ABA Section of Business Law
July/August 2001 (Volume 10, Number 6)
Freeing the banks
Gramm-Leach-Bliley brings convergence to the banking, insurance and securities industries.
By Karol K. Sparks
From our earliest days as lawyers, we shared a magic language, a language rife with "whereas," "moreover" and "accordingly" and maybe even a "caveat emptor" or two. For bank lawyers, the lawyer-speak that pronounces us a part of the club gushes acronyms.
We are challenged to complete a sentence without OCC (Comptroller of the Currency), FRB (Federal Reserve Bank), FDIC (Federal Deposit Insurance Corporation), DOJ (Department of Justice), OTS (Office of Thrift Supervision), and NCUA (National Credit Union Association), and those are just the regulators.
It worsens with our laws: FIRREA, FDICIA, CEBA and the like. If it is not an acronym, it's the name of a congressman who sears himself on our memory with the likes of: the Glass-Steagall Act, the Garn-St. Germain Act, the McCarran Ferguson Act .... and now the Gramm-Leach-Bliley Act of 1999. It seems almost sacrilegious to demean Gramm-Leach-Bliley with an acronym or abbreviation because it took decades to enact and it laid to rest too many years of acrimony amongst industries and even regulatory agencies. Yet, the nicknames proliferate: the GLB Act or GLBY (pronounced "Glibbey") or Gliba or just plain Glub. Take your choice.
What is Gramm-Leach-Bliley? It represents a comprehensive reform of the financial services industry. For the first time since the Great Depression, it permits the complete convergence of the banking industry and the insurance industry and the securities industry. It creates the structure for consolidation that ratifies the first such merger in recent history, the merger of Citicorp and Travelers to form Citigroup, and permits the acquisition of U.S. Trust by Charles Schwab, and it establishes the framework for functional regulation of these conglomerates.
In a nutshell, it broadens powers, clarifies which agencies may regulate what entity, and establishes complex schemes for determining which law or regulator wins in a controversy.
But what does it mean to business lawyers? It is a given that Gramm-Leach-Bliley directly affects the business of any bank regulatory or acquisition lawyer. It cuts more deeply, however, affecting the lives of business lawyers who represent any company engaged in "financial services."
For those of us who represent financial institutions, insurance agencies, insurance companies or securities firms, it redefines our clients' powers to consolidate. As a result, banks are acquiring insurance agencies; securities firms are buying banks; insurance companies are continuing to form savings associations; and all vice versas of these deals are possible. Title I of Gramm-Leach-Bliley permits joint ownership through the new vehicles of a financial holding company (FHC) and a financial subsidiary.
The potentially trendy FHC is a bank holding company that migrates into a broader range of activities, activities that are "financial in nature, incidental or complimentary thereto," including:
New powers, such as:
o insurance agency and underwriting
o underwriting, dealing and making a market in securities
o merchant banking or venture capital
o mutual fund activities (advisor, distributor, administrator, seller, sponsor)
o securities lending, safeguarding, exchanging
o issuing or selling asset-backed securities
o travel agency
o pension fund administrator
o underwriting and dealing in foreign government debt;
And old activities, such as
o lending
o lending related (appraisal, check guarantee, collection)
o personal and real property leasing
o operating nonbank depository institutions
o trust and fiduciary services
o financial and investment advising
o securities brokerage, riskless principal, private placement
o investing in government debt, foreign exchange, futures, bullion and coins
o management consulting and counseling
o career services
o community development activities
o money orders/travelers checks
o data processing (financial and economic data).
The Board of Governors of the Federal Reserve System and the Department of the Treasury may each add to this list, but only after seeking the comments of the other agency. In the first such development after enactment of the law, the Federal Reserve added "finder" activities to this list, permitting financial holding companies to locate and match third parties interested in a business transaction and to serve as a conduit between parties in a business transaction. Thus, for example, qualifying institutions are able to host Internet marketplaces.
In another development, the Federal Reserve proposed real estate brokerage as a financial activity; however, the proposal was not well-received by the real estate brokerage industry, and the decision is not final.
To qualify as an FHC, a company first must be or become a bank holding company with the Federal Reserve and then certify as an FHC. To this end, it must:
o File a "declaration" with the Federal Reserve electing to be an FHC.
o File a "certification" with the Federal Reserve, in which it affirms that all of its subsidiary banks and thrifts are well-capitalized and well-managed:
For the purposes of the well-capitalized test, each depository organization must have a leverage ratio of 5 percent, a risk-based Tier 1 ratio of 6 percent and a risk-based total capital ratio of 10 percent.
For purposes of the well-managed test, each depository organization must have a composite CAMELS rating of 1 or 2 (the highest ratings for a financial institution as determined by the primary regulator after an examination) and at least a 2 on the compliance and management components of that rating.
o Ensure that all of the subsidiary banks and thrifts have a "satisfactory" Community Reinvestment Act rating. In this regard, Gramm-Leach-Bliley directs the Federal Reserve to prohibit any FHC from establishing or acquiring a financial company if any of the banks or thrifts have received a less than satisfactory CRA rating in its most recent CRA exam. It also renders ineffective any FHC declaration made when the CRA test is not met.
Once that is accomplished, FHCs may acquire other companies engaged in financial activities or start new financial activities with 30 days after-the-fact notice to the Federal Reserve system. Thereafter, FHCs must continue to meet the well-capitalized and well-managed conditions. Failure to do so means enforcement proceedings and the possibility of divestiture in the event the conditions cannot be met. That means many of us may once again become enforcement lawyers if the economic downturn continues.
Approximately 500 bank holding companies were certified as FHCs in the first year after effectiveness of Title I of Gramm-Leach-Bliley. Interestingly, the majority of these institutions were community banks seeking to sell insurance.
The other new vehicle created by Gramm-Leach-Bliley is a financial subsidiary. A financial subsidiary is a company controlled by one or more banks or thrifts that engages in activities that are financial in nature or incidental to such activities. Whereas an FHC is a parent company, a financial subsidiary, as the name implies, is a new type of bank subsidiary that may be owned 25 percent to 100 percent by the parent bank or thrift.
Financial subsidiaries may engage in the activities listed above for FHCs, but Gramm-Leach-Bliley prohibits financial subsidiaries from underwriting insurance, except for the underwriting authority in place as of Jan. 1, 1999 (essentially credit insurance and captive risks) and engaging in merchant banking activities.
Just as FHCs must qualify to engage in new activities, so do banks and thrifts seeking to own financial subsidiaries. Thus, the bank and all of its depository organization affiliates must meet the well-capitalized, well-managed and CRA satisfactory tests of an FHC or face sanctions. In addition, Gramm-Leach-Bliley places additional conditions on banks and their financial subsidiaries:
o The bank's investment in, and the retained earnings of, the financial subsidiary must be deducted from the capital of the bank;
o The assets and liabilities of financial subsidiaries may not be consolidated with the parent bank;
o The bank must establish procedures for managing financial and operational risks associated with the bank and the financial subsidiary;
o The bank must insure that the financial subsidiary has a separate corporate identity;
o The assets of the financial subsidiary, when combined with the assets of all other financial subsidiaries owned by the bank, cannot exceed 45 percent of the parent banks assets or $50 billion, whichever is less; and
o The affiliate restrictions of Sections 23A and B of the Federal Reserve Act apply, except that the 10 percent of capital limitation as to extensions of credit or investments in any one subsidiary is not applicable. Instead, no more than 20 percent of the bank's capital may be lent to or invested in all financial subsidiaries.
Gramm-Leach-Bliley also requires the largest 100 banks in asset size to have one of the top three ratings of debt to engage in financial activities. The debt requirement, however, does not apply to agency activities and is therefore not relevant in connection with insurance powers.
National banks and state banks that are members of the Federal Reserve may own financial subsidiaries as provided above. State nonmember banks, however, are treated differently by Gramm-Leach-Bliley. They may generally only act as principal through financial subsidiaries subject to requirements similar to FHCs. The result is that the financial subsidiary has no relevancy to state nonmember banks as to insurance powers since financial subsidiaries may not act as a principal with respect to insurance. Because of all of the requirements associated with financial subsidiaries, they have not been a popular structure option to date.
For those of us who represent banks and especially bank trust departments, we must be aware that Gramm-Leach-Bliley eliminated the exemption banks have always had from broker-dealer regulation. Instead of the blanket exemption previously provided by Section 3(a)(4) of the Securities and Exchange Act, Title II of Gramm-Leach-Bliley includes very specific and fact-sensitive exceptions for certain bank activities that our clients have to meet or "push out" nonqualified activities into registered broker-dealers.
In sum, the exceptions relate to: third-party brokerage arrangements; trust activities; certain permissible securities transactions; stock purchase plans; sweep accounts; private placements; safekeeping and custody; and transactions in municipal securities. There is also a de minimis standard of not more than 500 transactions per year. Banks will be expected to maintain records that show compliance with these provisions.
Title II also provides for functional regulation of banking, insurance and securities entities that are commonly owned. As a consequence:
o Each of the regulators, the bank regulators, state insurance departments and the SEC will examine only its functionally supervised entity.
o Banking regulators will examine and supervise banking activities.
o Insurance departments will examine and supervise insurance companies and agencies.
o The SEC will examine and supervise broker-dealers, investment advisors and investment companies.
Obviously, an enormous amount of preparation is required for this division of jurisdiction, and numerous agreements must be reached as to the sharing of data and examination reports and the like.
For those of us who have financial-institution clients that sell insurance or have insurance-company or insurance-agency clients that sell insurance on behalf of financial institutions, there are new regulations promulgated by the banking agencies following the mandate of Gramm-Leach-Bliley that profoundly change the way sales of insurance may be conducted. The regulations deal with disclosures, antitying, place of sales, referral fees, consumer grievance procedures, prohibitions on domestic-violence discrimination and licensing.
All financial institutions selling insurance, including credit insurance, and anyone selling insurance on behalf of a financial institution must now provide five disclosures orally and in writing as to the nature of the product:
o Not a deposit
o Not FDIC insured
o Not insured by any federal government agency
o Not guaranteed by the bank
o May go down in value.
Potentially more disclaimers must be made by loan officers when insurance is offered in connection with a loan:
The bank may not condition an extension of credit on either:
o The consumer's purchase of an insurance product through the bank or any of its affiliates; or
o The consumer's agreement not to obtain, or a prohibition on obtaining, an insurance product from an unaffiliated entity.
Agents must obtain written acknowledgments from consumers that they received the required disclosures. Lest you think this is no big deal, consider that an insurance company that contracts with a bank to sell insurance through telemarketing channels must not only provide the above disclosures but must attempt to obtain the acknowledgment in writing. The telemarketing spiel and the fulfillment package both just mushroomed. And that's just one example of the effect of the new regulations, which are effective Oct. 1, 2001.
Gramm-Leach-Bliley makes privacy lawyers of us all. Just surf the Internet for a while and you will note that everyone from portals to e-banks to e-malls have posted privacy policies (See the article in Business Law Today, "Is it always better to share: Careful what you do with that customer information," May-June, 2001). It is big business for lawyers because Title V of Gramm-Leach-Bliley requires any person engaged in activities financial in nature to adopt a privacy policy and provide customers with an opportunity to opt out of any sharing of nonpublic personal information with third parties. Moreover, the Gramm-Leach-Bliley provisions do not preempt state law. Consequently, conflicting state law requirements must be met. The effective date of the privacy provisions was postponed to the first of July of 2001.
Yes, Gramm-Leach-Bliley laid to rest decades of turf battles that were waged first between the securities industry and the banking industry and then between the insurance industry and the banking industry. But so much of the new law depends on cooperation among regulatory agencies as divergent ideologically and geographically as the Board of Governors of the Federal Reserve system, responsible for monetary policy, and, for instance, the Department of Insurance of Hawaii.
That means that turf battles of a different nature may result as all these regulators continue interpreting Gramm-Leach-Bliley and begin the examination and supervision of "functionally regulated" entities.
It also means that we business lawyers, once we select our pet acronym for this law, should find ourselves with clients that have new regulatory challenges . . . and some new opportunities.
Sparks is a partner at Krieg DeVault LLP, in Indianapolis. Her e-mail is ksparks@kdlegal.com.
