Opinion ID: 287861
Heading Depth: 2
Heading Rank: 2

Heading: The Glass-Steagall Act

Text: 23 The District Court held that the Comptroller's authorization of the Account violated four provisions of the Glass-Steagall Act. It held that in the issuance of units of participation, the Bank was engaged in the business of dealing in securities for its own account in violation of 16 and 21, and that the relation between the Bank and the account was an affiliation or interlocking directorate between a bank and an organization principally engaged in the securities business in violation of 20 and 32 of the Act. 24 (1) Sections 16 and 21 25 Section 16 of the Glass-Steagall Act imposes the following limitation upon bank dealing in securities: 26    The business of dealing in securities and stock by the (national banking) association shall be limited to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers, and in no case for its own account, and the association shall not underwrite any issue of securities or stock   . (12 U.S.C. 24 (seventh).) 27 Section 21 of the Act prohibits commercial banks from engaging in the business of 'issuing, underwriting, selling or distributing' most types of securi ties. 5 Because the units of participation in the Account are securities, and the Bank is the statutory underwriter under the Securities Act of 1933, the District Court held that the Bank is engaged in the selling and underwriting of securities prohibited by 16 and 21 in operating the Account. 28 The words security and underwriter in the Securities Act of 1933 are terms of art with a high gloss. Their expansive definitions under the Securities Act cannot be imported wholesale into the Glass-Steagall Act when the two statutes serve different purposes, in different contexts of risk to the public. The securities laws are intended to protect investors, primarily through disclosure requirements. Their terms have been interpreted broadly to afford their protection to purchasers of all manner of investment interests, wherever it is needed. The Glass-Steagall Act, by contrast, was enacted to protect bank depositors and the banking system from the risk of insolvency incident to widespread investment of banks' assets in speculative securities during the twenties. Banks frequently not only invested in speculative securities, but entered the business of investment banking by underwriting original issues. Some of these activities were undertaken directly; others were carried on by securities affiliates formed and controlled by the banks to evade completely the weak restrictions upon direct bank dealing in speculative securities. Section 16 of the Act was addressed to three problems: 29 (1) Banks commonly invested their own assets in securities, risking commercial and savings deposits if the securities declined in value. 6 30 (2) Direct bank investment in securities created pressure for banks to make unsound loans to maintain the price of securities or the financial position of companies in which the bank had holdings. 7 31 (3) Large city banks frequently acted as issuers, or underwriters of blocks of securities, distributing them at a profit through correspondent country banks. The banks' pecuniary interest in the ownership, price, or distribution of securities created incentive to steer customers into investing in what the banks had to sell. 8 32 The problem of risk to deposits does not arise here, because the securities in the fund are purchased for the account of the customer, not the Bank. The ICI does claim, however, that the Bank's indirect holdings in the Account may amount to an interest in individual companies sufficient to influence its credit decisions. The short answer is that, since this indirect risk is present in all bank investments in securities for the account of customers, that problem was not within the contemplation of the Glass-Steagall Act. 33 With regard to the third abuse treated by 16, the ICI points out that because the Bank's compensation is tied to the size of the fund, there will be pressure to market the participations to maintain and increase its assets. I agree. 9 But the Bank is under similar pressure to sell all the services of its trust department. The Bank's interest in earning a regulated fiduciary charge bears little resemblance to its interest in earning an indeterminate distributing profit from securities which it owns or underwrites, and the interest forbidden by 16 is the latter. 34 Section 21 of the Act prohibits banks from engaging '   in the business of issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stocks, bonds, debentures, notes, or other securities   .' It was enacted to extend the prohibitions of 16 to members of the Federal Reserve System who were not national banks. Congress did not intend to bar those banks from buying and selling securities 'for the account of customers,' so 21 appears to add nothing to the argument under 16. If anything, the language of 21 confirms the view that Congress was concerned in both provisions with prohibiting bank dealing in speculative securities for the traditional and direct form of distribution profit. 10 35 (2) Sections 20 and 32 36 Sections 20 and 32 of the Act were enacted to maintain the separation between commercial banking and securities dealing by prohibiting interlocks and affiliations of personnel. Section 20 forbids certain types of bank affiliation with any organization 'engaged principally' in the same brand of securities dealing forbidden as a direct bank activity by 21. One type of prohibited affiliation, defined in 221a(b)(3), ordinarily exists when a majority of the directors of a securities organization are also directors of any one member bank. 37 Section 32 generally prohibits directors, officers, or employees of organizations 'primarily engaged' in securities dealing from serving in those capacities for a member bank. The Federal Reserve Board has consistently held that 32 prohibits bank officials from serving as officials of open-end investment companies because such companies (mutual funds) are primarily engaged in issuing their own shares. 12 C.F.R. 218.101 (1951). The Board ruled, however, that the Account and the Bank were a single entity for purposes of 32, since the Account would be a department of the Bank except for purposes of Investment Company Act. So long as the Account remained under the 'effective control' of the Bank, the Board stated that there was no prohibited interlock under 32. 30 Fed.Reg. 12836 (1965), adding 12 C.F.R. 218.111(j) (1965). 11 38 The participants' reserve power to sever the connection with the Bank would be worth something in the event of extraordinary mismanagement, but barring this contingency, the Account will remain part of the Bank's organization. Under the single entity theory, the Bank cannot interlock with itself but that is not really the point. The clear purpose of 20 and 32 is to prevent banks from entering into prohibited forms of securities dealing by the back door. We have held that the Bank may enter the business of operating the Account by the front door. The organizational pattern imposed to satisfy the requirements of the Investment Company Act does not in this context create a prohibited interlock or affiliation any more than the Account itself constitutes a forbidden excursion into the securities business. 39 The establishment of a bank-sponsored collective investment fund is not barred by the banking laws. A commingled managing agency account is a descendant of the individual managing agency account and the common trust fund, fitting within the traditional authority of banks to manage other people's money in a fiduciary capacity sanctioned by the Federal Reserve Act. Where the fiduciary tie between the bank and multiple principals is looser, the Comptroller's regulations and the securities laws will take up the slack. The essential element in this judgment on the applicability of the Glass-Steagall Act is the fact that the securities in the Account are bought and sold for the account of customers. The sale of an investment service to a potentially large number of customers gives rise to obligations under the securities laws, but these do not convert otherwise lawful transactions for the account of customers into prohibited securities dealings within the meaning of the Glass-Steagall Act. 40 The major consequence of expanded investment service by banks will be a quantitative change in the volume of securities bought, sold, and held by banks. While substantial transactions in securities by banks may be essential for the modern management of their customers' money, an increase in their already massive securities holdings for the account of customers has some disquieting consequences for the underpinnings of corporate accountability and competition in the economy at large. 12 The dimensions of the problem are broader, however, than the banking laws on the books. The Glass-Steagall Act enforces the separation of commercial banking and a particular kind of securities dealing. Its legislative history affords little support and even less guidance for a judicial decision to limit bank transactions in securities for customers because today they differ in degree. III 41 VALIDITY OF EXEMPTIONS FROM 10 OF THE INVESTMENT COMPANY ACT 42 The NASD, for its part, claims that the Bank's control of the Account is all too effective. It contests the orders by the Securities and Exchange Commission granting certain of the exemptions from 10 of the Investment Company Act requested by the Bank prior to registration of the Account as a diversified, open-end management investment company under the Act. The exemptions together permit three or 60 percent of the Account's five-member Committee to be persons affiliated with the Bank. 43 Section 10 of the Act was enacted to protect shareholders of investment companies from exploitation by insiders with conflicting interests in other companies or lines of business by requiring that a certain percentage of directors be free of affiliations which may involve divided loyalties. Without the exemptions, 10 of the Act would preclude the Account from having a majority of directors who are officers, directors, or employees of (1) a principal underwriter, 15 U.S.C. 80a-10(b)(2), (2) investment bankers, 80a-10(b)(3), and (3) a single bank, 80a-10(c). While the Bank fits each of these statutory categories, the overriding issue is the propriety of the exemption granted from 10(c) to permit a maximum of three instead of two Bank officers to serve on the five-member Committee. A working majority of Bank directors was essential to allow the Account to function in conformity with the banking laws. 44 Before considering the exemption from 10(c), it bears emphasis that there is nothing unusual in the fact that the Bank as investment adviser has majority control of the Committee of the Account. Open-end investment companies have traditionally been controlled and managed by their investment advisers; investors are buying their advice. Section 10(a) of the Act provides that 60 percent of the directors of an investment company may be affiliated with the investment adviser. Section 10(d), moreover, permits certain types of 'no-load' funds to have only one unaffiliated director if they meet specified conditions. The Bank sought but was denied an exemption which, if granted, would have enabled it to have only one unaffiliated Committee member. 13 45 Given these facts, the NASD's assertion that the Committee will abdicate its supervisory responsibilities because the Bank has 'effective control' of the Account in the eyes of the banking authorities requires a showing of something more than the normal pattern of majority control by an investment adviser. Nothing in the Comptroller's regulations still applicable precludes the Committee from exercising its responsibilities. Although Regulation 9, as originally promulgated, did not take account of the requirements of the Investment Company Act, all provisions of Regulation 9 inconsistent with that Act were superseded by the Comptroller's written approval of the Account in the form necessary to satisfy the Securities and Exchange Commission. The Bank's majority control for purposes of day-to-day management of the fund is a false problem. The real issue is whether exemptions allowing an extra director on the Bank side will undercut the Committee's watchdog role in areas of potential conflict of interest. 46 Section 6(c) of the Investment Company Act empowers the Commission to grant exemptions from the Act, or any rule or regulation adopted under it, '   if and to the extent that such exemption is necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions' of the Act. 15 U.S.C. 80a-6(c). The Commission has exercised this authority to exempt persons not within the intent of the Act and generally to adjust its provisions to take account of special situations not foreseen when the Act was drafted. Transit Investment Corporation, 28 S.E.C. 10, 16 (1948); The Atlantic Coast Line Company, 11 S.E.C. 661, 666-667 (1942). 47 In granting the exemptions at issue, the Commission first observed that the Account differs on the one hand from the bank-dominated securities affiliates of the twenties whose abuses inspired 10 14 and, on the other, from open-end investment companies (mutual funds) not subject to the supervision of the Comptroller. For these reasons, it was appropriate to consider whether a bank-sponsored fund was a type of investment company requiring the standard measure of unaffiliated directors or whether exemptions were justified by its novel characteristics. The Commission concluded that the risks of conflict of interest would be adequately controlled by the provisions of the Investment Company Act still applicable, supplemented by the Comptroller's regulations, and that the exemptions would permit the establishment of a desired new investment medium, still subject to all the safeguards necessary for the protection of its investors. 48 The conflict of interest problems created by bank affiliation with investment companies are of a different order when the fund is sponsored by the bank. In the proceedings below, the Commission considered four danger zones, previously cited by former Chairman William L. Cary in testimony before Congress recommending regulation of collective investment funds, 15 and urged by the NASD as reasons for denying the exemptions. 49 A. Retention of substantial cash deposits for the Account in the bank 50 The Commission discounted the danger that the Bank might retain an unwarranted portion of the Account's assets in cash in order to earn money for the Bank, stating that the temptation to leave funds uninvested would be contrary to the Account's stated policy of investment for long-term growth of capital and income, and to the Bank's interest in having the fund's assets increase. The interest in increasing the assets in the fund dictates not only that funds already held be invested in growth securities, but also, as we have seen, creates pressure to increase the number of participants. The undisputed fact that the Account will compete with the mutual fund industry can be expected to inhibit retention of its income-producing assets in the form of lopsided cash deposits, There is an important point of convergence between the interests of the Bank directors qua commercial bankers and their interest in the success of an investment medium offered as part of the Bank's services, a convergence not present when Bank personnel serve as directors of independent investment companies. 51 The Comptroller's regulations, moreover, state that funds held in a fiduciary capacity by banks shall not be held uninvested or undistributed for a period longer than is reasonable for the proper management of the particular account. 12 C.F.R. 9.10(a). Observance of this regulation is policed through examinations of bank trust departments which occur at least three times in every two years. 12 U.S.C. 481. The Commission reasonably concluded that the Bank's interest in holding the Account's asset in cash was offset by this combination of the carrot and the stick. 52 B. Use of Account investments to shore up Bank loans 53 Considered under 16 of the Glass-Steagall Act was the danger that the Bank might make unsound loans to shore up companies in which it had made investments for the Account. From the standpoint of the Investment Company Act, the risk is that the Bank will make bad investments for the Account to shore up unsound loans. In a letter to the Senate Committee on Banking and Currency, Chairman William McChesney Martin of the Federal Reserve Board explained why this area of risk was not regarded as significant. 54 For many years banks have participated in the management of employee benefit funds and other fiduciary accounts that hold stocks and other securities in an aggregate amount far exceeding those held by the entire mutual fund industry. The examinations conducted by bank supervisory agencies have disclosed practically no such misuse by banks of their investment advisory and management functions. In the case of managing agency funds, an additional safeguard is the prophylactic restrictions and requirements of the Investment Company Act of 1940, particularly publicity of the financial transactions of registered investment companies, which almost inevitably would expose such malfeasance. A further deterrent would be the adverse impact on a collective fund's performance-- its comparative financial record-- if any of its resources were used to make unprofitable investments; the detrimental effect on sales of participations might outweigh any benefits the bank could reasonably expect from its breach of fiduciary duty. 16 55 In addition to taking note of the Comptroller's supervision of investments, the Commission cited its own supervision of transactions involving a joint arrangement between the Bank acting as a principal and the Account under the insider provision of 17(d) of the Act, 15 U.S.C. 80a-17(d), 17 and concluded that the margin for misconduct of this sort was narrow. 56