Dec 05, 2007
Eight years ago, Congress passed the Gramm-Leach-Bliley Act (GLBA), lowering many of the barriers that were erected between the banking and securities industries following the Great Depression. Although GLBA repealed the blanket exception that prevented banks from having to register as brokers, it provided conditional exceptions for certain banking activities. In accordance with the Financial Regulatory Relief Act of 2006, the SEC and Federal Reserve have now adopted a uniform set of rules to implement those exceptions (72 Federal Register 56514-56568, 10/3/07). The rules become mandatory on the first day of a bank’s fiscal year that commences after September 30, 2008. This BankingLaw@Manatt newsletter provides a brief history of the evolution of the long-stalled Regulation R and a summary of its requirements.
A Brief History Of The 8-Year Process
Key Provisions of Regulation RNetworking Exception. This exception allows a bank to enter into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to the bank’s customers. Although the exception does not limit the amount of compensation a broker-dealer may pay the bank for referrals, it prohibits incentive compensation to unregistered employees and limits the amount they may receive for referrals. Employees may receive only a nominal, one-time cash fee of a fixed-dollar amount for each referral to a broker-dealer. Although unlicensed employees may not provide investment advice or make recommendations to customers regarding securities, they may describe in general terms the types of investment vehicles available from the bank and the broker-dealer under the arrangement.
Referral fees cannot be contingent on the purchase or sale of a security, the opening of a brokerage account, or the type of security transaction. Fees can be contingent, however, on the customer contacting the broker, keeping an appointment, or meeting qualifying criteria (e.g., minimum assets, net worth or income).
Nothing in the networking exception limits or restricts the ability of a bank employee to refer customers to other departments of the bank itself, including, for example, the bank’s trust or custodial departments. Likewise, the networking exception and the rules do not apply to referrals of retail, institutional or high net worth customers to a broker-dealer or other third party solely for transactions not involving securities, such as loans, futures contracts (other than a security future), foreign currency, over-the-counter commodities, or securities (such as U.S. government obligations) that would not require the other party to register under section 15 of the Exchange Act.
Institutional and High Net Worth Customer Exception. A bank may pay its employee a referral fee of more than a nominal amount for referring an “institutional customer” or a “high net worth customer” to a broker-dealer under a networking agreement with the bank.
The bank must have a reasonable basis for believing the customer meets one of these definitions before the referral fee is paid to the bank’s employee. The bank also must have an agreement in place with the broker/dealer which sets forth certain broker/dealer obligations outlined in the Regulation.
High net worth and institutional customers must receive a disclosure of: (i) the name of the broker/dealer, (ii) the fact that the bank employee participates in an incentive compensation program under which the employee may receive a fee for referring the customer to the broker/dealer, and (iii) the fact that payment of the fee may be contingent on whether the referral results in a transaction. The agreement between the bank and the broker/dealer must require the broker/dealer to perform a suitability analysis when the referral fee is contingent on a transaction, and a sophistication analysis for non-contingent fee arrangements.
Employees who receive these higher-than-nominal fees must be primarily engaged in banking activities other than referrals and must encounter high net worth or institutional customers in the ordinary course of their assigned duties for the bank. They cannot be registered or approved (or otherwise be required to be registered or approved) by any self-regulatory organization.
Contingent referral fees under this exception must be (1) a predetermined dollar amount or a dollar amount based on a predetermined formula (e.g., a fixed percentage of total assets placed in an account with the broker/dealer) that does not vary based on (i) the revenue generated by the profitability of securities transactions conducted by the customer, (ii) the quantity, price, or identity of the securities transactions conducted over time by the customer, or (iii) the number of customer referrals; or (2) a fixed percentage of the revenues received by the broker/dealer for investment banking services provided to the customer.
Trust and Fiduciary Activities Exception. This exception allows a bank that is acting in a trustee or fiduciary capacity to effect securities transactions as long as it is “chiefly compensated” with (i) an administrative or annual fee, (ii) a fee based on the percentage of assets under management (including 12b-1 fees), (iii) a flat or capped per-order fee that does not exceed the bank’s execution cost for security transactions for trust or fiduciary accounts, or (iv) any combination of such fees.
A bank must effect such transactions in its trust department or in another department that is regularly examined by bank examiners for compliance with fiduciary principles and standards. A bank that operates on a calendar-year basis must start monitoring its compliance on either an account-by-account or bank-wide basis beginning January 1, 2009, and would have to meet the applicable compensation restriction after the conclusion of 2010 (based on the average of the bank’s year-end compensation ratios for 2009 and 2010). Note: A bank that accepts securities orders as a directed trustee may do so under the custody exception in lieu of the trust and fiduciary exception.
In order to reduce administrative burdens, Regulation R permits banks to exclude the following from their calculation of the chiefly compensated test: accounts that have been open for less than three months; accounts acquired as part of a merger, acquisition, purchase of assets, or similar transaction for up to 12 months after the date of the acquisition; and accounts held at a non-shell foreign branches for the benefit of a U.S. person, provided they constitute less than 10% of the total number of trust and fiduciary accounts of the foreign branch (for the bank-wide test). It also provides that a bank that uses the account-by-account approach will not be considered a broker solely because a particular trust or fiduciary account does not meet the “chiefly compensated” test if, within three months of the end of the year in which the account fails to meet the standard, the bank transfers the account or the securities held by or on behalf of the account to a registered broker-dealer or other unaffiliated entity that is not required to be registered as a broker-dealer. A bank using the account-by-account approach may exclude, for purposes of the chiefly compensated test, the lesser of (i) 1% of the total number of trust or fiduciary accounts held by the bank (with a minimum of 1 account) or (ii) 500 accounts. A bank can rely on this de minimis exclusion only if it did not rely on it during the immediately preceding year and conducted the transactions in the exercise of its trust or fiduciary responsibilities.
A bank operating under this exception may not advertise that it provides securities brokerage services for trust or fiduciary accounts except as part of advertising the bank’s broader trust or fiduciary services. It also may not advertise the security brokerage services more prominently than the other aspects of the trust or fiduciary services provided to such accounts.
Sweep Accounts and Transactions in Money Market Funds. This exception allows a bank to sweep funds from a deposit account to a “no-load” open-end management investment company registered under the Investment Company Act that holds itself out as a money market fund.
Banks also are allowed, without registering as a broker, to effect transactions on behalf of a customer in securities issued by a money market fund, provided that:
(1) The bank provides the customer, directly or indirectly, with some other product or service, the provision of which would not, in and of itself, require the bank to register as a broker-dealer (e.g., an escrow, trust, fiduciary or custody account, a deposit account, a loan, or an extension of credit), and
(2) If the class or series of securities is not “no-load,” the bank may not characterize or refer to it as no-load, and the bank must provide the customer with a prospectus no later than at the time the customer authorizes the securities transactions.
Safekeeping and Custody Exception. Regulation R has separate rules for safekeeping and custody services, depending on whether the bank is undertaking transactions for (i) an employee benefit plan account, an IRA account, or a similar account for which it acts as a custodian, or (ii) any other account for which it is acting as a custodian.
IRA and Employee Benefit Plan Accounts. Regulation R permits a bank, under certain conditions, to accept orders for securities transactions from IRA, employee benefit plan, and similar accounts for which the bank acts as custodian. This includes pension plans, retirement plans, profit sharing plans, bonus plans, thrift savings plans, and incentive plans, among others.
(1) Employee Compensation. No bank employee may receive compensation from the bank or any other person that is based on (i) whether a securities transaction is executed for the account, or (ii) the quantity, price or identity of the securities purchased or sold by the account. This condition does not prohibit an employee from receiving compensation that is based on (a) whether a customer establishes a custodial account with the bank, (b) the total amount at account opening or at any other time, or (c) a bonus or similar plan that complies with Regulation R restrictions.
(2) Advertising Restrictions. A bank may not advertise that it accepts orders for securities transactions for which the bank acts as custodian, except in connection with its marketing of other custodial or safekeeping services. A bank may not advertise its services as a securities brokerage account service or as a substitute for a securities brokerage account. Sales literature used by a bank may not describe the services more prominently than other aspects of the custodial service.
(3) Other Restrictions. A bank may not act in a trustee or fiduciary capacity with respect to the account, other than as a directed trustee (i.e., a trustee that does not exercise investment discretion with respect to the account). A bank must: (i) direct the trade to a registered broker-dealer for execution, or (ii) the trade must be a cross trade or other substantially similar trade of a security that is made by the bank or between the bank and an affiliated fiduciary and is not in contravention of fiduciary principles established under applicable Federal or State law, or (iii) the trade must be conducted in some other manner permitted under the rules, regulations, or orders as the SEC may prescribe or issue. Finally, a bank may not act as a "carrying broker" for a broker-dealer other than with respect to government securities.Other Accommodation Arrangements. A bank may accept orders for securities transactions on an accommodation basis from other types of custodial accounts, subject to the following conditions:
(1) Accommodation. Transactions may only be made as an accommodation to customers. The term "accommodation" is not defined, but will be addressed in later guidance. Presumably, it would not include trades solicited by a bank.
(2) Employee Compensation. A bank employee may not receive compensation from the bank or any other person that is based on (i) whether a securities transaction is executed for the account, or (ii) the quantity, price or identity of the securities purchased or sold by the account. This condition does not prohibit an employee from receiving compensation that is based on (a) whether a customer establishes a custodial account with the bank, (b) the total amount at account opening or at any other time, or (c) a bonus or similar plan that complies with Regulation R restrictions.
(3) Bank Fees. A bank may not charge or receive a fee for effecting securities transactions that is based on: (i) whether the bank accepted the order for the transaction, or (ii) the quantity or price of the securities to be bought or sold. A bank may charge or receive a fee that is based on the type of security purchased or sold (e.g., a foreign security).
(4) Advertising Restrictions. A bank may not advertise that it accepts orders for securities transactions for which the bank acts as custodian. A bank's sales literature: (i) may state that the bank accepts securities orders for such an account only as part of describing the other custodial or safekeeping services the bank provides to the account, and (ii) may not describe the securities order-taking services provided to such an account more prominently than the other aspects of the custody or safekeeping services provided by the bank to the account. The advertising restrictions on accommodation accounts are more restrictive than for IRA or employee benefit plan accounts.
(5) Investment Advice and Recommendations. A bank may not provide investment advice or research concerning securities, make recommendations concerning securities, or otherwise solicit securities transactions, except as described in the preceding "Advertising Restrictions" section. A bank may respond to inquiries, provided no research or investment advice is offered. Other exceptions exist in connection with registered investment companies.
(6) Other Restrictions. A bank may not act in a trustee or fiduciary capacity with respect to the account, other than as a directed trustee (i.e., a trustee that does not exercise investment discretion with respect to the account). A bank must: (i) direct the trade to a registered broker-dealer for execution, or (ii) the trade must be a cross trade or other substantially similar trade of a security that is made by the bank or between the bank and an affiliated fiduciary and is not in contravention of fiduciary principles established under applicable Federal or State law, or (iii) the trade must be conducted in some other manner permitted under the rules, regulations, or orders as the SEC may prescribe or issue. Finally, a bank may not act as a "carrying broker" for a broker-dealer other than with respect to government securities.
Other Exemptions. Regulation R incorporates a number of other exemptions:
Regulation R is designed to accommodate the business practices of banks and protect investors. If more than one broker exception or exemption is available to a bank under the statute or rules for a securities transaction, the bank may choose the exception or exemption on which it relies to effect the transaction without registering as a broker-dealer. For example, if a bank effects a transaction in a security sold in an offshore transaction for a custody account that is permissible under either the Regulation S exemption in Rule 771 or the custody exemption in Rule 760, the bank may choose which exemption to rely on and comply with in effecting the transaction. Similarly, if a bank effects no more than 500 securities transactions as agent for its customers in a calendar year, the bank may rely on the de minimis exception in the Exchange Act in lieu of any other available exception or exemption for such transactions. The bank, of course, must comply with all of the requirements contained in the exception or exemption on which it relies.
Effective Date. Banks do not have to come into compliance with Regulation R until the first day after their fiscal year beginning after September 30, 2008 (i.e., January 2, 2009 for most banks). No contract will be void or voidable because a bank that is a party to the contract violated the Act or Regulation R based solely on its status as a broker when the contract was created: (i) for contracts entered into before March 31, 2009; or (ii) if, at the time the contract was entered, the bank acted in good faith, had reasonable compliance policies and procedures in place, and its violation did not result in any significant harm, financial loss or cost to the person seeking to void the contract.
Click Here for Link to the Final Rule
Banks that conduct activities governed by new Regulation R should consult their bank regulatory counsel and their regulators to ensure compliance with the Regulation. Banks that contemplate expanding into securities activities with new products and services need to anticipate the administrative burden and cost of complying with Regulation R.
Attorney ContactsGene R. Elerding, 310.312.4158Mick Grasmick, 310.312.4369
Gene R. Elerding Gene Elerding’s practice focuses on banking law, with an emphasis in regulatory and operational issues affecting financial institutions and advertisers. He represents a growing number of companies in connection with e-commerce, online banking, check disputes, deposit agreements, information management and payment system issues. He advises clients on a wide variety of legal issues affecting product development, privacy, vendor services, cash management, consumer disclosures and compliance. His hobby is regulatory trivia.
Mick Grasmick Mr. Grasmick's practice focuses on mergers and acquisitions, non-banking activities, formation of new banks, interstate and other expansion by banks, bank holding companies and other financial institutions and the requirements and restrictions on expansion of state and federal bank regulatory agencies; bank supervision and examination, and general banking corporate matters and regulatory and legislative developments.
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