Financial Services Reform Legislation of 1999, the Gramm-Leach-Bliley Act of 1999
Barry A. Abbott, Andre W. Brewster and Charles P. Ortmeyer of Howard, Rice, Nemerovski, Canady, Falk & Rabkin, A Professional Corporation
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At the heart of the Gramm-Leach-Bliley Act are provisions that allow affiliations among banks, securities firms, and insurance companies.
The Act repeals two sections of the Glass-Steagall Act, which restrict banks and their affiliates from being affiliated with companies engaged in the business of underwriting and dealing in securities. The two sections are Section 20 (12 U.S.C. §377), which prohibits a Federal Reserve member bank (including a national bank) from affiliating with a company "engaged principally" in underwriting, dealing, publicly selling or distributing securities, and Section 32 (12 U.S.C. §78) which prohibits officer, director, or employee interlocks between a Fed member bank and a company "primarily engaged" in the securities activities listed in Section 20.
The Act also creates a major new exception to Section 4(a) of Bank Holding Company Act of 1956, which prohibits a bank holding company from acquiring interests in companies other than banks. Prior to the Act, the principal flexibility in this prohibition was the exception created by BHCA Section 4(c)(8), which allowed a bank holding company to acquire interests in companies with activities "so closely related to banking . . . as to be a proper incident thereto." This phrase gave rise to a large body of Federal Reserve Board regulation and lore that defined the outer limits of permissible bank holding company activities. Out of bounds were affiliations with, among other things, real estate brokerage or development companies and commercial or industrial companies.
After the Act's passage, Section 4(c)(8) will remain frozen in time, allowing bank holding companies to have interests in companies engaged in activities that the Board has determined by regulation or order as of the day before enactment of the Act to be so closely related to banking as to be a proper incident thereto. But in addition to those activities, bank holding companies can now engage in a whole new range of financial activities by electing to become a "financial holding company," or "FHC."
The new flexibility arises from the addition of subsections to Section 4 to provide an expanded environment in which qualifying BHCs may operate. While given expanded powers, FHCs remain bank holding companies subject to the other provisions of the Bank Holding Company Act. As before, if a company controls a bank, it will still be considered a bank holding company.
Activities That Are "Financial
The Act authorizes FHCs and FHC affiliates to engage in activities that are "financial in nature or incidental to financial in nature," or activities that are "complementary to financial activities." The Act deems the following activities to be financial in nature:
(1) Lending, exchanging, transferring, investing for others, or safeguarding money or securities.
(2) Insuring, guaranteeing, or indemnifying against loss, harm, damage, illness, disability, or death, or providing and issuing annuities, and acting as principal, agent, or broker for purposes of the foregoing.
(3) Providing financial, investment, or economic advisory services, including advising investment companies.
(4) Issuing or selling instruments representing interests in pools of bank-eligible securities and assets.
(5) Underwriting, dealing in, or making a market in securities, without any revenue limitation (as had previously applied to so-called "Section 20 Subsidiaries"). This opens the door for bank affiliates to sponsor and distribute mutual funds.
(6) Engaging in any activity that the Board had determined on the date of enactment to be so closely related to banking or managing or controlling banks as to be a proper incident thereto;
(7) Engaging in any activity in the United States that is permissible under the Board's Regulation K for a BHC to engage in outside the United States and that the Board has determined to be "usual in connection with the transaction of banking or other financial operations abroad."
In addition, the Act blesses as "financial in nature" the acquisition of interests in and control of any company " whether financial or not " through securities underwriting, merchant banking, or insurance company investments. In the case of securities affiliates, the investment must be part of a bona fide underwriting or merchant or investment banking activity, including investment activities engaged in for the purpose of appreciation and ultimate resale or disposition of the investment, and the investment may be held for a period of time that is reasonable in relation to the investment activities (the Act terms this activity "merchant banking"). In the case of insurance companies, the portfolio investment must be made in the ordinary course of business of the insurance company in accordance with relevant state law governing such investments.
Neither securities firms nor insurance companies are permitted under this authority to "routinely manage or operate such company or entity except as may be necessary or required to obtain a reasonable return on investment upon resale or disposition." In other words, these investments must be made in the ordinary course of business and the overall relationship must be sufficiently passive that it can be viewed as an investment relationship rather than an exercise of operating control over the portfolio company.
Apart from the activities expressly designated in the Act as "financial in nature," the Federal Reserve Board is given primary authority to determine for bank holding company affiliates what activities are financial in nature or incidental to financial in nature, or complementary to a financial activity. However, the Act provides for a consultative process between the Board and the Secretary of the Treasury on the designation of activities, and in effect the Secretary can veto a proposal for designation of an activity.
The Board is further charged with defining the extent to which the following activities are financial in nature or incidental to a financial activity:
(1) Lending, exchanging, transferring, investing for others, or safeguarding financial assets other than money or securities.
(2) Providing any device or other instrumentality for transferring money or other financial assets.
(3) Arranging, effecting, or facilitating financial transactions for the account of third parties.
These activities are undertaken on behalf of third parties, and while nominally financial in nature, were separated out for a separate Federal Reserve Board determination because of concern over the potential scope of these activities.
Conditions to Qualify as
A BHC may elect to become a FHC if all of its subsidiary banks are well capitalized and well managed. A BHC meeting such requirements must file a declaration with the Board to the effect that the company elects to be a financial holding company. If at any time any of an FHC's subsidiary banks lost the well-capitalized or well-managed rating, the FHC would be required to agree to correct the conditions within 45 days, and the Board may impose activity limitations until the conditions are corrected. If the conditions are not corrected within 180 days, the Board may require divestiture of any subsidiary depository institution, or the FHC may elect instead to cease to engage in the expanded activities "financial in nature" and become limited again to the activity restrictions of old section 4(c)(8).
The legislation amends the Community Reinvestment Act to provide that an election of a BHC to become an FHC will not be effective if any of the holding company's subsidiary insured depository institutions has received a less than "satisfactory" rating in its most recent Community Reinvestment Act examination. In addition, the Act amends the BHCA to require the appropriate Federal banking agency to prohibit an FHC or insured depository institution from commencing any new activities or acquiring companies engaged in expanded activities "financial in nature" (other than merchant banking or insurance portfolio investment activities), if any insured depository institution affiliate has failed to receive in its last examination at least a "satisfactory" CRA rating. The provision does not authorize any agency to require the divestiture of any company already owned by the FHC prior to the time that the prohibition becomes effective or to limit in any way any activity already engaged in by the FHC prior to that time.
of New FHCs.
If a non-bank holding company becomes an FHC after the effective date of the Act, the company may continue to engage in non-financial activities and to own companies engaged in non-financial activities if:
§ The holding company lawfully was engaged in the activity or held shares of such company on September 30, 1999;
§ The holding company is "predominantly engaged in financial activities"; and
§ The company engaged in such activity continues to engage only in the same activities that such company conducted on September 30, 1999 and other activities permissible under the Act.
A company will be deemed "predominantly engaged in financial activities" if the consolidated annual gross revenues of the holding company family, other than subsidiary depository institutions, derived from activities that are financial in nature or incidental to a financial activity represent at least 85% of the consolidated annual gross revenues of the company. The test is a continuing test, such that if the revenue from non-financial activities at any time exceeds 15% of the consolidated annual gross revenues (excluding revenues derived from subsidiary depository institutions), the FHC's grandfathered activities would become restricted.
a. With Commercial Companies. An FHC-controlled depository institution may not offer or market any product or service of a portfolio company whose shares are owned by the FHC's insurance or securities subsidiaries, nor may a depository institution permit any of its products or services to be marketed by such a company.
b. With Non-Financial Affiliates. A depository institution controlled by an FHC may not engage in a covered transaction (as defined in Section 23A(b)(7) of the Federal Reserve Act) with any affiliate controlled by the FHC.
Functional regulation is a major theme of the Act that applies whether an activity is conducted in a BHC/FHC subsidiary or in a subsidiary of a depository institution. Thus, banking activities will be regulated by bank regulators, securities activities by securities regulators, and insurance activities by insurance regulators. The Act defines "functionally regulated subsidiary" as any company that is not a BHC or a depository institution, and that is a registered broker-dealer, registered investment adviser, registered investment company, insurance company, or entity subject to the supervision of the Commodity Futures Trading Commission.
The Federal Reserve Board is cast in an oversight role, monitoring the financial condition of the BHC/FHC or any subsidiary, the systems for monitoring and controlling financial and operating risks, the transactions with depository institutions, and the compliance with the BHCA or other Federal laws that the Board has specific jurisdiction to enforce.
The Board is authorized to examine the BHC/FHC and its subsidiaries. But its authority to examine functionally regulated subsidiaries is circumscribed in several ways so that examinations will be exceptions to the general rule that the subsidiary will be examined by its functional regulator. Other Federal banking agencies (except to a limited extent the FDIC) are likewise limited with respect to functionally regulated subsidiaries. Federal banking agencies are generally prohibited from inspecting or examining registered investment companies. The Board is to use examinations and reports of functional regulators to the greatest extent possible.
The Board may not prescribe capital requirements for any functionally regulated subsidiary that is not a depository institution and is in compliance with applicable capital requirements of its functional Federal or state regulator. The Board also cannot prescribe capital requirements for federally-registered investment advisers or any subsidiary that is licensed as an insurance agent with the appropriate state insurance authority. In setting BHC capital requirements, the Board cannot consider the activities of an affiliated registered investment company unless the BHC controls the investment company through ownership of more than 25% of its shares, and the position has a market value of $1 million or more. The Board cannot require a BHC that is a broker-dealer, insurance company, investment company, or investment adviser to infuse funds into a subsidiary depository institution if the BHC's functional regulator objects (but in such a situation, the Board could require divestiture of the depository institution).
The Board cannot adopt rules, issue orders, etc., affecting functionally regulated affiliates unless the action is necessary to address an unsafe or unsound practice or breach of fiduciary duty by such subsidiaries that pose a "material risk" to the safety and soundness of the depository institution or the domestic or international payments system and it is not possible to address such risk through requirements imposed directly upon the depository institution.
The Federal banking regulators are empowered to adopt prudential safeguards governing transactions between depository institutions, their subsidiaries and affiliates so as to avoid significant risk to the safety and soundness of the institution.
The Act strikes a compromise between the Federal Reserve Board's position that expanded financial services should be conducted only through holding company affiliates and the Comptroller's desire to allow such activities to be conducted through direct bank subsidiaries.
Under the new system, national banks may own and control "financial subsidiaries." Subject to some exceptions, financial subsidiaries may engage in activities that are financial in nature or incidental to a financial activity, along with activities that national banks may engage in directly. Thus, bank subsidiaries will be allowed to underwrite corporate debt and equities and to sell insurance without any geographic limits. Bank subsidiaries will also be able to offer new financial products (such as, for example, hybrid banking/insurance products) that are determined to be "financial in nature." However, four activities are specifically prohibited: insurance or annuity underwriting, real estate investment and development, insurance company portfolio investments, and "merchant banking" (that is, securities firm portfolio investing) activities.
For a financial subsidiary to engage in activities financial in nature, the parent national bank and all depository institution affiliates must be well capitalized, well managed, and have a satisfactory CRA rating. The aggregate consolidated total assets of all financial subsidiaries of the national bank may not exceed the lesser of 45% of the parent bank's consolidated total assets or $50 million. The Comptroller must approve of the financial subsidiary's engagement in the activities. The financial subsidiary may only act as an agent and not a principal in connection with these activities unless it is one of the 100 largest banks and has outstanding debt rated within the 3 highest investment grade rating categories by a nationally recognized statistical rating organization (or satisfies a comparable standard).
In determining compliance with applicable capital standards, (i) the aggregate amount of the national bank parent's equity investments in all financial subsidiaries (including the operating subsidiary's retained earnings) must be deducted from the bank's capital; and (ii) the assets and liabilities of the financial subsidiary may not be consolidated with those of its parent bank. Equity investments in the financial subsidiary by a parent national bank must not exceed the amount the bank could pay as a dividend without obtaining prior regulatory approval.
A financial subsidiary of a national bank will be treated as a nonbank affiliate of the bank and not as a subsidiary of the bank for purposes of applying the restrictions on transactions with affiliates contained in Sections 23A and 23B of the Federal Reserve Act. For purposes of the anti-tying provisions of the Bank Holding Company Act Amendments of 1970, a financial subsidiary of a national bank will be deemed to be a subsidiary of a BHC and not a subsidiary of a bank.
The conference report states that it is the intent of the conferees that the Act's provisions will supersede and replace the OCC's Part 5 regulations on operating subsidiaries.
of Insured State Banks.
The Act amends the Federal Deposit Insurance Act to provide that an insured State bank may own or control a subsidiary that engages as principal in activities that would only be permissible for a national bank to conduct through a financial subsidiary, provided that the State bank and each insured depository affiliate are well capitalized, and that the State Bank complies with capital deduction and financial statement disclosure requirements, and with financial and operational safeguards. Such subsidiaries will be subject to the same rules as financial subsidiaries of national banks for purposes of Sections 23A and 23B of the Federal Reserve Act.
Two other Glass-Steagall Act provisions are not affected by the
Act. Section 16 (12
U.S.C. §24 (Seventh)) restricts a national bank's and a Fed member
bank's ability to underwrite and deal in securities and stocks "
other than "bank-eligible" government securities " and prohibits
such banks from purchasing or selling securities except upon the
order and for the account of customers.
Section 21 (12 U.S.C. §378) prohibits organizations that
underwrite or deal in securities from accepting deposits.
Technically, these expanded activities, like section 4(c)(8), are
cast as exceptions to the Section 4(a) prohibition on owning interests
in entities that are not banks.
 One could ask how activities "incidental" to financial activities differ from activities "complementary" to financial activities. Aside from an apparent additional degree of separation, on a technical level the Act requires the Board in the case of a "complementary" activity to find that the activity "does not pose a substantial risk to the safety or soundness of depository institutions or the financial system generally." In addition, complementary activities must be approved by the Board on a case-by-case basis under the notice procedures contained in section 4(j) of the BHCA.
A mirror image procedure is included with regard to the Comptroller's
determination of financial activities that are permissible for financial
subsidiaries of national banks.
The definition of "financial subsidiary" excludes subsidiaries that
engage solely in activities that national banks are permitted to
engage in directly and that are subject to the same rules concerning
such activities as national banks, and subsidiaries that a national
bank is authorized to have under the express terms of a Federal
statute, such as the Bank Service Company Act.
However, the Act provides that after five years, the Board and the
Secretary may jointly adopt rules that permit financial subsidiaries
to engage in merchant banking activities.