, to make disclosures along the lines contemplated by H.R. 18 in accordance with such rules as the Commission may prescribe. Conflicts of interest. Banks are now significant participants in the fund industry. Because this was not the case when the Investment Company Act and the Advisers Act were enacted, these statutes currently do not address all of the conflicts of interest that may arise when banks provide investment management and related services to funds. H.R. 18 recognizes these conflicts, and addresses them by prohibiting certain transactions between funds and their bank affiliates. We believe that the Commission would be better able to address such conflicts if it were given authority to define and deal with those conflicts by rules or orders. This would permit the Commission to strike a balance between protecting investors from abusive conflict of interest situations and enabling funds to enter into advantageous transactions. The following paragraphs discuss the specific provisions of H.R. 18 relating to these conflicts of interest. Fund acquisition of securities to satisfy bank customer's indebtedness. -------- FOOTNOTES -------- -[9]- Under the provision, the Commission would have the authority to exempt an investment company from this prohibition if it determines that an exemption is consistent with the public interest and the protection of investors. -------------------- BEGINNING OF PAGE #28 ------------------- H.R. 18 would prohibit an investment company from knowingly acquiring a security during the existence of an underwriting or selling syndicate, if the proceeds would be used to retire any part of an indebtedness owed to an affiliated person of the investment company. This provision is intended to address the possibility that a bank could use its affiliated fund as a source of readily available capital to assist a financially troubled borrower. The bank's indebtedness would be repaid, but the fund could be left with unsuitable or risky assets. H.R. 18 would prevent this scenario from occurring. We recommend, however, that the bill be amended to provide the Commission with authority to prohibit specific abusive situations of this type by rule or order. The Commission is concerned that, because of the broad wording of this provision, the bill could be read to preclude securities acquisitions that would not be abusive.-[10]- The recommended approach would allow regulatory flexibility and would avoid prohibiting investment companies from participating in appropriate and potentially advantageous securities transactions. Borrowing from an affiliated bank. H.R. 18 would prohibit a registered investment company from borrowing money from an affiliated bank. This prohibition is intended to deal with the potential for overreaching by a bank in a loan transaction with an affiliated fund. H.R. 18 would authorize the Commission to grant exemptions from this prohibition. Under the Investment Company Act, mutual funds may borrow only from banks. As discussed above, because the Investment Company Act contemplates that banks would not have an active role in the management of funds, the statute does not specifically address potential overreaching when the lending bank is affiliated with the fund. The Commission supports addressing this issue legislatively, but we recommend that the bill be amended to provide the Commission with authority to adopt rules or issue orders that limit or prohibit banks from lending to affiliated funds in those instances in which the potential for overreaching exceeds the potential benefits to fund shareholders.-[11]- -------- FOOTNOTES -------- -[10]- For example, this provision could be read to prohibit an equity fund from acquiring stock of an issuer whose publicly traded debt securities happen to be in the portfolio of an affiliated bond fund. Moreover, this provision may increase the compliance responsibilities of an investment company to monitor the securities holdings and lending activities of all of its affiliates. We question whether the interests of investors will be furthered by imposing such an extensive compliance burden on funds. -[11]- Placing the restriction on banks would be consistent with the affiliated transaction provisions of the Investment Company Act, which prohibit affiliated persons from engaging in transactions with a fund, but do not make it unlawful for the fund itself to enter into an affiliated transaction. Because a fund's day- to-day operations typically are managed by its (continued...) -------------------- BEGINNING OF PAGE #29 ------------------- Bank serving as custodian for affiliated fund. H.R. 18 would permit management investment companies to use affiliated banks as custodians in accordance with Commission rules.-[12]- While the Investment Company Act already gives the Commission rulemaking authority regarding investment company custodial arrangements, H.R. 18 would confirm that this rulemaking authority extends to custodial arrangements involving affiliated banks.-[13]- We support this provision. Independence of board of directors. H.R. 18 contains provisions that are intended to strengthen the independence of a fund's board of directors. It would expand the definition of "interested person" of an investment company to include (1) any person who, within the past six months, executed any portfolio transactions for, engaged in any principal transactions with, or loaned money to the investment company, (2) any person who, within the same period, has acted as custodian or transfer agent for the investment company, and (3) any affiliate of such persons.-[14]- H.R. 18 also would amend the provision of the Investment Company Act that prohibits a majority of an investment company's board of directors from consisting of persons who are officers, directors, or employees of any one bank. The bill would expand this restriction to cover officers, -------- FOOTNOTES -------- -[11]-(...continued) investment adviser, the adviser has the ability to cause the fund to enter into affiliated transactions. The affiliated transaction provisions recognize this and place the burden of compliance on the adviser and other affiliated persons rather than on the fund. These provisions, therefore, empower the Commission to pursue enforcement actions directly against those persons that cause the fund to enter into affiliated transactions. -[12]- The bill would prohibit unit investment trusts ("UITs") from using affiliated banks as custodians until the Commission permits such arrangements by rule. There appears to be no reason to distinguish between the custodianship of UIT assets and that of other investment company assets and, therefore, we recommend that this provision be modified to permit UITs to use affiliated bank custodians in accordance with Commission rules. -[13]- While the rule governing investment company self- custody of assets has been applied to cover custodial arrangements with affiliated banks, we believe the Investment Company Act should be amended to indicate more clearly the Commission's authority to adopt rules relating to affiliated bank custodianships. -[14]- We question the need to include custodians, transfer agents, and their affiliates as interested persons. It would appear that the conflict of interest potential raised by a board member's being affiliated with a custodian or transfer agent is rather minimal. -------------------- BEGINNING OF PAGE #30 ------------------- directors, or employees of any single bank holding company (including its subsidiaries and affiliates) or of any single bank (including its subsidiaries). We support this provision. Voting requirements when bank holds controlling interest in fund as a fiduciary. Next, H.R. 18 would address certain conflicts that may arise when a bank that advises a fund also holds a controlling interest in the fund in a fiduciary capacity.-[15]- To ensure that the bank does not use its fiduciary authority to further its own interests (such as voting to perpetuate itself or its affiliate as investment adviser to the fund), H.R. 18 would require the fiduciary to follow certain procedures when voting fund shares.-[16]- The voting requirements would not apply to banks holding investment company shares on behalf of common trust funds, pension plans, governmental plans, and collective trust funds. We support this provision with minor technical changes to clarify these exceptions. Acquiring investment company shares as a fiduciary. Finally, H.R. 18 would add a new provision to the Investment Company Act to impose a disclosure requirement on a fund's investment adviser when the adviser purchases the fund's securities in a fiduciary capacity. The adviser would be required to provide disclosures as prescribed by the Commission to the person to whom periodic financial statements of the fiduciary account are sent (typically the person who created the trust). This provision authorizes the Commission to adopt rules to protect fund investors who are also trust beneficiaries, and, at the same time, authorizes the appropriate banking agency to review purchases by fiduciaries of securities issued by affiliated investment companies. Although the Commission acknowledges the potential conflict of interest that arises when a fund's adviser purchases shares of the fund in a fiduciary capacity, the Commission questions whether the Investment Company Act is the appropriate statute to deal with that conflict of interest. Such a conflict would appear to involve not the operations of an investment company, which are governed by the Investment Company Act, but the relationship between the bank as fiduciary and its clients or customers. The Commission submits that issues involving that relationship would be better addressed by amending the federal banking laws or the rules adopted under those laws than by amending the Investment Company Act. Common trust funds. -------- FOOTNOTES -------- -[15]- Section 2(a)(9) of the Investment Company Act (15 U.S.C. 80a-2(a)(9)) creates a presumption of "control" where a person owns more than 25% of a company's voting securities. -[16]- Specifically, H.R. 18 would require the fiduciary to (1) pass through voting rights to beneficiaries or certain other designated persons, (2) vote the shares it holds in proportion to all other shareholders, or (3) vote in accordance with Commission rules. -------------------- BEGINNING OF PAGE #31 ------------------- H.R. 18 would codify a long-standing Commission position that the exception from the securities laws available to bank common trust funds-[17]- applies only if the fund is used solely to accommodate bona fide pre-existing trust clients of a bank, and is not advertised or offered to the general public.-[18]- The bill would modify the language of the common trust fund exception in the Investment Company Act, and the companion provisions in the Securities Act and the Exchange Act, to restrict the exception's applicability to a common trust fund meeting three conditions. First, the common trust fund must be employed solely as an administrative convenience for the management of accounts created and maintained for fiduciary purposes. Second, interests in the fund may not be advertised or offered for sale to the public, except in connection with generic advertising of the bank's overall fiduciary services. Third, the common trust fund may not be charged any fees or expenses that, when added to any other fee charged to a participant account, would exceed the total compensation that would have been charged if no assets of the participating account had been invested in the common trust fund, except for "reasonable and necessary expenses related to the prudent operation of the fund," as determined by the appropriate federal banking agency. We support this provision. -------- FOOTNOTES -------- -[17]- The federal securities laws exempt interests in common trust funds from the registration requirements of the Securities Act of 1933 (15 U.S.C 77c(a)(2)) and exclude common trust funds from the definition of investment company under the Investment Company Act (15 U.S.C. 80a-3(c)(3)). In addition, because interests in common trust funds are exempted securities under the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(12)(iii), persons effecting transactions in these interests need not register as broker-dealers. The definition in each of these statutes is virtually identical, limiting the exception to any common trust fund or similar fund maintained by a bank exclusively for the collective investment or reinvestment of moneys contributed thereto by the bank in its capacity as a trustee, executor, administrator, or guardian. -[18]- E.g., In the Matter of The Commercial Bank and Marvin C. Abeene, Admin. Proc. File No. 30-8567 (Dec. 6, 1994). See also Investment Company Act Rel. No. 3648 (Mar. 11, 1963); H.R. Rep. No. 429, 88th Cong., 1st Sess. 11 (1963). END OF DOCUMENT