Broker-Dealer/Financial Institutions
AUGUST 2004
Rule 3b-9 Comes Full Circle: Functional Regulation
and Proposed Regulation B
INTRODUCTION
The Securities and Exchange Commission
(“Commission”) published for comment proposed
Regulation B under the Securities Exchange Act of
1934, as amended (“Exchange Act).1 Proposed
Regulation B sets forth the implementing rules of the
broker “push out” provisions of the Gramm-LeachBliley Act of 1999 (the “GLBA”) and is intended to
provide guidance and flexibility to banks in their
securities activities. The GLBA eliminated a blanket
exclusion from the definition of broker for banks and,
in its place, set forth 11 specific bank exceptions in
an amended definition of broker, which permit banks
to engage in limited securities activities outside of
the Exchange Act’s broker-dealer regulatory regime.
The Commission established an aggressive notice
and comment period originally scheduled to expire on
August 2, 2004, but has since extended the comment
period to September 1, 2004.
HISTORICAL BACKGROUND
The much-anticipated implementing rules for the
GLBA “push out” provisions have experienced a
fairly long and controversial evolution. Proposed
Regulation B is intended to incorporate in regulatory
form long-held notions of functional regulation that
not surprisingly have created tension between the
banking industry and the Commission’s regulatory
1
approach. Concepts of functional regulation long
predated the so-called Interim Final Rules (as
discussed below), even the GLBA itself. Arguably,
proposed Regulation B had its humble beginnings in
1985 when the Commission adopted ill-fated Rule 3b9 under the Exchange Act.2
Rule 3b-9
In 1985, the Commission sought to regulate bank
expansion into the brokerage business by requiring
banks, in effect, to “network” with registered brokerdealers for purposes of providing discount and retail
brokerage services to bank customers.3 Rule 3b-9 –
modest in comparison to the GLBA and proposed
Regulation B – set forth conditions that sought to
segregate bank brokerage functions from banking
and to allocate them to a registered broker-dealer
under the Exchange Act’s broker-dealer regulatory
regime. Rule 3b-9 became the precursor to the current
statutory exception for third-party networking
arrangements.
The Commission’s theory for regulating bank
brokerage activities (otherwise subject to a blanket
exclusion at the time) under Rule 3b-9 was that bank
brokerage activities had evolved radically since
Congress first passed the Banking Act of 1933
(otherwise commonly known as the Glass-Steagall
Act), which separated commercial banking from
Securities Exchange Act Release No. 49879 (June 17, 2004), 69 FR 39862 (June 30, 2004)..
2
See Securities Exchange Act Release No. 22205 (July 12, 1985).
3
Rule 3b-9 was in apparent response to decisions in the early 1980’s by the Office of the Comptroller of the Currency
(“OCC”) and Federal Reserve Board expanding bank securities powers. These positions were upheld in two important
judicial decisions. See Securities Industry Association v. Board of Governors, 468 U.S. 207 (1983) (unanimous approval
of the sale of a discount brokerage to commercial bank previously approved by the Federal Reserve Board); and Securities
Industry Association v. Comptroller of the Currency, 577 F. Supp. 252 (D.D.C. 1983) (upholding OCC’s approval of
national bank acquisitions of discount brokers).
Kirkpatrick & Lockhart LLP
investment banking. The separation of commercial
banking from investment banking, and related
limitations on bank securities activities, under GlassSteagall was viewed as justification for incorporating
in 1934 the blanket exclusion for banks under the
Exchange Act. In justifying its authority to adopt
Rule 3b-9, the Commission pointed to the prefatory
language of Section 3 of the Exchange Act, which
states “unless the context otherwise requires” and
argued that the context did require that banks
engaging in broad securities activities no longer were
acting as banks, as envisioned by Glass-Steagall and
the Exchange Act, but were more aptly functioning as
broker-dealers. Therefore, the context required that
banks be regulated as broker-dealers. Hence, the
concept of functional regulation of bank-broker
activities was born.
The American Bankers Association (“ABA”)
promptly sued the Commission for exceeding its
statutory authority in attempting to regulate bank
securities activities that were otherwise excluded
from the Commission’s jurisdiction to regulate the
business of broker-dealers.4 The District of
Columbia Circuit Court of Appeals agreed with the
ABA and overturned the validity of Rule 3b-9. The
Commission declined to appeal the decision.
Although the court reinforced the ability of banks to
engage in brokerage activities absent broker-dealer
regulation, many large banks had already established
captive broker-dealers and registered them with the
Commission or acquired existing registered brokerdealers. Notions of functional regulation, however,
did not die with short-lived Rule 3b-9. The erosion of
Glass-Steagall continued and banks entered into
broader full service brokerage, advisory, and mutual
fund activities. In addition, the pressures of
modernization of the commercial banking, investment
banking and insurance industries further eroded
regulatory impediments preventing financial
institutions from providing commercial banking,
investment banking, brokerage, asset management,
and insurance under a seamless institutional brand.
Stated differently, financial conglomerates became
the driving impetus to force the change in the way
commercial banks, investment banks, asset
management firms, and insurance companies
engaged in business and in the way they were to be
regulated.
The GLBA
The GLBA was the culmination of many years of
legislative reform to build a regulatory framework
modern enough to address the expansion of
America’s large and not-so-large financial
institutions into multiple lines of financial services
under a single provider. On November 12, 1999,
President Clinton signed the GLBA into law, which
repealed Glass-Steagall provisions that had
prohibited affiliations between commercial banks and
investment banks and insurance companies and
made changes in the way in which those institutions
would be regulated. The GLBA, among other things,
eliminated the blanket exclusion from broker-dealer
registration and regulation for banks. In its place the
GLBA crafted a series of exceptions from the
definitions of broker and dealer under the Exchange
Act.5 Below are general summaries of the 11
statutory exceptions from the definition of “broker”
created by the GLBA:
n
Third-Party Brokerage Arrangements – This
exception essentially codifies the Commission
staff’s long line of financial institution
“networking” no-action letters.6 This
exception requires, in relevant part, that (i) a
bank enter into a written agreement with a
registered broker-dealer, (ii) the brokerage
services be clearly separate from the bank and
its depository services, (iii) unregistered bank
employees solely perform clerical and
ministerial functions (no order taking or
securities recommendations), and (iv)
unregistered bank employees not receive
incentive compensation tied to securities
transactions, although they are eligible to
receive referral compensation of a nominal, one
time cash fee of a fixed dollar amount not
related to any successful sales.7 This
exception is referred to as the “networking
exception.”
4
See American Bankers Ass’n. v. SEC, 804 F.2d 739 (D.C. Cir. 1986).
5
The Commission has already adopted implementing rules for permissible bank-dealer activities. See Securities Exchange
Act Release No. 47364 (Feb. 13, 2003).
6
The Commission staff issued numerous networking no-action letters to thrifts, savings banks, and credit unions because,
unlike national or state-chartered banks, thrifts and savings banks do not satisfy the definition of “bank” in Section
3(a)(6) of the Exchange Act and, therefore, could not qualify for the blanket exclusion for banks. The purpose of these
no-action positions was to permit these institutions to compete on a more equal footing with banks that otherwise did not
face similar broker-dealer regulatory issues.
7
See Section 3(a)(4)(B)(i).
Kirkpatrick & Lockhart LLP
2
n
Trust and Fiduciary Activities – This exception
permits banks to engage in limited securities
functions commensurate with the bank’s
trustee or fiduciary capacity. This exception
limits the nature of the compensation that a
bank may permissibly receive consistent with
its fiduciary functions. Namely, a bank must be
chiefly compensated for securities transactions
consistent with fiduciary principles and
standards and on the basis of administrative or
annual fees, an asset-based fee, a flat or
capped fee not more than the cost of
processing a securities transaction, or a
combination of the foregoing types of fees
(collectively, “fiduciary fees”).8 Banks are not
permitted to solicit any brokerage activities
other than in conjunction with their permissible
trust and fiduciary activities, and all securities
trades must be routed through a registered
broker-dealer9 or be a cross trade.
The Exchange Act defines fiduciary capacity
for these purposes to include a bank acting (i)
as a trustee, (ii) as an executor, (iii) as an
administrator, (iv) as a registrar of stocks and
bonds, (v) as a transfer agent, (vi) as a
guardian, (vii) as an assignee, (viii) as a
receiver, (ix) as a custodian under a uniform gift
to minor act, (x) as an investment adviser (if the
bank receives an advisory fee), (xi) in any
capacity in which a bank possesses investment
discretion for another, or (xii) in any similar
capacity.10
n
Permissible Securities Transactions – This
exception permits banks to effect transactions
in (i) commercial paper, banker’s acceptances,
or commercial bills; (ii) exempt securities (as
defined in Section 3(a)(10) of the Exchange
Act); (iii) specified Canadian government
obligations; and (iv) so-called Brady Bonds.11
n
Stock Purchase Plans – This exception permits
a bank to act as a transfer agent in connection
with securities transactions for employee
benefit plans, dividend reinvestment plans
(under limiting restrictions), and issuer-stock
purchase plans.12 To the extent that a bank
effects securities transactions under this
exception, trades must be routed through a
registered broker-dealer13 or be a cross trade.
n
Sweep Accounts – This exception permits a
bank to sweep cash from demand deposit
accounts into no load money market mutual
funds.14
n
Affiliated Transactions – This exception
permits a bank to trade securities for affiliates
other than broker-dealer affiliates or merchant
banking affiliates.15
n
Private Securities Transactions – This
exception permits a bank to offer and sell
securities in a private offering that is relying on
Section 3(b), Section 4(2), or Section 4(6) of the
Securities Act of 1933, as amended (“Securities
Act”) (and related rules and regulations),
subject to restrictions on affiliations with
broker-dealers and limits on the amount of the
offering relative to the bank’s capital.16
n
Safekeeping and Custody – This exception
permits a bank, as part of its “customary
banking activities,” to (i) provide safekeeping
and custody with respect to securities,
including the exercise of warrants or other
rights of customers; (ii) facilitate the transfer of
funds or securities as custodian or clearing
agency in connection with clearing and settling
customer securities transactions; (iii) effect
securities lending or borrowing transactions for
customers as part of the bank’s safekeeping or
custody activities or otherwise invest cash
8
See Section 3(a)(4)(B)(ii) and Section 3(a)(4)(C).
9
Similar to the Interim Final Rules, proposed Regulation B retains a special purpose exemption permitting banks to route
mutual fund orders directly to the Fund/SERV facility of the National Securities Clearing Corporation. Proposed
Regulation B expands on the Interim Final Rules by permitting a bank to transact mutual fund shares directly with the
fund’s transfer agent in the absence of routing the transaction through a registered broker-dealer, provided that the
transfer agent not receive transaction-based compensation, including 12b-1 and revenue sharing fees.
10 See Section 3(a)(4)(D).
11 See Section 3(a)(4)(B)(iii).
12 See Section 3(a)(4)(B)(iv).
13 See, supra,note 9.
14 See Section 3(a)(4)(B)(v).
15 See Section 3(a)(4)(B)(vi).
16 See Section 3(a)(4)(B)(vii).
Kirkpatrick & Lockhart LLP
3
collateral pledged in such lending or borrowing
transactions; (iv) engage in certain activities in
connection with pledges of securities; and (v)
act as custodian or provider of other related
administrative services to individual retirement
accounts or pension, retirement, profit-sharing,
bonus, thrift savings, incentive or other similar
benefit plans.17 Securities trades under this
exception must be routed through a registered
broker-dealer18 or be a cross trade. A bank,
however, cannot act as a carrying broker under
this exception.
n
Identifiable Banking Products – This
exception permits a bank to trade in so-called
“identifiable banking products.”19 These
products generally are depository accounts,
debit accounts, banker’s acceptances,20 certain
loan participation interests, and certain swap
agreements.
n
Municipal Securities – This exception permits
a bank to trade in municipal securities, as
defined in Section 3(a)(29) of the Exchange
Act.21
n
De Minimis Transactions – This exception
permits a bank 500 transactions in securities
(other than those transaction otherwise
expressly excepted above) in a calendar year.22
Interim Final Rules
The GLBA established a date of March 12, 2001 for
the statutory exceptions to become effective. As the
date approached, many banks began seeking
guidance on interpretative issues under the statute,
as neither the Commission nor its staff had
previously published rules or any formal
interpretative guidance. In response to requests for
guidance, the Commission on May 11, 2001
published so-called Interim Final Rules, with an
effective date of October 1, 2001. The Interim Final
Rules were a compilation of new rules defining terms
under the 11 exceptions or exempting bank securities
activities from broker-dealer regulation. Proposed
Regulation B will withdraw most of the rules
previously adopted under the Interim Final Rules.
The banking industry and banking regulators reacted
negatively to the Interim Final Rules. Notably, a joint
comment letter from the Board of Governors of the
Federal Reserve System (signed by none other than
Alan Greenspan), the OCC, and the Federal Deposit
Insurance Corporation criticized the Commission’s
approach, arguing that the “Interim Final Rules . . .
create an extremely burdensome regime of overly
complex, costly and unworkable requirements that
effectively negate the statutory exemptions and the
congressional intent underlying those exemptions.”
Industry trade groups were no less charitable in their
criticism. For example, the Bank Securities
Association questioned the legality of the
Commission adopting the Interim Final Rules as
“final” in the absence of the notice and comment
periods prescribed by the Administrative Procedures
Act.
In light of the heavy criticism, the Commission
suspended the effectiveness of the Interim Final
Rules through a series of orders, which restored the
blanket exclusion for banks, and added a similar
exclusion for thrifts and savings banks,23 until the
staff could meet with the banking industry and
propose new rules. The last of these orders is
scheduled to expire November 12, 2004.24
PROPOSED REGULATION B
Over three years following the adoption of the
Interim Final Rules, the Commission issued for
comment much-anticipated Regulation B, which
proposes to revise, restructure and codify certain
provisions of the Interim Final Rules into a single
regulatory compilation. Proposed Regulation B is
17 See Section 3(a)(4)(B)(viii).
18 See, supra, note 9.
19 See Section 3(a)(4)(B)(ix).
20 An exception for banks transacting in banker’s acceptances appears to be redundant insofar as Section 15(a)(1) of the
Exchange Act, the broker-dealer registration requirement, excludes from registration any person effecting transactions in,
among other things, banker’s acceptances. See also Section 3(a)(4)(B)(iii) (permitting bank to effect transactions in,
among other things, banker’s acceptances).
21 See Section 3(a)(4)(B)(x).
22 See Section 3(a)(4)(B)(xi).
23 See, supra, note 6 regarding thrifts and savings banks and their status as “banks” under Section 3(a)(6) of the Exchange
Act.
24 See Securities Exchange Act Release No. 47649 (Apr. 8, 2003).
Kirkpatrick & Lockhart LLP
4
made up of eight separate subparts, each containing
definitions, regulations and exemptions relevant to
the statutory exceptions. Below is a summary of the
networking, trust and fiduciary, sweep, safekeeping
and custody, and special purpose implementing
regulations. Because the Interim Final Rules
pertaining to the networking, trust and fiduciary,
sweep, and custody regulations were the most
controversial of the Interim Final Rules and generated
the most critical commentary, they have been
highlighted below. The special purpose exemptions
are discussed briefly below because they are new
since the adoption of the Interim Final Rules. Other
statutory exceptions or minor technical points have
not been discussed.
Subpart A – The Networking Exception
As noted above, the GLBA amended the statutory
definition of “broker” to add Section 3(a)(4)(B)(i) of
the Exchange Act, which codifies a long line of
Commission staff no-action letters in the financial
institution networking context. This exception also
effectively codifies key aspects of Rule 3b-9.
For the most part, the networking exception was fairly
well-settled at the time of the Interim Final Rules
given the depth of interpretative and no-action
guidance that existed over the previous decade or so
prior to the Commission’s adoption of the Interim
Final Rules. The networking exception was even
codified in a sales practice rule of NASD®, Conduct
Rule 2350. Thus, banks were generally well aware
and accustomed to the conditional requirements
permitting them to offer and sell securities products
to bank customers through registered broker-dealers.
The Interim Final Rules, however, broke new ground
in regulating the permissible compensation payments
that could be made to bank employees who were not
otherwise registered representatives of registered
broker-dealers (so-called “unregistered bank
employees”).
One condition of the networking exception restricts
the compensation payable to unregistered bank
employees. The exception does permit unregistered
bank employees to receive a “nominal, one time cash
fee of a fixed dollar amount” that is not tied to a
successful securities transaction. Permissible referral
fees were part of staff no-action lore, but the staff
had avoided defining exactly what a nominal referral
fee was intended to be. The Commission first defined
the meaning of “nominal” fee in the Interim Final
Rules.
In Rule 3b-17(g)(1) of the Interim Final Rules, the
Commission defined nominal fees for these purposes
in reference to (i) a payment that would not exceed
one hour of the gross cash wages of the unregistered
bank employee making a referral; or (ii) points paid in
a cash or non-cash bonus system equally weighted
for referrals for all bank investment and noninvestment products. Rule 3b-17 prohibited nominal,
one-time cash referral fees from being related to the
size, value, or completion of a securities transaction,
the amount of any securities assets gathered, the size
of the customer’s bank account, or the customer’s
financial status.
The Commission received numerous comments
concerning the restrictions on referral fee payments
to unregistered bank employees. In proposing
Regulation B, the Commission reaffirmed its position
that the term “nominal” should be defined to combat
what it perceived as payments of excessive referral
fees – fees that, according to the Commission, were
not inconsequential or trifling, as would be
commonly understood as nominal.
Proposed Regulation B defines terms important to the
networking exception, including nominal referral fees.
The definition of “nominal, one-time cash fee of a
fixed dollar amount” is based on three objective
alternatives and may be no more than the greater of:
(i) the unregistered employee’s base hourly rate of
pay; (ii) a dollar amount equal to $15 in 1999 dollars
to be adjusted annually for inflation (based on the
Consumer Price Index (“CPI”)); or (iii) $25. These
fees can be made up of a non-cash component, but
the value of the non-cash portion must be readily
ascertainable by the bank and the total amount of
any non-cash portion alone or, when combined with a
cash fee, cannot exceed the limits prescribed above
and must be part of an incentive program that
primarily rewards activities unrelated to securities
offers and sales. This component of proposed
Regulation B is intended to retain existing bank
practices of paying bonuses through a point system.
The fee, payable one time per customer referral, also
cannot be based on the “success” of a securities
transaction, but could be contingent on the customer
keeping an appointment with a broker-dealer or
satisfying qualification standards to engage in
brokerage transactions. The fee also cannot vary
based on the financial status of the customer, the
registered broker-dealer receiving the referral, the
number of employee referrals, or particular kinds of
securities offered and acquired. In short, the fee
Kirkpatrick & Lockhart LLP
5
must be fixed.
Subpart B – Trust and Fiduciary Exception
According to the Commission, the Interim Final Rules
that regulated the trust and fiduciary exception
generated the most comments. Proposed Regulation
B revises the Commission’s previous approach to
interpreting five key statutory conditions that apply
to the trust and fiduciary exception. According to
the statute, (i) a bank must act in a trust or fiduciary
capacity, as defined in the Exchange Act; (ii) the bank
must provide trust and fiduciary services in its trust
department or other department that is regularly
examined for compliance with fiduciary principles and
standards; (iii) the bank must be “chiefly
compensated” for any securities transactions
consistent with its fiduciary activities and in the form
of permissible fiduciary fees; (iv) any securities
transactions must be routed through a registered
broker-dealer25 or via a cross trade; and (v) the bank
cannot solicit a brokerage business other than by
reference to effecting securities transactions in
conjunction with its trust and fiduciary business.
The primary focus of the Commission’s regulation
and industry comments centered on the meaning of
“chiefly compensated” – a term undefined by the
GLBA. The Interim Final Rules would require banks
to make determinations as to compensation on an
account-by-account basis (unless qualifying for a
narrow exemption). That is, a bank would have to
review each trust account to determine if it was
chiefly compensated in the form of fiduciary fees or
was otherwise receiving compensation
commensurate with a broker-dealer transacting in
securities.
The banking industry and banking regulators
universally objected to the account-by-account
analysis and the narrowness of the Commission’s
application of the trust and fiduciary exception under
the Interim Final Rules. Proposed Regulation B is the
result of ongoing meetings between the banking
industry and Commission staff intended to more
appropriately address traditional bank trust and
fiduciary activities. Subpart B of proposed
Regulation B sets forth key definitions, four
exemptions from the chiefly compensated condition,
including a much-anticipated “line of business”
alternative to the Interim Final Rule’s account-byaccount analysis, and safe harbors deemed
25
necessary by the banking industry should a bank
temporarily fall outside of the “chiefly compensated”
condition. Although the proposed rules are intended
to give banks greater flexibility in conducting their
trust and fiduciary activities, they nevertheless
remain complex and likely will require banks to
expend substantial time and effort reviewing the rules
and establishing appropriate compliance systems
(not to mention, at least in some cases, changing
current business practices).
1. Key Definitions
Proposed Regulation B divides the term “chiefly
compensated” into two exclusive components made
up of qualifying fees or what this discussion has
deemed to be fiduciary fees (“relationship
compensation”) and non-qualifying fees (“sales
compensation”). If, during the preceding year, a bank
had more relationship compensation than sales
compensation in connection with its trust and
fiduciary activities, it would satisfy the “chiefly
compensated” condition of the trust and fiduciary
exception.
Proposed Regulation B also defines “relationship
compensation” and “sales compensation”
predominantly in the way the Interim Final Rules
previously defined those terms. Relationship
compensation means payments to the bank from the
customer, account beneficiary, or the account based
on (i) an administrative or annual fee, (ii) a fee based
upon a percentage of assets under management, (iii)
a flat or capped per order processing fee that does
not exceed the cost incurred by the bank in
connection with executing securities transactions for
the bank’s trust and fiduciary customers; or (iv) any
combination of the fees described in (i), (ii), and (iii).
Sales compensation means (i) a fee for effecting a
securities transaction that is in excess of a flat or
capped per order processing fee, as defined in
Proposed Regulation B; (ii) payments that, if paid to
a broker-dealer, would constitute payment for order
flow (e.g., economic benefits paid in connection with
routing orders to a particular market center or brokerdealer for execution); (iii) finder’s or referral fees that
are not otherwise excepted under the networking
exception; (iv) third-party distribution fees; (v) 12b-1
fees; and (vi) administrative or shareholder servicing
fees paid by an investment company, regardless of
whether paid under a 12b-1 plan; however, proposed
See, supra, note 9.
Kirkpatrick & Lockhart LLP
6
Regulation B sets forth seven types of service fees
that will not constitute sales compensation (e.g.,
transfer and sub-transfer agent fees, fees for subaccounting, account statements, shareholder
communication deliveries, and certain processing
fees). The exceptions are referred to as the “seven
carve outs.”
2. Determining “Chiefly Compensated”
One of the primary revisions contained in proposed
Regulation B addresses the manner in which banks
will determine the permissible balance of relationship
compensation versus sales compensation necessary
to comply with the trust and fiduciary exception.
Proposed Regulation B permits a bank to make this
important determination on the basis of a “line of
business” approach rather than on an account-byaccount basis. Essentially, a bank could identify a
line of business (defined as an identifiable
department, unit, or division of the bank with similar
types of accounts for which the bank acts in a similar
type of fiduciary capacity) each year and, if the ratio
of sales compensation to relationship compensation
was no more than 1:9, the bank would satisfy the
chiefly compensated condition. Proposed Regulation
B also contains a one-year safe harbor should a bank
exceed the 1:9 ratio in a given year. The safe harbor
would permit the bank to rely on the line of business
alternative for another year, provided that it satisfies
all other conditions of the trust and fiduciary
exception and can verify that the ratio of sales
compensation to relationship compensation during
the preceding year did not exceed a 1:7 ratio. A bank
may only rely on the proposed safe harbor once in
any five-year period.
A bank may still determine its compliance with the
chiefly compensated condition on an account-byaccount basis under a separate provision of
proposed Regulation B, and may qualify for a
conditional safe harbor if the bank is temporarily
outside of the chiefly compensated condition on an
account-by-account basis – i.e., a bank receives more
sales compensation than relationship compensation
for a particular account. A bank may not rely on the
safe harbor more than once in a five-year period,
provided that the bank satisfies certain numerical
benchmarks for all accounts not in compliance with
the chiefly compensated condition.
Aside from the line of business alternative, Proposed
26
Regulation B also includes an exemption that would
grandfather certain payment streams to banks
(regardless of their nature) that are derived from trust
and fiduciary services to living, testamentary, or
charitable trust accounts opened or established
before July 30, 2004. Similarly, banks that act as an
indenture trustee in connection with executing
securities transactions in no-load money market
mutual funds could nonetheless rely on the trust and
fiduciary exception even if their compensation as an
indentured trustee did not satisfy the chiefly
compensated condition.26
3. Trust and Fiduciary Capacity
In proposing Regulation B, the Commission withdrew
its previous definition of “trustee capacity” in the
Interim Final Rules. Proposed Regulation B will not
specify the trustee capacities in which a bank may act
for purposes of relying on the trust and fiduciary
exception. The Commission noted, however, that a
bank acting as an IRA-custodian would not be acting
in a trust capacity for purposes of the trust and
fiduciary exception. Nor would the Commission
expand the meaning of “similar capacity” under the
definition of trust and fiduciary capacity to include
agency activities of a bank that are not subject to
standards of trust and fiduciary law.
Subpart D – Sweep Accounts Exception
Banks have established customer accounts in which
the bank provides an overnight or periodic sweep of
cash on deposit at the bank into money management
instruments, including money market mutual funds.
The statutory exception conditions reliance on cash
sweeps into no-load money market funds. The
Interim Final Rules defined the meaning of no load to
include a fund without a front-end or deferred sales
load or other distribution charges against assets in
excess of .25% of the average annual assets (a clear
reference to previous guidance of NASD®). Many
commented on the Commission’s use of the NASD
.25% threshold as a limit to the fees a bank may
receive for administering its sweep product.
Proposed Regulation B retained the 25 basis point
benchmark, arguing that the NASD’s position
regarding the meaning of “no load” had widespread
public understanding when the GLBA was enacted.
The Commission even cited to testimony of a bank
trade group as support for restricting no-load funds
to those that do not have distribution charges in
As discussed below, proposed Regulation B also establishes a special purpose exemption that could apply to a bank acting
as an indentured trustee for certain customers.
Kirkpatrick & Lockhart LLP
7
excess of .25% of net assets. Proposed Regulation B
established a special purpose exemption, as
discussed below, that a bank may be able to rely on if
the sweep product does not satisfy proposed
Regulation B’s definition of no load.
The Commission also confirmed that the sweep need
not be “daily” but must be automatic and systematic
in order to satisfy the sweep account exception.
Subpart F – Safekeeping and Custody Exception
The Commission and staff have long-standing
positions that holding and handling customer funds
and securities is a quintessential broker-dealer
function. Because banks, when acting as custodians,
hold and handle customer funds and securities in
connection with securities transactions, they
arguably would be acting as broker-dealers absent an
exception or exemption. The GLBA recognized that
banks have performed traditional custodian functions
that should remain outside of the broker-dealer
regulatory structure regardless of the bank’s access
to customer funds and securities. Hence, the GLBA
added a conditional exception applicable to a bank’s
safekeeping and custody functions.
The Commission’s approach under the Interim Final
Rules limited banks from accepting securities orders
– a core broker-dealer function – in connection with
their safekeeping and custody activities unless in
reliance on two narrow exemptions permitting limited
order taking generally and order taking and execution
conducted by a “small bank.” Depending on the
exemption, a bank could not receive compensation
for effecting a securities transaction for a custody
account, prompting criticism from commenters.
Additionally, the Interim Final Rules limited the
manner in which a bank could staff and pay its
personnel for engaging in custody activities. The
banking industry criticized the Commission’s
approach to the safekeeping and custody exception,
as well as the implausibility and limited utility of the
exemptions.
Under proposed Regulation B, if a bank receives
orders in connection with its safekeeping and
custody activities, it could nevertheless qualify for
the expanded general exemption for banks receiving
orders or an expanded exemption for “small banks.”
The proposal requires that a bank rely on one or the
other of the exemptions, not both. A bank acting in a
trust or fiduciary capacity could not rely on proposed
Regulation B’s general bank and small bank custody
exemptions.
For these purposes, proposed Regulation B defines
custody account to mean an account established by
written agreement between the bank and customer,
which sets forth fees payable and obligations
regarding various functions for the custody account
or individual retirement account for which the bank
acts as custodian.
1. General Exemption
Under proposed Regulation B, a bank may accept
orders and receive 12b-1 fees, shareholder servicing
fees, or other fees that do not vary with securities
transactions for accounts that are subject to a
grandfather provision (accounts established before
July 30, 2004) or accounts with “qualified investors”
(e.g., certain institutional accounts defined in Section
2(a)(54)(A) of the Exchange Act). The exemption
restricts payments to bank employees preventing
them from receiving compensation based on the size,
value or completion of any securities transaction that
the employee processes for the custody account.
The proposed exemption further restricts any
securities solicitation to responses to inquiries from
potential investors, if the responses are limited to
information that has been disclosed in a registration
statement or sales literature prepared by the issuer’s
principal underwriter that is a registered brokerdealer.
2. Small Bank Exemption
Proposed Regulation B modifies the small bank
exemption first established under the Interim Final
Rules. Notably, the Commission expanded the
definition of “small bank” to include a bank that had
less than $500 million in assets as of December 31 for
both of the two prior calendar years, up from the $100
million threshold under the Interim Final Rules. A
“small bank,” however, cannot be affiliated with a
bank holding company or savings and loan holding
company that had consolidated assets in excess of $1
billion in both of the two previous calendar years.
Independent of the conditional restrictions of the
small bank definition, the proposed small bank
exemption restricts a small bank from being affiliated
with a registered broker-dealer (a small bank could,
however, be party to a networking arrangement with
an unaffiliated broker-dealer). The Commission’s
theory for this restriction is that a small bank that has
absorbed the costs to establish the regulatory
infrastructure to operate a registered broker-dealer
should not be permitted to execute securities orders
through the safekeeping and custody exception. In
the Commission’s view, those orders should be
exposed to the customer protection provisions of the
Exchange Act.
A small bank also is restricted in the amount of “sales
Kirkpatrick & Lockhart LLP
8
compensation” that it may receive and the level of
solicitation in which it may engage as part of its
securities order taking functions for custody
accounts. The definition of sales compensation in
the trust and fiduciary exception applies to the small
bank exemption. The proposed exemption caps the
amount of annual sales compensation for these
purposes at $100,000, adjusted for inflation in
reference to the CPI. Thus, 12b-1 fees, administrative
servicing fees (other than the fees subject to the
“seven carve outs”), third-party distribution fees,
revenue sharing fees, and any fees in excess of a flat
or capped fee all factor into the $100,000 limit.
The proposed exemption similarly limits the
compensation to bank employees. Under the
proposal, bank employees may not receive incentive
compensation related to securities transactions
except for permissible referral fees in reliance on the
networking exception. In contrast to the restrictions
of the Interim Final Rules, the Commission argued
that the exception for referral fees permits banks to
pay employees for asset gathering, although under
the narrow referral fee conditions of proposed
Regulation B. Proposed Regulation B also withdraws
the Interim Final Rule restrictions on a bank using
bank personnel who are also registered
representatives of a broker-dealer (so-called “dual
employees”). Additionally, proposed Regulation B,
in contrast to the Interim Final Rules, would not
require bank employees to have primary duties for
the bank other than effecting securities transactions
for customers.
3. Carrying Broker Limitation
The statutory exception for safekeeping and custody
conditions reliance on a bank not acting as a
“carrying broker.” Neither the GLBA, Interim Final
Rules, nor proposed Regulation B defines this term.
The Commission in the Interim Final Rules made
passing reference to this term in a footnote. The
Commission’s interpretation was ambiguous and
raised practical questions about a bank’s conduct as
a carrying broker outside of the safekeeping and
custody exception.
In proposed Regulation B, the Commission attempted
to clarify the meaning of carrying broker in the
absence of establishing a definition under its
proposed rules. According to the Commission, a
bank could be viewed as acting as a carrying broker if
it performs the back-office functions of a brokerdealer, such as extending credit, maintaining records
of customer transactions, receiving and safekeeping
customer funds and securities, and delivering trade
confirmations. A bank does not act as a carrying
broker, according to the Commission, when a bank
customer chooses the bank to custody assets and
the bank selects broker-dealers to execute and clear
customer trades.
The ambiguity of the Commission’s interpretation of
carrying broker should concern banks that are used
to establish special or special reserve accounts under
the Commission’s customer protection rule, Rule
15c3-3 under the Exchange Act. Very generally, this
rule requires broker-dealers that maintain custody of
customer funds and securities to segregate customer
assets into, among others, special bank accounts
established for the benefit of customers. Similarly,
broker-dealers that are not deemed to have custody
of customer assets must rely on an exemption to the
substantive conditions of Rule 15c3-3 by
establishing special purpose bank accounts
exclusively for the benefit of customers. The
Commission’s interpretations, particularly the
interpretation in the Interim Final Rules, raise
questions whether segregated bank accounts
permissible under Rule 15c3-3 would cause a bank to
become a “carrying broker” and be outside of the
safekeeping and custody exception.
The Commission generally clarified in proposed
Regulation B that a bank maintaining custody of
customer assets of a broker-dealer pursuant to Rule
15c3-3 alone would not be a carrying broker. The
Commission, however, was much more clear that its
interpretation would not affect banks being
designated as a good control location under Rule
15c3-3(c)(5), but less affirmative where the bank is
used to segregate customer funds under other
provisions of Rule 15c3-3.
Subpart G – Special Purpose Exemptions
Proposed Regulation B also establishes six
miscellaneous or special purpose exemptions that, in
part, apply to banks engaged in transactions
involving mutual fund shares that may not fall
squarely under other exceptions of the GLBA and
underlying rules. One special purpose exemption, for
example, will permit a bank to engage under specified
conditions in effecting mutual fund transactions for
certain employee retirement plans where the bank
acts as trustee or custodian of the plan. A key
condition of this exemption requires the bank to
offset any fees the bank receives from the mutual
fund in connection with investments in fund shares
against fees the plan owes the bank.
Another key exemption will permit a bank to effect
trades in shares of money market mutual funds that
may assess distribution charges against the fund’s
Kirkpatrick & Lockhart LLP
9
net assets in excess of the 25 basis point restriction
of the sweep exception (i.e., “load funds”). Basically,
this exemption applies to cash management services
provided to qualified investors or persons that direct
the cash flow of asset-backed securities having a
minimum original asset amount of $25,000,000 for
which the bank acts in a trustee or fiduciary capacity,
or as escrow, collateral, depository, or paying agent.
Other exemptions permit banks to effect transactions
in (i) mutual fund shares directly with Fund/SERV or
the fund’s transfer agent; and (ii) securities issued in
reliance on Regulation S under the Securities Act.
Proposed Regulation B also exempts thrifts, savings
banks, and credit unions to the same extent as banks
under certain of the exceptions. Thrifts and savings
banks are not afforded similar bank exemptions,
however, in the case of the general exemption under
the safekeeping and custody exception or in the case
of special purpose exemptions for mutual fund
transactions for employee retirement plans or for
Regulation S offers to foreign persons. The
proposed special purpose exemption for credit
unions is limited to activities of a credit union in
reliance on the networking and trust and fiduciary
exceptions.
Transition
Under the proposal, banks, including thrifts, savings
banks, and credit unions, will retain the blanket
exclusion from the definition of broker until January
1, 2006. This is intended to allow banks to establish
systems to monitor compliance with the exceptions
and “push out” any activities to a registered brokerdealer in the absence of an exception or an
exemption. Additionally, banks are temporarily exempt
from having contracts voided based on inadvertent
violations of the broker exceptions and proposed
Regulation B for an 18-month period following the
delayed effective date of the implementing rules of
proposed Regulation B.
C. DIRK PETERSON
202.778.9324
dpeterson@kl.com
Kirkpatrick & Lockhart LLP
10
Kirkpatrick & Lockhart LLP has one of the most active and experienced broker-dealer practice groups in the United
States. Our Broker-Dealer Practice Group is comprised of more than 40 attorneys, located in our Boston, Dallas,
Washington, D.C., Los Angeles, New York and San Francisco offices. Many of our attorneys previously have
worked at the Securities and Exchange Commission, self regulatory organizations, other regulatory agencies and the
U. S. Department of Justice in senior and chief counsel positions. In addition, many of our attorneys have
published articles, written books, and spoken at numerous conferences and symposia concerning various aspects
of the securities laws and broker-dealer regulation.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.kl.com for more information.
BOSTON
R. Bruce Allensworth
Michael S. Caccese
Mark P. Goshko
D. Lloyd Macdonald
Wm Shaw McDermott
Derek M. Meisner
617.261.3119
617.261.3133
617.261.3163
617.261.3117
617.261.3120
617.261.3114
DALLAS
Michael D. Napoli
214.939.4927 mnapoli@kl.com
ballensworth@kl.com
mcaccese@kl.com
mgoshko@kl.com
dmacdonald@kl.com
smcdermott@kl.com
dmeisner@kl.com
LOS ANGELES
Mark A. Klein
William P. Wade
310.552.5033 mklein@kl.com
310.552.5071 wwade@kl.com
NEW YORK
Warren H. Colodner
Eugene R. Licker
Richard D. Marshall
Keith W. Miller
William O. Purcell
212.536.3912
212.536.3916
212.536.3941
212.536.4045
212.536.3922
wcolodner@kl.com
elicker@kl.com
rmarshall@kl.com
kmiller@kl.com
wpurcell@kl.com
SAN FRANCISCO
Eilleen M. Clavere
David Mishel
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1015
415.249.1070
415.249.1010
eclavere@kl.com
dmishel@kl.com
mperlow@kl.com
rphillips@kl.com
WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Alan J. Berkeley
Charles L. Eisen
Stephen W. Grafman
Michael J. King
Rebecca H. Laird
202.778.9068
202.778.9886
202.778.9289
202.778.9050
202.778.9077
202.778.9057
202.778.9214
202.778.9038
calexander@kl.com
dambler@kl.com
cbardsley@kl.com
aberkeley@kl.com
ceisen@kl.com
sgrafman@kl.com
mking@kl.com
rlaird@kl.com
Jeffrey B. Maletta
Dean E. Miller
Charles R. Mills
Michael J. Missal
R. Darrell Mounts
Brian A. Ochs
C. Dirk Peterson
David Pickle
Alan C. Porter
Glenn R. Reichardt
Robert H. Rosenblum
Donald W. Smith
Ira L. Tannenbaum
Stephen G. Topetzes
Robert J. Zutz
202.778.9062
202.778.9371
202.778.9096
202.778.9302
202.778.9298
202.778.9466
202.778.9324
202.778.9887
202.778.9186
202.778.9065
202.778.9464
202.778.9079
202.778.9350
202.778.9328
202.778.9059
jmaletta@kl.com
dmiller@kl.com
cmills@kl.com
mmissal@kl.com
dmounts@kl.com
bochs@kl.com
dpeterson@kl.com
dpickle@kl.com
aporter@kl.com
greichardt@kl.com
rrosenblum@kl.com
dsmith@kl.com
itannenbaum@kl.com
stopetzes@kl.com
rzutz@kl.com
Stavroula E. Lambrakopoulos
2 0 2 . 7 7 8 . 9 2 4 8 slambrakopoulos@kl.com
®
Kirkpatrick & Lockhart LLP
Challenge us.
®
www.kl.com
BOSTON
n
DALLAS
n
HARRISBURG
n
LOS ANGELES
n
MIAMI
n
NEWARK
n
NEW YORK
n
PITTSBURGH
n
SAN FRANCISCO
n
WASHINGTON
............................................................................................................................................................
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2004 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.