Banks And Broker-Dealers Combining? A Brave New World - Part I

Wednesday, September 1, 2004 - 01:00
Saiber LLC
Ernest E. Badway

Part II of this article appears in the October 2004 issue of The Metropolitan Corporate Counsel.In these uncertain times, many broker-dealers are looking for creative business combinations and relationships to create new revenue streams. The Gramm-Leach-Bliley Financial Services Modernization Act ("GLBA") opened a brave new world for banks and broker-dealers.

The GLBA eliminated many of the barriers that had previously been erected between the banking and broker-dealer businesses by the Glass-Steagal Act, depression era legislation designed to reduce risk. This article will review several issues related to the growing alliance between the banking and brokerage business. However, its focus will primarily be from the brokerage side of the transactions.

Our discussion is not an exhaustive dissertation on all the issues, but an attempt to sensitize those interested in pursuing these relationships to the issues involved. Accordingly, Part I of this article will focus on possible business combinations or investments by banks into the brokerage business. We will discuss the formation of a GLBA financial holding company ("FHC"), and the possible merger-acquisition of a broker-dealer by this FHC. Equity and subordinated debt investments will be examined as alternatives to a possible acquisition. In Part II, the discussion will relate to less radical forms of doing business, including commission and employee sharing as well as third-party brokerage agreements.

Financial Holding Companies

Any merger, acquisition, or equity investment made by a bank to enter into a relationship with a broker-dealer requires the creation of a GLBA FHC so that the bank and broker-dealer may continue to perform their individual financial services.

The Federal Reserve Bank (the "FRB") implemented regulations that govern GLBA FHCs. See C.F.R. 225.81 et seq. To create an FHC, the FRB must approve its formation, and, anecdotally, the FRB seems to be quite generous in granting this status. Once created, the FHC may have subsidiaries performing previously prohibited activities. An FHC may also be created from a previously formed bank holding company that has elected to become an FHC.

For a bank holding company to become an FHC, the FRB requires it to be "well capitalized," "well managed," and to elect to become an FHC. A bank holding company is "well capitalized" if it satisfies certain requirements, including the capital ratio and has no restriction on its capital. See 12 C.F.R. 225.2(r). Similarly, a bank holding company is "well managed" if: (1)the FRB has given it, at least, a satisfactory composite rating for the company, management and compliance programs after periodic reviews, or (2)if the FRB has never reviewed it, now performs a review of the company and concludes it is well managed. See 12 C.F.R. 225.2(s). If these criteria are met, the bank holding company must then make an election to be an FHC by submitting a declaration to the FRB electing FHC status, and certifying that all of the bank holding company controlled depository institutions are well capitalized and well managed.

When established properly, an FHC may then have subsidiary operations that include both banking and brokerage services. Further, the FHC may purchase a broker-dealer company, or make a debt or equity investment.

Subordinated Debt Transactions

This newly created FHC may then make a capital investment into a broker-dealer through subordinated debt. Subordinated debt is a loan of capital to the broker-dealer that is subject to other creditors' claims. This infusion of capital may be used to expand the broker-dealer's operations.

However, subordinated debt must still be reflected as a charge to net capital for the broker-dealer. Pursuant to SEC Rule 15c3-1, the Net Capital Rule, aggregate indebtedness may not exceed 1,500 percent of net capital. "Aggregate indebtedness" is defined to mean "the total money liabilities of a broker or dealer arising in connection with any transaction whatsoever," with certain exceptions such as "... indebtedness subordinated to the claims of creditors pursuant to a satisfactory subordination agreement as defined in [Rule 15c3-1(d)]." See SEC Rule 15c31(c)(1)(x).

Subordinated debt transactions also have limits on the withdrawal of this capital. For example, the FHC may invest in a broker-dealer by choosing convertible, subordinated debt, a form of debt that may be converted into equity securities of the broker-dealer. The broker-dealer is restricted in the conversion of this subordinated debt to equity capital.

The NASD also requires approval of this type of transaction as well as limiting the terms of the subordinated debt transaction; for example, prepayment of this debt must be approved by the NASD. Other restrictions on the conversion of subordinated debt to equity exist, including that no significant lessening of a firm's net capital may result from the transaction. Further, if there is prepayment, the conversion to equity must be simultaneous with the prepayment. Finally, the lenders must agree, before the prepayment, that none of the prepaid funds will be withdrawn from the member during the period that the relevant subordination agreement would be in force. See Letter from SEC Staff of Division of Market Regulation to NASD, dated May 29, 1981; NASD Guide to Rule Interpretations (1996).

Such limitations on subordinated debt transactions require the FHC investor to ensure that it has a long-term investment goal prior to the infusion of capital into the broker-dealer.

Equity Transactions

An FHC may also purchase the equity of a broker-dealer by purchasing common-voting, common-non-voting, preferred-voting or preferred-non-voting stock.

Securities regulatory concerns arise with either common or preferred voting stock. (However, as discussed below, even non-voting stock raises regulatory scrutiny.) If control is affected by this sale - selling 5% or more of voting stock to the FHC (the standard for control) - the broker-dealer must seek approval from the NASD before effecting the transaction. See NASD Membership and Registration Rule 1017.

The Rule 1017 application "shall describe in detail the change of ownership, control, or business operations and include a business plan, pro forma financials, an organizational chart, and written supervisory procedures reflecting the change." If the application requests approval of a change in ownership or control, the application also shall include the names of the new owners, their percentage of ownership, and the sources of their funding for the purchase and recapitalization of the member. See NASD Rule 1017(b)(2)(A). If the application requests the removal or modification of a membership agreement restriction, requests an increase in associated persons involved in sales, offices, or markets made, additional information shall be provided in the application. After approval, the broker-dealer would also have to amend its Form BD to reflect this change of control.

Regulatory concerns also exist even with the purchase of non-voting stock. The broker-dealer must disclose the investment on its Form BD, and the NASD may require information on the investor. If the NASD staff determined the investment was improper, the broker-dealer may also have to unwind the transaction.

Despite the possibility of capital infusion, the parties must navigate regulatory concerns over shifting ownership. Securities regulators especially seek to maintain tight control over the ownership of broker-dealers. In fact, many broker-dealer acquisitions have gone awry when parties have sought to complicate ownership of a broker-dealer.


In sum, the possible business combination between banks and broker-dealers is a creative approach to develop new business. However, if the parties deviate from accepted regulatory standards, no amount of new business will compensate for the regulatory scrutiny the combined business will encounter. The next article will discuss non-acquisition forms of bank and broker-dealer combinations.

Ernest E. Badway is a Partner in the law firm of Saiber Schlesinger Satz & Goldstein, LLC, Newark, New Jersey. He previously served as an attorney with the Division of Enforcement, United States Securities and Exchange Commission. He represents broker-dealers and brokers in securities regulatory, securities defense and white collar criminal defense in matters arising from trading and underwriting activities, as well as defending enforcement actions by the SEC, NASD, NYSE, the New York Attorney General's Office, and the New Jersey Bureau of Securities.

Please email the author at with questions about this article.