Regulation R Implementing Exceptions for Banks from the Definition of 'Broker' in Section 3(a)(4) of the 1934 Exchange Act


As a result of the Gramm-Leach-Bliley (GLB) Act, banks are required to "push out" certain of their securities brokerage activities to registered broker-dealers. In September 2007, the SEC and the Federal Reserve Board jointly adopted Regulation R to implement several of the exceptions for a bank to engage in securities activities without being registered as a broker-dealer. In this commentary, Robert A. Boresta and Basil V. Godellas of Winston & Strawn LLP examine the provisions of Regulation R.
 
The authors write: The application of Regulation R begins with the question — is a security involved? Regulation R provides exceptions from broker-dealer registration for banks engaging in the business of effecting transactions in securities for the account of others. If there is no security involved, a bank need not look to Regulation R. Whether a transaction involves a security may be obvious in the case of traditional securities, such as stocks and bonds, or traditional bank products, such as checking accounts, but may also be unclear in the case of other products, such as derivatives. Still other products such as commodities and swaps, though not considered securities, could be structured in such a manner that they involve securities components that are subject to Regulation R. Similarly, while traditional loans are not considered securities, loans may be packaged and sold in such a manner that they could be considered securities. Products such as interest rate hedges, ISDA swaps, or currency hedges in U.S. or foreign currencies need to be carefully analyzed. In general, bilateral OTC transactions in foreign currency between two parties who are both ‘eligible contract participants,’ as defined in the Commodity Exchange Act, will not be considered securities and may be conducted through a bank. However, an investment contract or option on a security would be considered a security. In order to determine whether a security exists, there needs to be a clear understanding of the precise instruments and the types of counterparties that are involved in the transaction.
 
The possibility that debt instruments may be securities is often overlooked but is important in order to determine whether the sale of debt instruments in any particular case can be effected through a bank rather than through a registered broker-dealer. Generally, the analysis of whether debt instruments that are not characterized as bonds ordebentures are securities turns on the application of the family resemblance test established by the Supreme Court in Reves v. Ernst & Young, 494 U.S. 56, 110 S. Ct. 945, 108 L. Ed. 2d 47 (1990) (“Reves”). Under this test, a note is presumed to be a security unless it bears a strong resemblance, determined by examining four specified factors, to certain instruments that are not securities, such as consumer notes or mortgage loans. Under the Reves test, the transaction-specific factors relevant to determining whether a debt instrument is a security include the parties’ characterization of the instrument being sold, the denomination and manner of distribution of the instrument, as well as more general factors such as the general public’s reasonable expectations concerning how the instrument would be treated.