APPENDIX[1] Commission Concerns with H.R. 10 This appendix discusses specific provisions in the version of H.R. 10 reported by the House Banking Committee that pose some of the most serious threats to the Commission’s ability to protect investors and the integrity of our markets. A. Broker-Dealer Activities 1. New Products The new products provision was originally designed to provide a fair process for handling new products sold by banks that might have securities elements. Briefly, this process is as follows. With respect to a new product sold by a bank, the Commission would be required to conduct a rulemaking in consultation with the appropriate banking regulators. Before requiring a bank to move any new activities into a separate entity, the Commission would have to formally demonstrate that the new product is a security and that investor protection concerns warrant requiring activities with respect to such new product to be conducted through a registered broker-dealer. The rulemaking process is designed to give fair notice to the banking industry and opportunity for all interested persons to comment. However, this process has now been expanded to include requirements that are unacceptable to the Commission. H.R. 10 now includes a provision that permits any bank to obtain an automatic stay of the Commission’s action, if the bank challenges the Commission’s determination. The Commission does not object to judicial review of its actions, and, in fact, any aggrieved party can currently go to court to seek a stay of Commission action if it feels one is warranted. However, the automatic stay in H.R. 10 would act to delay Commission enforcement or regulatory action against a bank, perhaps for years. This is an unreasonable burden to place on the Commission, particularly given the speed with which this industry innovates and the fact that the rulemaking process -- in lieu of enforcement actions or use of the Commission’s interpretive authority -- would already delay significantly the Commission’s actions. The Commission’s hands should not be tied indefinitely while the judicial review process winds its way through the courts. Moreover, as the nation’s securities regulator, the Commission is bewildered by a new provision that would appear to give bank regulators deference in determining which products are securities, and subject to securities regulation. 2. Derivatives Activities The Commission’s principal concern in this area involves derivatives activities where the derivatives are securities or involve delivery of securities. Earlier bills have allowed these products to be booked by banks, but required the transactions to be conducted only with qualified investors, and effected through a registered broker-dealer. This scheme carefully permitted banks to maintain most of their derivatives activities “as is„ -- securities law protections would only apply where the derivative product was a security or involved delivery of a security. Moreover, it recognized investor protection concerns by restricting such derivatives dealing activities to qualified investors. However, the version of H.R. 10 reported by the Banking Committee wreaks havoc with this delicate balance. It would exempt “any swap agreement„ from the broker-dealer registration requirements, even swaps that are securities or that involve delivery of securities. Swap agreement is defined broadly and, as markets develop, could include standardized products that are used for price discovery purposes in equity and debt markets, all outside the scope of federal securities law. This open-ended exemption is unacceptable to the Commission because all securities can be recast as derivatives -- a callable bond could be viewed as a derivative. Because those derivatives that are securities or that involve the delivery of securities no longer would need to be sold through a registered broker-dealer, many of the protections of federal securities laws would not apply. Thus, the sales practice, net capital and other investor and market protection requirements of the federal securities laws will not govern sales of securities derivatives. In addition, the current version of H.R. 10 would eliminate the statutory requirement that securities-based derivatives be sold only to qualified investors, thus permitting an expanded class of products to be sold to any type of investor, regardless of the level of sophistication. Finally, the banking regulators, rather than the Commission, would control the scope of this exemption for securities-based derivatives. For example, bank regulators would decide whether investor protection concerns warranted limiting bank sales of credit and equity derivatives to sophisticated investors. 3. Receipt of Brokerage Commissions for Trust and Transfer Agency Activities Banks have traditionally provided trust services. Previous versions of H.R. 10 contained an exemption tailored to cover traditional trust activities. Specifically, this provision covered instances where a bank executed securities transactions in a fiduciary or trustee capacity through its trust department, or in employee benefit plans, dividend reinvestment plans, and issuer plans, but was not compensated on an incentive basis for such activity. In order to protect trust customers from banks having a “salesman’s stake„ in their transactions, previous bills did permit banks to charge an annual fee, an assets-under- management fee, or an order processing fee, but expressly prohibited a bank trust department and transfer agent from charging brokerage commissions that exceeded execution costs. H.R. 10 has since been rewritten to permit banks, provided they are “primarily„ compensated by fees other than brokerage commissions, to accept commissions in excess of their execution costs. The vague term “primarily„ makes this a potentially huge loophole. Even though the current version of H.R. 10 attempts to limit potential excess by further requiring that additional compensation be “consistent with fiduciary principles,„ this is shallow protection. Any protections afforded to investors under fiduciary law will vary by state. In addition, fiduciary law may permit investor protections to be lessened, if not eliminated entirely, by contractual provisions. Significantly, we understand that banks also have been effective recently in lobbying state legislatures to statutorily relax some state fiduciary law requirements. It is not enough to say that banks are “fiduciaries.„ Broker-dealers are also “fiduciaries;„ nonetheless, Congress has determined that the protections of federal securities laws are necessary and integral to provide customers with full investor protection. Under the current version of H.R. 10, a bank and its personnel could have economic incentives -- a so-called “salesman’s stake„ -- in a customer account, without being subject to the strict suitability, best execution, sales practices, supervision, and accountability requirements that are imposed by the federal securities laws. As the Commission has stated, consistent regulation of securities activities is imperative in order for the nation’s investors to be fully protected. Moreover, investor protections with respect to bank activities in certain stock purchase plans were even further eroded under the current version of H.R. 10. The bill would delete the prohibition on a bank accepting brokerage commissions that exceed its execution costs, without even a requirement that any brokerage commissions that the bank receives be “consistent with fiduciary principles.„ In fact, transfer agents involved in sales of issuer stock purchase plans owe a fiduciary duty to issuers, not to investors, and the investor protections of the federal securities laws would not apply to bank customers. 4. Private Placement Activities Small banks have traditionally conducted private placements in order to assist local business clients in capital formation. Accordingly, previous versions of this bill have permitted a bank that was not affiliated with a registered broker-dealer to engage in private placement activities with qualified investors. The version of H.R. 10 reported by the Banking Committee would abandon this focus on small banks. H.R. 10 has been rewritten to allow all but the very largest banks to conduct private placement activities. The only restriction is that a bank that wishes to engage in private placements directly cannot be affiliated with a broker-dealer that underwrites corporate debt and equity securities. This would permit a large universe of banks (regardless of their size and history of private placement activities) to conduct private placement activities directly, outside of the reach of many of the investor protections provided under federal securities law. As it is, private placements are subject to fewer disclosure requirements under federal securities laws because they qualify for an exemption from the Securities Act of 1933. Although banks have been permitted to engage in private placement activities for about 25 years, most big banks have moved such activities to their registered broker-dealer section 20 affiliates (where private placement activities count toward the 75 percent of “permissible„ revenue). Once Glass- Steagall barriers (and the 75 percent revenue test) are eliminated, this significant market will be moved back into banks, outside of the protections of federal securities regulation. 5. Definition of “Qualified Investor„ Many of the exceptions provided for bank securities activities in previous bills have relied on the fact that less sophisticated investors would continue to have the protections of the federal securities laws governing their transactions. Thus, earlier versions of this legislation generally defined “qualified investor„ narrowly with respect to complex instruments, like derivatives (essentially institutional investors), and more broadly with respect to private placements, asset-backed securities and loan participations. Unfortunately, the current version of H.R. 10 defines “qualified investor„ broadly with respect to all products, including derivatives, to include corporations, natural persons with more than $10 million and governments with more than $50 million. By significantly expanding the definition of “qualified investor,„ the current version of H.R. 10 would permit banks to offer derivative instruments to a broader class of investors, including individuals, fully outside the protections of federal securities law. This means a less sophisticated class of investors will not be protected by the additional supervisory, sales practices and suitability requirements imposed by federal securities laws, at the very time they would need them most. Moreover, certain municipalities and the Government Finance Officers Association (“GFOA„) have stated that even sophisticated investors require the protections of federal securities laws, particularly suitability, with respect to derivatives trading activities. B. Mutual Fund Advisory Activities The Commission is pleased to see that the current version of H.R. 10 maintains important amendments to the federal securities laws to close the loopholes that banks enjoy with respect to their mutual fund advisory activities. These provisions were non-controversial and are necessary to evenly protect all mutual fund investors. In addition, these provisions are important because they would afford Commission examiners greater access to information regarding bank advisory activities that could affect bank-advised mutual funds. Such access is necessary to detect and prevent front-running, abusive trading by portfolio managers, and conflicts of interest. In addition, the Commission suggests one additional technical change discussed below. Currently, the Investment Company Act statutorily disqualifies certain types of entities (such as brokers, dealers, advisers, transfer agents) and employees of such entities (including employees of banks) who have been convicted of a felony or have been subject to a civil injunction. However, the Act does not contain a similar statutory disqualification that would apply to a bank (as opposed to employees of the bank) that had engaged in wrongdoing. Commission staff have drafted a brief amendment that would accomplish this, and we encourage the Commerce Committee to adopt such an amendment, which is important to provide investors in bank-advised funds the same protections provided to investors in other funds. C. Broker-Dealer Holding Company In order to provide an effective two-way street between the banking and securities industries, securities firms must have the ability to affiliate with banking institutions without subjecting their entire holding company to top-down, bank safety and soundness supervision by the Federal Reserve. Accordingly, a broker-dealer holding company (“BDHC„) must have the ability to affiliate with a wholesale financial institution (“WFI„), and BDHCs that engage primarily in securities activities (regardless of whether they are affiliated with a WFI) must be able to choose Commission supervision of the holding company. In addition, the Commission should retain backup examination authority over WFI holding companies to ensure compliance with securities laws. The Commission advocates the addition of broker-dealer holding company provisions to H.R. 10, and notes that an effective provision of this nature was included in the Commerce Committee’s H.R. 10 report of October 1997. **FOOTNOTES** [1]: This Appendix is part of the Testimony of Arthur Levitt, Chairman, U.S. Securities and Exchange Commission, Concerning H.R. 10, the “Financial Services Act of 1999,„ Before the Subcomm. on Finance and Hazardous Materials, House Comm. on Commerce (May 5, 1999). A-1