SEC Issues Proposed Bank Broker-Dealer Rules
The SEC issued its long awaited revised regulation to implement the "push-out" exemptions for banks from broker-dealer ("BD") registration provided by the Gramm-Leach-Bliley Act of 1999 ("GLBA"). The regulation, contained in a new proposed Regulation B, includes highly detailed provisions that build on the framework created in the final Interim Regulations (the "Interim Regulations") issued by the SEC in 2001. The Interim Regulations never took effect due to complaints from banks, banking regulators and members of Congress, each of which criticized those regulations as unduly burdensome and inconsistent with the intent of Congress to avoid disrupting traditional banking activities.
Regulation B incorporates the basic framework of the Interim Regulations but, through a series of complex provisions, provides some additional relief to banks. The SEC indicated that Regulation B still may be changed in response to comments by banks and their regulators, and requested comments on a number of specific provisions. The SEC stated that it wants concrete information and data, not mere conceptual arguments, as to why proposed Regulation B might disrupt traditional banking activities. The exemptions available to thrifts are separately described at the end of this Article.
This Article summarizes key provisions of proposed Regulation B and also reflects certain comments made by senior members of the SEC staff who were involved in its drafting, as well as senior members of the federal bank regulatory agencies, at a conference discussing Regulation B (the "Conference") in DC co-hosted by Goodwin Procter on June 18, 2004. Regulation B is anticipated to become effective approximately one year after it is finalized, with the interim period used by banks to develop appropriate compliance systems.
I. Trust and Fiduciary Activities. Regulation B retains the "chiefly compensated" test from the Interim Regulations under which "relationship compensation" received by a bank from trust and fiduciary activities must exceed "sales compensation." Compensation that is neither relationship nor sales compensation, such as fees for providing transfer agent servicing, is not taken into consideration. As described below, Regulation B includes a number of exemptions designed to ease the burden of compliance with the test, including a grandfather provision for existing trust accounts and a safe harbor for banks whose sales compensation is no more than 10 percent of its relationship compensation.
Grandfather Provision. An exemption is provided for securities transactions for certain trust accounts, including living, testamentary, or charitable trusts opened before 30 days after publication of Regulation B in the Federal Register (approximately July 24, 2004) (the "Grandfather Date"). In order to qualify for the exemption, a bank must comply with the other conditions of the exemption (e.g., the advertising restriction) and the bank may not individually negotiate with the accountholder or beneficiary of the account to increase the proportion of sales compensation compared to relationship compensation. At the Conference, SEC staff indicated that they would be willing to consider expanding the exemption to include other types of trust accounts.
Safe Harbor. Regulation B allows a bank to satisfy the chiefly compensated test on a bank-wide or line of business basis if the bank's ratio of sales compensation to relationship compensation for each line of business was no more than one to nine during the preceding year. A "line of business" means an identifiable department, unit or division of a bank organized and operated on an ongoing basis for business reasons with similar types of accounts and for which the bank acts in a fiduciary capacity. All accounts within a particular line of business must be included in determining whether the bank meets the required ratio.
In order to take advantage of the safe harbor provision, a bank must maintain procedures reasonably designed to ensure that, before opening a trust or fiduciary account, or at any time thereafter that the bank individually negotiates with the accountholder or beneficiary to increase the proportion of sales compensation as compared to relationship compensation, the bank reviews the account to ensure that it "is likely to receive more relationship compensation than sales compensation with respect to that account." This safe harbor provision is anticipated to give banks significantly greater certainty of compliance with the chiefly compensated test, but will require complex compliance procedures.
Account-by-Account Compliance Alternative. For lines of business that do not meet the one to nine ratio, a bank may satisfy the chiefly compensated test on an account-by-account basis (i.e., sales compensation cannot exceed relationship compensation for each account). A bank relying on account-by-account compliance must be able to demonstrate that it met the chiefly compensated test during the preceding year, has met the other conditions of the trust exemption (e.g., the advertising restriction), and maintains procedures reasonably designed to ensure that, before opening a trust or fiduciary account, or at any time thereafter that the bank individually negotiates with the accountholder or beneficiary to increase the proportion of sales compensation as compared to relationship compensation, and reviews the account to ensure that it "is likely to receive more relationship compensation than sales compensation with respect to that account."
Fail Safe Provisions. Regulation B includes fail safe provisions for banks that fail to meet the one to nine ratio of the safe harbor provision or the account-by-account application of the chiefly compensated test. A bank may continue to rely on the safe harbor if it meets the other conditions of the trust exemption (e.g., the advertising restriction), can demonstrate that its ratio of sales compensation to relationship compensation during the preceding year was no more than one to seven, and did not rely on the fail safe provision during any of the preceding five years. For those accounts not included in the safe harbor, a bank does not lose the exemption with respect to any account as long as the account was in compliance with the chiefly compensated test during the preceding five years and the account comes into compliance within one year. If the account does not come into compliance within the next year, the account still may be exempt if the bank documents the reason why the account failed to meet the chiefly compensated test and the reason is linked to the bank's exercise of fiduciary responsibility, and the number of accounts that failed to meet the test is no more than the lesser of 500 accounts or one percent of the total number of accounts that failed. The fail safe provisions may be relied on by a bank if more than ten percent of the total number of accounts for which it acts as a trustee or fiduciary did not meet the chiefly compensated test.
IRA Custodial Accounts. Under proposed Regulation B, as SEC staff confirmed at the Conference, only IRA trust accounts, and not custodial accounts, are eligible for the trust and fiduciary exemption. IRA custodial accounts offered by small banks, however, may qualify for the small bank custody exemption.
II. Sweep Activities. The GLBA provided an exemption for banks that effect transactions "as part of a program for the investment or reinvestment of deposit funds into any no-load, open-end management investment company registered under the Investment Company Act of 1940 that holds itself out as a money market fund." In the release accompanying Regulation B, the SEC stated that this exemption applies only to "arrangements for the automatic transfer of funds on a regular basis" and only to such arrangements involving deposit balances held at a bank by the bank's own customers. The SEC rejected arguments that the exemption would allow sweeps of customer deposits held in banks other than the sweeping bank. The SEC requested comment on this interpretation of the exemption and whether the term "program" should be defined in Regulation B. At the Conference, SEC staff stated that it is not necessary for a sweep program to be electronic or automated, but rather customer "sweep" orders may be entered manually by bank personnel. Also, the SEC staff stated that, while the sweeps must be regular, they need not be daily. As noted, the exemption is limited to sweeps of customer deposits into no-load money market mutual funds. The SEC interpreted the definition of "no-load" in accordance with its customary meaning under the securities laws, rejecting arguments by banks that the term be interpreted to allow sweeps into funds that pay the banks greater than 25 basis points in 12b-1 fees.
The restrictions on the sweep exemption are significantly mitigated by a new exemption for investments in money market mutual funds (discussed in Section III, below).
III. Investments in Money Market Funds. Proposed Regulation B includes a new exemption for investments in money market mutual funds by a bank on behalf of trust and fiduciary accounts, certain agency accounts, and bank customers who are qualified investors (e.g., banks, mutual funds, and persons with $25 million or more of investable assets). The exemption is not limited to noload money market mutual funds. If the fund is not no-load, the bank may not characterize or refer to the fund as no-load and must disclose any payments received by the bank from the mutual fund complex and identify any such payments that are sales loads, deferred sales loads, or 12b-1 fees.
IV. Safekeeping & Custody. The SEC also proposed exemptions for institutions engaging in safekeeping and custody activities. Although not a major topic at the Conference, a key threshold issue the proposal addresses is what is a "custodian," as compared to a "carrying broker" or "clearing broker" (with the latter two requiring broker-dealer registration (except in the case of government securities)). The preamble to Regulation B sets forth 8 factors that the SEC will use when making this distinction. However, the principal distinction is that a carrying broker generally performs back office functions for a BD, while a custodian principally services the customer. This is most likely to be an issue when a bank services custodial clients in tandem with a broker-dealer affiliate.
Assuming the bank is acting in a custodial capacity, then the proposal provides a general custody exemption and a slightly more liberal one for "small banks," as defined below.
A. General Custody Exemption. The focus of the general custody exemption is when a bank can accept orders to effect securities transactions without having to register as a BD (the SEC generally considers acceptance of such orders to be a brokerage activity). Under the proposed general custody exemption, a bank only may accept such orders at all for persons (collectively, "Eligible Parties") that are:
- customers with an account opened by the Grandfather Date, or
- qualified investors (as defined above).
The proposed general custody exemption does not allow banks to accept orders for anyone else.
As to the Eligible Parties, the general custody exemption imposes several further conditions for banks to accept orders without having to register as a BD. More specifically:
- the bank cannot accept any compensation for the orders (other than 12b-1 and shareholder servicing fees) (at the Conference, an "assets under custody" or "money movement fee" was deemed acceptable);
- bank employees may not receive any compensation for the transaction (although they can receive fees based on the establishment or size of the account, and, unlike the Interim Regulations, the employees can be dual employees with a BD and can focus principally on securities activities); and
- the bank may not solicit these transaction services, except through the limited use of third party materials.
Moreover, with respect to condition 1 above, for a bank to accept 12b-1 fees it must make all reasonably available shares of the investment company (not just the shares providing 12b-1 fees) available to the customer.
B. Small Bank Custody Exception. Proposed Regulation B permits small banks to engage in a broader range of custody related activities without having to register as a BD. For these purposes, a "small bank" generally is defined as one:
- which itself has less than $500 million of assets (increased from $100 million in the Interim Regulations), and
- whose holding company has consolidated assets of not more than $1 billion.
A small bank may accept orders for accounts in which it acts as a custodian if:
- the bank is not affiliated with a BD;
- the bank only itself solicits such securities transactions in connection with a broader range of services;
- the annual compensation the bank receives from the exemption (including 12b-1 and revenue sharing fees, but not including standard custody fees) does not exceed $100,000 (this low of a ceiling was deemed problematic at the Conference); and
- the bank does not pay any incentive compensation to employees, other than pursuant to a networking arrangement (as with the general consent exception, restrictions in the Interim Regulations on dual employees and on employees engaging principally in these activities were eliminated).
A small bank also is permitted to provide trust services using this exemption (rather than having to comply with the general conditions for the trust exemption described above), as long as the overall fees remain less than $100,000.
V. Networking Arrangements. Section 201 of the GLBA establishes an exception for banks from the definition of BD for certain brokerage arrangements between a bank and a BD commonly known as a "networking arrangement." The statute establishes several requirements for these types of arrangements, including requiring the BD to "clearly" identify itself as the party performing the brokerage activities and requiring brokerage activities conducted on bank premises to be "clearly marked" and, if possible, "physically separate" from deposit taking areas. In addition, the statute permits unregistered bank personnel only to perform clerical and ministerial functions in connection with brokerage transactions and only to receive a "nominal one-time cash fee of a fixed dollar amount" for referrals of brokerage business. Networking arrangements are, in addition, subject to requirements under longstanding guidance issued by the federal banking regulators relating to retail sales of nondeposit investment products and to the rules of the self-regulatory organizations, such as NASD Rule 2350.
Proposed Regulation B does not restate all of the requirements applicable to networking arrangements, but it does provide guidance on the nature of the nominal, one-time referral fee that unregistered bank employees may receive. Under the proposal, a referral fee will be considered nominal if it does not exceed the greater of:
- the employee's base hourly rate of pay,
- the equivalent of $15 in 1999 as adjusted for inflation (currently approximately $17 according to the SEC), or (3) $25.
The referral fee must be paid in either cash or points (or some combination thereof) having a readily ascertainable cash value, where the points are available for use in an incentive program that covers a broad range of products "that is designed primarily to reward activities unrelated to securities," a standard that the proposed Regulation B leaves undefined. The fee must be one-time, but it may be paid partially at the time of the referral and partially at a later time (such as the end of the year) as long as the amount of the payment is ascertainable at the time of the referral and is not contingent on factors such as the number of referrals during the year. The amount of referral compensation must be fixed for a particular employee, and it may not vary based upon "success factors" such as the customer's net-worth or likelihood of purchasing securities or on whether the referral results in a transaction. However, the fee may be contingent on whether the customer keeps a scheduled appointment with a BD or meets certain minimum requirements that the BD has established generally for all referrals. A referral fee may only be paid for referrals, which the rule defines as action by an unregistered employee to direct a customer to a BD, and an unregistered employee may not receive compensation for performing other functions, such as qualifying a customer, that proposed Regulation B (as well as SEC staff at the Conference) state should be performed only by the BD.
VI. Employee Benefit Plans. Proposed Regulation B also provides an exemption for bank trustees and non-fiduciary administrators that effect transactions in securities of open-end investment companies for participants in employee benefit plans. To qualify for their exemption, a bank must offset any compensation it receives from a fund in which plan assets are invested against fees and expenses owed by the plan and disclose all fees and expenses charged for services provided to the plan and all compensation received from the fund. If the plan permits a brokerage-window, the participants only may make purchases through a BD. Finally, banks only may pay employee incentive fees consistent with those permitted in the networking arrangements described in Section V above.
VII. Regulation S Transactions. Proposed Regulation B also generally would permit banks to effect transactions involving offshore, non-US persons on an agency or riskless principal basis without having to register as a BD. The bank could also re-sell any eligible Regulation S securities after their initial issuance on behalf of or to a non-US person as long as the bank complies with Regulation S. The exemption would not be available if the security is being sold from the inventory of a bank or an affiliate, or generally if the bank or an affiliate is underwriting a new issue security on a firm-commitment basis.
VIII. Thrift Exemption. With certain notable exemptions, Regulation B generally provides thrifts the same exceptions from BD registration as are provided to the banks. However, thrifts are not given the benefit of the general custody exemption (described in Section IV.A. above); the employee benefits exemption (described in Section VI); or the Regulation S exemption (described in Section VII). At the Conference, SEC staff indicated that they would be willing to consider adding these exemptions for thrifts if commenters could demonstrate that thrifts historically have engaged in these activities.
Federal Banking Agencies Issue Advisory on Accepting Accounts from Foreign Governments, Embassies and Political Figures
The FRB, FDIC, OCC, OTS and NCUA (the "Agencies") jointly issued an interagency advisory (the "Advisory") that provides guidance to financial institutions ("FIs") concerning accepting accounts from foreign governments, foreign embassies and foreign political figures. The Advisory makes it clear that before accepting such an account, FIs are expected to:
- apply and consider the FI's board approved standards and guidelines for opening new accounts; and
- consider the FI's own business objectives, the FI's assessment of the risks associated with the particular accounts or lines of business and the FI's capacity to manage those risks.
The Agencies also advise FIs that there are varying degrees of risk associated with different types of accounts and financial relationships with foreign governments, embassies and political figures. The Advisory also;
- directs FIs that either have or are considering financial relationships with foreign governments, embassies or political figures to make such customers aware of the legal and regulatory requirements to which the FI is subject, and
- encourages FIs to "seek to structure such relationships in order to conform them to conventional U.S. domestic banking relationships so as to reduce the risks that might be presented by such relationships." The Agencies also note that FIs can expect an "increased level of scrutiny" by examiners in connection with reviews of these financial relationships.
SEC to Act on Proposals Regarding Short Sale Regulation, Disclosure Regarding Fund Advisory Contract Approvals and Added Fund Corporate Governance Requirements
The agenda for the SEC's open meeting on Wednesday, June 23 includes consideration of whether to adopt:
- amendments to the regulations governing short sales and
- amended and new disclosure requirements regarding board approval of advisory contracts in proxy statements, registration statements and shareholder reports for open-end and closed-end funds and variable annuities. (The June 8, 2004 Alert discusses these agenda items, which were originally scheduled to be addressed on June 9.)
The SEC will also consider whether to adopt amendments to various commonly relied on exemptive rules under the Investment Company Act of 1940, as amended, to require any fund that relies on an exemptive rule to observe certain governance practices.