Independent Broker Dealer- Atlanta Financial Advisor, article

For more than seven years, the Securities and Exchange Commission (SEC) and the Federal Reserve Board (FRB) (collectively, the Agencies) struggled to implement the specific functional exceptions from the definitions of the terms “broker” and “dealer” under the Securities Exchange Act of 1934 (Exchange Act), as amended by the Gramm-Leach-Bliley Act of 1999 (GLB Act). Under the GLB Act, U.S. banks, including the U.S. branches and agencies of foreign banks, are required to “push out” their securities brokerage activities to registered broker-dealers while retaining the ability to continue to perform certain traditional banking activities.1 In September 2007, the Agencies jointly adopted Regulation R to implement the Push Out Provision.2 In particular, Regulation R imposed certain requirements on a bank in connection with offshore offers and sales of securities under SEC Regulation S (the Regulation S Exemption).

A bank engaging in offshore securities transactions that are not encompassed within the Regulation S Exemption will need: (i) to conform its activities under the Regulation S Exemption; or (ii) register as a broker-dealer with the SEC. As a practical matter banks cannot register as brokerdealers under the Exchange Act because of the restrictions on their capital and operations imposed under the securities laws and inherent conflicts with banking regulations. Accordingly, a bank, including the U.S. branch or agency of a foreign bank, should re-assess the manner in which it offers and sells securities offshore to ensure that it complies with the Regulation S Exemption. If a bank conducts offshore securities activities that do not qualify for the Regulation S Exemption, it should consider establishing an affiliated broker- dealer in order to be able to “push out” those activities to an affiliate. Under Regulation R, a bank is required to comply with the Regulation S Exemption no later than the first day of the fiscal year commencing after September 30, 2008.

Regular S Exemption

Regulation S consists of a set of rules governing offers and sales made outside the United States without registration under the Securities Act. Rule 903 of Regulation S provides a non-exclusive safe harbor for the offer and sale of securities outside the United States by issuers, distributors,3 their affiliates and anyone acting on their behalf (Issuer Safe Harbor). Rule 904 of Regulation S provides a safe harbor for resales by persons other than issuers or distributors (Resale Safe Harbor). If the provisions of either of the safe harbors are met, offers and sales will be deemed to have been made outside the United States and, thus will not be subject to the registration requirements of Section 5 of the Securities Act.

Two general conditions (collectively, the General Conditions) apply to all offers, sales and resales made under Regulation S, regardless of whether such offers, sales or resales are made under the Issuer Safe Harbor or the Resale Safe Harbor. First, the offer or sale must be made in an “offshore transaction.” An “offshore transaction” is a transaction in which no offer is made to a person in the United States, and either at the time the buy order is originated, the purchaser is outside the United States (or the seller and any person acting on its behalf reasonably believes the purchaser is outside the United States), or the transaction is executed in, on or through the facilities of a designated offshore securities market (for the Resale Safe Harbor), or a physical trading floor of an established foreign securities exchange (for the Issuer Safe Harbor). Second, no “directed selling efforts” may be made in the United States in connection with an offer or sale of securities pursuant to Regulation S. “Directed selling efforts” are those activities that could reasonably be expected, or are intended, to condition the Wall Street Lawyer market with respect to the securities being offered in reliance upon Regulation S. Activities such as mailing printed material to U.S. persons, conducting promotional seminars in the United States, and placing advertisements with radio and television stations broadcasting into the United States or in publications with a general circulation in the United States, could constitute “directed selling efforts” in the United States if they discuss the offering or are otherwise intended to condition the U.S. market with respect to securities being offered abroad.

The Preliminary Notes to Regulation S state that Regulation S does not obviate the need for any person to comply with the Exchange Act whenever such requirements are applicable. In the adopting release for Exchange Act Rule 15a-6 which concerns the activities of foreign brokerdealers, the SEC set forth certain general principles of broker-dealer registration applicable to the activities of international broker-dealers. In that release the SEC stated that “the definitions of “broker’ and ‘dealer’ do not refer to nationality, and the scope of these definitions includes both domestic and foreign persons performing the activities described therein. Consequently, any use of the U.S. jurisdictional means to engage in these activities could trigger the broker-dealer registration requirements of section 15(a).”4 The SEC also indicated in that release that it follows a territorial approach in applying its broker-dealer registration requirements to the international operations of broker-dealers. Under this approach, all broker-dealers physically operating within the United States that effect, induce, or attempt to induce any securities transactions would be required to register as broker-dealers with the SEC, even if these activities were directed only to foreign investors outside the United States.5 The SEC has confirmed its view on this issue in a recent noaction letter.6 In addition, the SEC stated that it uses an entity approach with respect to registered broker-dealers:

“Under this approach, if a foreign brokerdealer physically operates a branch in the United States, and thus becomes subject to U.S. registration requirements, the registration requirements and the regulatory system governing U.S. broker-dealers would apply to the entire foreign broker-dealer entity. If the foreign broker-dealer establishes an affiliate in the United States, however, only the affiliate must be registered as a brokerdealer; the foreign broker-dealer parent would not be required to register.”7

Thus, absent an exemption a bank engaging in the business of effecting offshore transactions in securities in reliance on Regulation S from within the United States would be required to register as a broker-dealer.

In order to qualify for the Regulation S Exemption, a bank must: (i) effect a sale, as agent, in compliance with the requirements of the Issuer Safe Harbor of an eligible security8 to a purchaser who is not located in the United States; (ii) effect, by or on behalf of a person who is not a U.S. person (within the meaning of Regulation S), a resale of an eligible security after its initial sale with a reasonable belief that the eligible security was initially sold outside of the United States to a purchaser who is not in the United States or to a registered broker or dealer; or (iii) effect, by or on behalf of a registered broker or dealer, a resale of an eligible security after its initial sale with a reasonable belief that the eligible security was initially sold outside of the United States within the meaning of and in compliance with the Issuer Safe Harbor to a purchaser who is not in the United States. If the resale is made prior to the expiration of any applicable distribution compliance period specified in Rule 903(b)(2) or (b)(3) of Regulation S,9 the resale is to be made in compliance with the requirements of the Resale Safe Harbor.10

Related Changes to the Definition of Dealer

The SEC also adopted conforming changes to the definition of “dealer” in the Exchange Act to give effect to the Regulation S Exemption and other changes in the final version of Regulation R.11 In particular, the SEC adopted a conditional exemption that allows banks to effect riskless principal transactions with non-U.S. persons pursuant to Regulation S to conform with Rule 771.12 As with the changes to Rule 771, amended Exchange Act Rule 3a-5-2 recognizes that non- U.S. persons generally would not rely on the protections of the U.S. securities laws when purchasing securities under Regulation S from U.S. banks, and that non-U.S. persons can purchase the same securities from banks located outside of the United States.13 The exemption only applies to purchases and sales of “eligible securities”14 that a bank makes on a “riskless principal” basis, i.e., a transaction involving contemporaneous buy and sell orders, which from a regulatory perspective, are tantamount to agency trades.

Recommended Practices

Banks that are considering relying on the Regulation S Exemption and the related exemption from the definition of dealer should consider the following issues after establishing that a transaction: (i) complies with the general conditions of Regulation S (an offshore transaction with no directed selling efforts in the United States); and (ii) involves an eligible security, that is, the securities are not being sold from the inventory of the bank or an affiliate and are not being underwritten by the bank or an affiliate of the bank.

1. Does the transaction involve a bank, as agent or riskless principal, effecting a sale in compliance with the Issuer Safe Harbor to a non- U.S. person as defined in Regulation S (Non- U.S. Person), who is not in the United States (Foreign Purchaser)? A bank may not sell under this exemption to any purchaser who is in the United States, even if such person is a Non-U.S. Person.
2. Does the transaction involve a bank, as agent, effecting by or on behalf of a Non-U.S. Person, a resale of an eligible security to a Foreign Purchaser or a registered broker-dealer, or if acting as riskless principal, purchasing an eligible security from a Non-U.S. Person and re-selling that security to a Foreign Purchaser or to a registered broker-dealer? If so, does the bank have a reasonable belief that the security was initially sold outside of the United States under the Issuer Safe Harbor? Meeting the reasonable belief standard requires a bank to conduct certain diligence, such as checking with an issuer’s transfer agent and obtaining other information available from third-party sources.15 Is a Regulation S distribution compliance period still in effect? If so, the resale should be made in compliance with the Resale Safe Harbor. Even if the distribution compliance period has expired, in adopting Regulation R the SEC indicated that purchasers other than registered brokerdealers may not be in the United States.16
3. Does the transaction involve a bank, as agent, effecting by or on behalf of a registered broker- dealer, a resale of an eligible security to a Foreign Purchaser, or if acting as riskless principal, purchasing an eligible security from a registered broker-dealer, and re-selling that security to a Foreign Purchaser? If so, does the bank have a reasonable belief that the security was initially sold outside of the United States under the Issuer Safe Harbor? Is a Regulation S distribution compliance period still in effect? If so, the resale should be made in compliance with the Resale Safe Harbor.

Conclusion

As a result of the changes to the definitions of broker and dealer and the SEC rules promulgated to give effect to those changes, banks may no longer freely effect offshore transactions without risk of engaging in broker-dealer activities. Accordingly, banks should examine their policies and procedures governing offshore transactions and make appropriate changes to conform to the new regulatory scheme brought about by Regulation R.

Notes:

1. The banking exception to the definition of broker consists of ten (10) banking activities and an additional de-minimus exemption for up to 5 00 transactions in securities in any calendar year, provided that such transactions are not effected by an employee of the bank who is also an employee of a broker or dealer.
2. 72 Fed. Reg. 56 ,514 (October 3 , 2 007). The SEC adopted Regulation R on September 19, 2 007 and the FRB adopted Regulation R on September 24 , 2 007. The Agencies acted after consultation with the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation and the Office of Thrift Supervision and consideration of all comments received on the proposed rules. Regulation R also addresses sales of securities under a networking agreement; securities activities that are part of a trust or fiduciary business; the investment of funds into money market funds; accepting orders for securities for certain custodial account holders on an accommodation basis; certain transactions involving mutual funds, variable annuity contracts and variable life insurance policies, transactions involving a company’s securities for its employee benefit plans and participants and securities lending activities.
3. A distributor includes any underwriter, dealer or other person that participates, pursuant to a contractual arrangement, in the distribution of the securities offered or sold in reliance upon Regulation S.
4. Section III.B.1.,Release No. 34-27017; July 11, 1989. Wall Street Lawyer 10
5. Id.
6. See, e.g., NO-ACT, WSB File No. 1213200411, Dilworth Capital Management, LLC (Dec. 09, 2004).
7. Id.
8. The term “eligible security” is defined to mean a security that: (i) is not being sold from the inventory of the bank or an affiliate of the bank; and (ii) is not being underwritten by the bank or an affiliate of the bank on a firm commitment basis, unless the bank acquired the security from an unaffiliated distributor that did not purchase the security from the bank or an affiliate of the bank. Rule 771(b)(2).
9. The distribution compliance period ranges from 4 0 days to one year.
10. Under a prior proposal, a bank would have only been permitted to rely on a reasonable belief that a security was sold in compliance with Regulation S when it purchased a security from a non-U.S. person but not when it purchased a security from a broker-dealer. In response to comments the final rules relax this standard allow for a bank to only have a “reasonable belief” that the eligible security was initially sold outside the United States when purchasing from a broker-dealer.
11. 72 Fed. Reg. 56,562 (October 3, 2007).
12. In the same release the SEC amended and re-designated an existing exemption from the definition of “dealer” for banks’ securities lending activities as a conduit lender. and made conforming changes to Exchange Act Rule 15a-6 that provides a limited exemption from U.S. broker-dealer registration for foreign broker-dealers operating pursuant to the amended definitions of “broker” and “dealer” under the Exchange Act. In addition, the SEC withdrew three rules under the Exchange Act no longer necessary either because of judicial invalidation; the passage of time or subsequent legislation. Id.
13. Section II.A., 72 Fed. Reg. 56,562 (October 3, 2007).
14. Exchange Act Rule 3a5-2(b).
15. See the Comment Letter from the Institute of International Bankers, March 23, 2007.
16. See Section VI.A., 72 Fed. Reg. 56,514 (October 3, 2007).

About the Author

Robert A. Boresta (rboresta@winston.com) specializes in broker-dealer regulation and Michael A. Mancusi (mmancusi@ winston.com) specializes in banking regulation. They are each corporate partners in Winston & Strawn’s Financial Services Practice Group. For additional information please see: www.winston.com.