Regulation R Alert
March 2007
Authors:
Elaine A. Lindenmayer
+1.415.249.1042
elaine.lindenmayer@klgates.com
www.klgates.com
Once, Twice, Three Times a Charm?
Agencies Propose Bank-Broker
“Push Out”
C. Dirk Peterson
+1.202.778.9324
dirk.peterson@klgates.com
William P. Wade
+1.310.552.5071
william.wade@klgates.com
K&L Gates comprises approximately 1,400
lawyers in 21 offices located in North
America, Europe and Asia, and represents
capital markets participants, entrepreneurs,
growth and middle market companies,
leading FORTUNE 100 and FTSE 100
global corporations and public sector
entities. For more information, please visit
www.klgates.com.
Introduction
It took an act of Congress to make it happen, but the Securities and Exchange Commission
(“SEC”) and the Board of Governors of the Federal Reserve System (the “Fed”) have
proposed rules – dubbed “Regulation R” – that promise to be a major step forward in
reviving the statutory exceptions from “broker” status for banks under the Securities
Exchange Act of 1934 (“Exchange Act”) enacted by the Gramm-Leach-Bliley Act (“GLBA”)
over seven years ago. Comments on the proposals are due by March 26, 2007.
Given the Fed’s endorsement of Regulation R, major changes to the proposal appear to be
unlikely. Accordingly, although banks – which for this purpose include savings associations
and trust companies – will not be expected to comply with the final rules until June 30, 2008,
at the earliest, the proposal has an immediate impact on planning and preparation, both for
banks engaged in securities activities and for broker-dealers that support or complement
those activities. Among other things, banks will need to develop internal operating and
compliance procedures designed to identify and distinguish between securities activities
within the scope of the statutory exceptions under the Exchange Act – sometimes referred
to as the “carve outs” – and other activities which may have to be modified, discontinued,
or “pushed out” to affiliated and unaffiliated registered broker-dealers. Banks will need
to review their “networking” arrangements with broker-dealers carefully, particularly
with respect to bank employee compensation policies, to ensure they are consistent with
Regulation R. Broker-dealers, in turn, will be under similar obligations to review and update
internal procedures to reflect certain shared obligations imposed by Regulation R.
Regulation R, as detailed and complex as it is, is by no means the whole story. Although
the Exchange Act prescribes eleven separate exceptions or “carve out” activities in which
banks may engage without being considered a “broker,” Regulation R addresses only four
of them specifically, and includes several proposed regulatory exemptions for transactions
and activities the SEC and the Fed (the “Agencies”) apparently believe are not covered by
the statutory exceptions. Moreover, the federal banking agencies, as required by the GLBA,
are expected to develop, in consultation with the SEC, “recordkeeping requirements” to
enable banks to “demonstrate compliance” with the terms of the statutory exceptions and the
final rules ultimately adopted under Regulation R. Finally, Regulation R creates a potential
inconsistency with NASD interpretations regarding referral compensation to unregistered
recipients and leaves unresolved a major controversy between the SEC and the banking
industry regarding the applicability of “selling away” under rules of NASD, Inc. (“NASD”),
as discussed below.
71 Fed. Reg. 77522 (December 26, 2007).
Proposed Rule 781, 71 Fed. Reg. at 77550.
The Agencies have requested comment on whether it would be useful or appropriate to adopt additional rules
implementing exceptions not addressed in Regulation R, as proposed.
Regulation R Alert
Table of Contents
PROPOSED REGULATION R
I. A CONDENSED HISTORY . . . . . . . . . . . . . . . 3
C. Sweep Accounts . . . . . . . . . . . . . . . . . . . . . . . . 11
II. ANALYSIS OF REGULATION R. . . . . . . . . . 4
1. The Statutory Exception. . . . . . . . . . . . . . . . . . . 11
A. “Networking” Arrangements . . . . . . . . . . . . . . 4
1. The Statutory Exception. . . . . . . . . . . . . . . . . . . . 4
2. Proposals Relating to the
Statutory Exception. . . . . . . . . . . . . . . . . . . . . . . 5
a. Meaning of “Nominal One-Time
Cash Fee of a Fixed Dollar Amount”. . . . . . . . . . 5
b. Meaning of “Contingent”. . . . . . . . . . . . . . . . . . . 5
c. Bonus Payments . . . . . . . . . . . . . . . . . . . . . . . . . . 6
3. New Exemption for Referrals of
Institutional and High Net-Worth Clients . . . . . . 6
a. Definitions of “Institutional” and
“High Net-Worth” Customers . . . . . . . . . . . . . . . 6
b. Employee Eligibility . . . . . . . . . . . . . . . . . . . . . . 7
c. Written Agreement and Client
Disclosures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7
2. Proposals Relating to the
Statutory Exception. . . . . . . . . . . . . . . . . . . . . . 11
3. New Exemption for
“Non-No-Load” Funds. . . . . . . . . . . . . . . . . . . . 11
D. Safekeeping and Custody Activities. . . . . . . . 12
1. The Statutory Exception. . . . . . . . . . . . . . . . . . . 12
2. Proposals Relating to the
Statutory Exception. . . . . . . . . . . . . . . . . . . . . . 12
3. Exemption for Employee
Benefit Plan and IRA Accounts. . . . . . . . . . . . . 13
4. Exemption for “Accommodation”
Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
5. Exemption for Non-Fiduciary,
Non-Custodial Accounts . . . . . . . . . . . . . . . . . . 14
6. Impact on Banks. . . . . . . . . . . . . . . . . . . . . . . . . 14
E. Exemptions for Other Transactions. . . . . . . . 15
4. Impact on Banks and Broker-Dealers. . . . . . . . . . 8
1. Regulation S Transactions. . . . . . . . . . . . . . . . . 15
B. Trust and Fiduciary Activities. . . . . . . . . . . . . . 8
2. Securities Lending Transactions
and Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
1. The Statutory Exception. . . . . . . . . . . . . . . . . . . . 8
2. Proposals Relating to the Statutory
Exception . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8
a. “Chiefly Compensated”. . . . . . . . . . . . . . . . . . . . 8
3. “Fund/SERV” Exemption . . . . . . . . . . . . . . . . . 16
4. Exchange Act Section 29(b) Relief. . . . . . . . . . 16
NASD CONSIDERATIONS . . . . . . . . . . . . . . . . 16
b. “Relationship Compensation”. . . . . . . . . . . . . . . 9
I. “SELLING AWAY” . . . . . . . . . . . . . . . . . . . . . 16
c. Advertising Restrictions . . . . . . . . . . . . . . . . . . . 10
A. NASD Conduct Rule 3040 . . . . . . . . . . . . . . . 17
3. Exemption for “Bank-Wide” Chiefly
Compensated Computation. . . . . . . . . . . . . . . . . 10
B. Impact On Banks. . . . . . . . . . . . . . . . . . . 17
4. Additional Exemptions for Particular
Types of Accounts . . . . . . . . . . . . . . . . . . . . . . . 11
II. REFERRAL INTERPRETATIONS. . . . . . . 17
5. Impact on Banks. . . . . . . . . . . . . . . . . . . . . . . . . 11
March 2007 | Regulation R Alert
Proposed Regulation R
I. A CONDENSED HISTORY
To put Regulation R in context, and appreciate the
magnitude of the difficulties and controversies that led
to the current joint rulemaking, a brief review of what
previously transpired may be useful.
The Exchange Act. Section 3(a)(4) of the Exchange
Act defines “broker” to include “any person engaged
in the business of effecting transactions in securities
for the account of others.” From the inception of
the Exchange Act in 1934, however, banks have
enjoyed a blanket exemption from the broker-dealer
regulatory regime of the SEC, the NASD, and other
self-regulatory organizations.
The GLBA. With the advent of major banking
and financial services reform in 1999, political
compromise forced a change in the status of the
blanket exemption. In keeping with the goal of
fostering “functional regulation” as part of the price
of “reform” legislation, the GLBA repealed the blanket
exemption for banks from “broker” status and replaced
it with eleven statutory “carve outs” permitting specific
securities activities in which banks could engage as
agent without being considered a broker under the
Exchange Act. The carve outs, which are codified
in Exchange Act Section 3(a)(4)(B), cover securities
transactions effected by banks in the context of thirdparty brokerage networking arrangements, trust and
fiduciary activities, permissible securities transactions,
certain stock purchase plans, sweep accounts, affiliate
transactions, private securities offerings, safekeeping
and custody activities, identified banking products,
municipal securities, and de minimis number of other
securities transactions. Significantly, Congress stated
that these exceptions were intended “to facilitate
certain activities in which banks traditionally have
engaged.”
Under the revised regulatory structure, therefore, a
bank that engages in an activity falling outside the
carve outs would be considered a “broker” subject
to regulation as a broker under the Exchange Act.
The GLBA also enacted “dealer” activity exceptions to replace
banks’ blanket exemption from “dealer” status under the Exchange
Act. In sharp contrast to the checkered regulatory history of the
“broker” activity exceptions, however, SEC regulations implementing
the dealer activity exceptions, which were adopted in final in 2003,
have been relatively non-controversial.
See H.R. Conf. Rep. No. 106-434, at 163-64 (1999).
As a practical matter, a bank typically would find it
virtually impossible to operate as a regulated “broker.”
Consequently, the bank in that case would be required
to discontinue the activity, modify it to conform with
a statutory “carve out” exception, or “push out” the
activity from the bank to a registered broker-dealer.
SEC Proposals. The statutory “carve out” exceptions
(or, depending on your point of view, the “push out”
provisions) originally were to take effect in May
2001. In the face of this deadline and numerous open
interpretive questions, the SEC published “Interim
Final Rules” intended to implement the exceptions
in May 2001. The proposals were complex and,
in many instances, completely unworkable from a
bank’s point of view. Opposition to SEC positions or
actions from the banking industry was not particularly
surprising. The Interim Final Rules were so complex
and controversial, however, that even Senator Gramm
and other members of Congress reacted negatively.
The fate of the Interim Final Rules was sealed when
the heads of the federal banking agencies submitted a
joint letter (signed by Fed chairman Alan Greenspan
among others) harshly criticizing the Interim Final
Rules as creating “an extremely burdensome regime of
overly complex, costly and unworkable requirements
that effectively negate the statutory exemptions and the
congressional intent underlying those exemptions.”
For the next three years, the SEC met with banking
industry representatives and regulators in an attempt
to craft proposals that would be acceptable to all
concerned. Eventually, in 2004 the SEC replaced
the Interim Final Rules with proposed “Regulation
B,” which sought to organize key provisions of the
statutory exceptions in a single compilation of eight
separate subparts, each containing its own definitions,
regulations, and exemptions. In short, Regulation
B was intended to be less complex than the ill-fated
Interim Final Rules, but nonetheless met the same fate.
Again, the banking industry opposed Regulation B as
too complex and inconsistent with the congressional
objective of facilitating traditional bank securities
activities.
While the SEC was engaged in successively proposing
the Interim Final Rules and Regulation B, it issued
several orders extending the blanket exemption for
banks. The latest extension is scheduled to expire
July 2, 2007.
71 Fed. Reg. 77557 (Dec. 26, 2006).
March 2007 | Regulation R Alert
“Regulatory Relief.” At length, it became apparent
that the SEC was not, by itself, in a position to satisfy
competing objectives simultaneously. On the one
hand, the banking industry expected that any rules
implementing the carve outs must be consistent
with the congressional purpose of permitting banks
to continue securities activities in which they had
engaged traditionally without having to conform with
new, rigid definitions and procedures. On the other,
the SEC insisted that its rules had to promote “investor
protection” first. Enter Congress – again.
The stalemate finally was broken in October 2006 with
the enactment of the Financial Services Regulatory
Relief Act of 2006 (the “Regulatory Relief Act”).
The Regulatory Relief Act expressly directed the
SEC and the Fed, after consulting and seeking the
concurrence of the other federal banking agencies, to
propose a single set of rules to implement the bank
“broker” exceptions no later than April 11, 2007.
The Regulatory Relief Act also provides a clean slate,
providing expressly that the joint rules adopted by
the Agencies will “supersede any other proposed or
final rule issued by the Commission” relating to the
bank “broker” exceptions after the date of enactment
of the GLBA and that no such rule issued by the SEC
“whether or not issued in final form, shall have any
force or effect on or after that date of enactment.”
Third Try. Regulation R, proposed on December 18,
2006, was published after the Agencies had “consulted
extensively” with the other federal banking agencies,
and is characterized by the Agencies as designed to
“accommodate the business of banks and protect
investors.” It defines key terms used in the statutory
exceptions relating to networking arrangements, trust
and fiduciary activities, and sweep accounts, explains
or elaborates selected requirements of those exceptions,
and proposes several additional exemptions for selected
categories of securities activities.
In acknowledging that the eventual adoption of
Regulation R in final form will supersede the Interim
Final Rules and Regulation B, as required by the
Regulatory Relief Act, the Agencies stated that “[a]ny
discussion or interpretation of these prior rules in
their accompanying releases would not apply” to
The Regulatory Relief Act also amended the Exchange Act to
clarify that insured savings associations are included in the definition
of “bank.”
Regulation R. Hence, in a significant departure
from typical administrative rulemaking procedure,
the preamble discussion of Regulation R contains
no references to the SEC’s discussion of issues and
concepts in the context of the Interim Final Rules and
Regulation B, notwithstanding the fact that many of
the same concepts have been carried over into
Regulation R.
Although narrowly focused and still complex in certain
respects, proposed Regulation R represents a major step
forward in the rulemaking process. The remainder of
this Alert summarizes key aspects of Regulation R and
highlights issues and questions in selected areas that
may require additional clarification or modification.
II. ANALYSIS OF REGULATION R
A. “Networking” Arrangements
1. The Statutory Exception
This exception applies to bank employees who
refer clients to registered broker-dealers and receive
referral compensation, even though these employees
are not registered, qualified, or associated with a
registered broker-dealer (“unregistered employees”).
It essentially codifies a long line of SEC staff noaction letters and NASD Conduct Rule 2350 that
specify the conditions under which banks and
their employees may participate in “networking”
arrangements without being subject to broker-dealer
regulation. The exception requires, in relevant part,
that (i) a bank enter into a written agreement with a
registered broker-dealer, (ii) brokerage services be
kept clearly separate from the bank and its depository
services, (iii) unregistered bank employees perform
solely clerical and ministerial functions (no order
In a companion release, the SEC separately (i) reproposed a
conditional exemption originally proposed in 2004 to allow banks to
effect riskless principal transactions with non-U.S. persons pursuant
to SEC Regulation S under the Securities Act of 1933; (ii) proposed
to amend and redesignate an existing exemption from the definition
of “dealer” for securities lending activities conducted by a bank as
a “conduit lender”; (iii) proposed to amend a rule granting a limited
exemption from U.S. broker-dealer registration for foreign brokerdealers to conform with the Exchange Act’s amended definitions of
“broker” and “dealer”; and (iv) requested comment on its intention
to withdraw a rule defining the term “bank” for purposes of the
Exchange Act in light of the passage of the Regulatory Relief Act.
71 Fed. Reg. 77550 (Dec. 26, 2006).
March 2007 | Regulation R Alert
taking or securities recommendations, although general
discussions of investment products are acceptable), 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 referral or transaction.
2. Proposals Relating to the Statutory Exception
Proposed Rule 700 defines “nominal one-time cash fee
of a fixed dollar amount” and “contingent on whether
the referral results in a transaction” for purposes of the
statutory exception.
a. M
eaning of “Nominal One-Time Cash Fee
of a Fixed Dollar Amount”
Under proposed Rule 700(c), a cash payment would
constitute a “nominal one-time cash fee of a fixed
dollar amount” if it satisfies any of three alternative
standards. The proposed alternatives are intended
to recognize the varying sizes and geographical
locations of banks and, in this light, balance
permissible payment structures with the purpose of
the “nominal” amount limitation. Regardless of its
actual size or location, however, a bank presumably
could choose to conform with whichever of the
three alternative standards produces the highest
referral fee compensation under the circumstances.
Regulation R also would permit certain types of
bonus payments that have not been considered
“nominal” under previous proposals.
Elements of the SEC’s past proposals (e.g., referral
fee based on hourly rate paid to unregistered
employee making the referral or stated dollar
amount, adjusted for inflation, based on industryrecognized index) are evident in proposed Rule 700.
In an important departure from proposed Regulation
B, however, Regulation R would require that referral
fees be paid in cash only and in a fixed amount. The
proposal would not permit referral fees to be paid
in non-cash forms, such as vacations, annual leave,
consumer goods, or stock grants.
Average Hourly Test. Under the first alternative, a
referral fee would be considered “nominal” if the
fee did not exceed either (i) twice the average of the
minimum and maximum hourly wage established
by the bank for the current or prior year for the
employee’s “job family,” or (ii) 1/1000 of the
average of the minimum and maximum annual
base salary established by bank for the current or
prior year for the employee’s “job family.” “Job
family” would mean a group of jobs involving
similar responsibilities, or which require similar
skills, education, or training that the bank or a
separate unit branch or department of the bank
has established and uses in the ordinary course of
its business to distinguish among employees for
purposes of hiring, promotion, and compensation.
Examples of “job families” would include tellers,
loan officers, or branch managers.
Actual Hourly Wage Test. The second alternative
would define a nominal referral fee as an amount
per referral not exceeding twice the unregistered
employee’s actual base hourly wage. Although
slightly more permissive, this alternative is
reminiscent of an approach taken by the Interim
Final Rules, which measured acceptable referral
fees on the basis of the gross cash wages of the
unregistered employee, a method criticized as
inequitable because it failed to take into account
different hourly rates in high-and low-cost
regions.
Capped Fee. The third alternative would permit a
referral fee that does not exceed $25, as adjusted
every five years for inflation, beginning April 12,
2012. The inflation adjustment under Regulation
R would be based on the Employment Cost Index
for Wages and Salaries, Private Industry Workers
published by the Bureau of Labor Statistics in
contrast to Regulation B, which would have used
the Consumer Price Index as the index measure.
b. Meaning of “Contingent”
Proposed Rule 700(a) defines the phrase “contingent
on whether the referral results in a transaction”
generally to mean referral fee payments that are
dependent on (i) a purchase or sale of a security;
(ii) the opening of an account with a broker or
dealer; (iii) a transaction involving a particular type
of security; or (iv) multiple securities transactions.
Regulation R is unclear about the intended
distinction between (i) and (iii).
However, the proposal would permit a referral fee
to be contingent on whether a customer (i) contacts
or keeps an appointment with a broker-dealer;
or (ii) meets any objective, base-line criteria for
referrals established by the bank or broker-dealer,
March 2007 | Regulation R Alert
such as minimum assets, net worth, or income
requirements, marginal federal or state income
tax rates, or citizenship or residency requirements.
These permissible contingencies are a departure
from earlier proposals, which prohibited the use
of any measure of assets or financial status as a
condition for paying referral fees.
c. Bonus Payments
Proposed Rule 700(b) permits bonus plans for
unregistered employees that contain elements of
“incentive compensation” (e.g., success payments
or other payments that encourage client referrals),
provided that the bonus plans are discretionary and
based on factors or variables that do not take into
account securities transactions or any particular
referral activities individually or collectively at
the bank. This proposal essentially is intended to
give banks flexibility in structuring compensation
arrangements that take into account integrated
services generally provided to private banking
clients. In the view of the Agencies, the bonus
plans described in the proposal are not likely to
give unregistered employees a promotional interest
(often referred to as a “salesman’s stake”) in a
client’s account activity, particularly where the
client receives broad-based financial services, of
which brokerage services are merely a part.
The proposal expressly preserves bonus plans for
bank management and other personnel if they
are based on overall profitability of the bank on
a stand-alone or consolidated basis, any of the
bank’s affiliates (other than an affiliated brokerdealer) or operating units, or a broker-dealer if
such profitability is only one of “multiple factors
or variables” used to determine the bonus. The
condition permitting broker-dealer profitability
is unclear at best, and likely will need further
clarification. In this regard, banks may want to
consider requesting clarification regarding bonus
programs based on bank profitability generally as
well as whether profitability of individual customers
is an acceptable variable to consider.
3.New Exemption for Referrals of Institutional
and High Net-Worth Clients
Proposed Rule 701 is a new exemption that would
allow a bank to pay an employee a contingent referral
fee not subject to the “nominal amount” restrictions
described above if the client referred to the networking
broker-dealer is an “institutional” or “high net-worth”
customer, and several other detailed conditions are
satisfied. This reflects a significant departure from
the SEC’s previous approach of interpreting the
networking exception in the narrow context of bank
tellers referring retail depositors to broker-dealers for
securities services, with seemingly no recognition of,
or accommodation for, the very different context of
“private banking” and similar client relationships.
The proposal’s underlying rationale – that certain types
of clients, based on their asset size or net worth, are
presumed sophisticated and capable of evaluating
material aspects of their securities investments – is
not entirely alien to the federal securities laws. The
exemption for high net-worth individuals, however,
reflects a more profound change in the SEC’s traditional
thinking under the Exchange Act, inasmuch as the
SEC has long resisted distinguishing among client
types when applying the regulatory regime of the
Exchange Act in satisfaction of its investor protection
mandate.
a. D
efinitions of “Institutional” and “High
Net-Worth” Customers
The proposed exemption requires that, prior to or at
the time of the referral, the bank must “determine”
that the customer being referred is an “institutional
customer” or “high net-worth customer.” The
broker-dealer would have responsibilities for
determining that the client satisfied the financial
thresholds described below before paying the
referral fee.
“Institutional Customer.” This term has two
alternative definitions, including three separate
financial tests, which apply depending on the
type of services for which the referral is made.
Generally, an “institutional customer” includes a
corporation, partnership, limited liability company,
trust or other non-natural person that has at least $10
million in investments or $40 million in assets. An
“institutional customer” also includes a non-natural
person with $25 million in assets if the referral is
made for “investment banking services.” The latter
term is defined to include, “without limitation,”
acting as an underwriter, acting as a financial adviser
In contrast, the NASD’s suitability and public communication rules
do make distinctions with respect to their application to retail and
institutional/high net-worth clients.
March 2007 | Regulation R Alert
with respect to mergers, acquisitions, tender offers,
or similar transactions, providing venture capital,
equity lines of credit, private investment-private
equity transactions or similar investments, serving
as placement agent for an issuer, and engaging in
similar activities. According to the Agencies, the
distinction for “investment banking services” is
designed to “permit banks to facilitate access to
capital markets by referring smaller businesses to
broker-dealers.”
“High Net-Worth Customer.” This includes a
natural person who, either individually or jointly
with his or her spouse, has at least $5 million in net
worth, excluding primary residences and liabilities
individually or together, if applicable, with the
spouse. The net worth determination requires that
assets held jointly with a spouse be limited to 50%
of such assets – an approach that is very different
from other joint net worth tests under the federal
securities laws, such as Regulation D’s accredited
investor standards. The proposal requires a bank
either to determine the financial qualifications
of a high net-worth customer or obtain a signed
acknowledgement from the customer confirming
that he or she meets the applicable standards prior
to each referral. In addition, before the referral fee
is paid to the bank employee, the broker-dealer must
determine if the customer meets the high net-worth
or institutional customer threshold.
Regulation R thus introduces yet another set of
complicated financial status tests to go with other,
different tests under the federal securities laws
for “accredited investors,” “qualified investors,”
“qualified clients,” and “qualified purchasers.”
To compound the complexity, the NASD also has
defined the term “institutional customer” in an
entirely different way for purposes of its rules.
One SEC Commissioner justifiably expressed
skepticism for the necessity of imposing another
complex financial status test to an already crowded
and conflicting mix of tests. The Agencies, who
logically could have simply borrowed from
established standards, provided no justification
for introducing the new financial thresholds and
methodologies. It does not seem unreasonable to
question the reasons for, and the practicality of, the
new unfamiliar thresholds.
b. Employee Eligibility
Bank employees may receive contingent referral
fees of a non-nominal amount only if they satisfy
the following conditions: (i) the employee making
the referral must be unregistered (i.e., he or she may
not be an associated person of a broker-dealer, such
as a registered principal or representative); (ii) the
employee must have duties other than acting as a
referral agent or liaison between the bank and the
networking broker-dealer; (iii) the employee must
not be statutorily disqualified for purposes of the
Exchange Act; and (iv) the employee must deal
with institutional and high net-worth clients in the
ordinary course of his or her duties for the bank.
In addition, the bank must disclose to the networking
broker-dealer the names of its unregistered
employees making referrals of institutional and
high net-worth customers. The networking brokerdealer, in turn, is responsible for determining that
the unregistered employee is not an associated
person of any broker-dealer or otherwise subject
to a statutory disqualification. The proposal does
not indicate what level of diligence is necessary to
satisfy this obligation – presumably a check of the
NASD’s Central Registration Depository (“CRD”)
system should suffice to satisfy this obligation.
c. Written Agreement and Client Disclosures
The proposal requires that the networking
arrangement be set forth in a written agreement
that not only addresses the obligations described
above, but also contains specific obligations related
to client suitability and sophistication in the case of
referrals for contingent and non-contingent referral
fees. The proposal places responsibility on the
networking broker-dealer to notify the bank if, in
the case of certain contingent referrals, a client
engages in unsuitable securities transactions. The
written agreement also must obligate the brokerdealer to notify the bank if it determines that a
client is not in fact an institutional or high networth customer or if an unregistered employee
is statutorily disqualified. The proposal provides
no guidance regarding exactly what the bank is
supposed to do if it is informed that a customer
has engaged in unsuitable securities transactions or
if the customer is not an institutional or high networth customer.
March 2007 | Regulation R Alert
The proposal also requires a bank to deliver a
disclosure statement to the client that identifies
the name of the networking broker-dealer and
material aspects of the unregistered employee’s
compensation (i.e., that it may be contingent,
incentive-based, and non-nominal). This disclosure
delivery responsibility also must be reflected in the
written agreement between the bank and networking
broker-dealer.
4. Impact on Banks and Broker-Dealers
NASD Conduct Rule 2350 currently requires, and has
required for some time, that bank-broker networking
arrangements be memorialized in a written agreement.
Not surprisingly, existing agreements would have no
reason to address the specific obligations required
by Rule 701. These legacy agreements have instead
been tailored to satisfy obligations outlined in NASD
rules and SEC staff no-action letters in the networking
context. Accordingly, existing agreements will need
to be reviewed and amended to reflect the newly
prescribed obligations of the bank and the brokerdealer making and receiving referrals in reliance on the
Rule 701 exemption, as well as potential indemnities
for compliance breakdowns. In addition, operating
procedures of banks and broker-dealers will need to
be tailored to reflect obligations of review, disclosure
and notification. Banks also will need to review
bonus programs and other incentive compensation
arrangements to ensure they meet the conditions of
the exception. Banks and broker-dealers will need
to consider conflicting NASD interpretations, which
are discussed below, on the permissibility of paying
referral fees and bonuses to unregistered employees in
connection with referring bank clients to the brokerdealer under the networking exception.
B. Trust and Fiduciary Activities
1. The Statutory Exception
This exception applies to securities transactions
effected by a bank acting in a “trustee” or “fiduciary”
capacity in the bank’s trust or other department “that is
regularly examined by bank examiners for compliance
with fiduciary principles and standards.” The bank
must be “chiefly compensated” for such transactions,
consistent with fiduciary principles and standards,
on the basis of an “administration or annual fee,” a
“percentage of assets under management,” a “flat or
capped per order processing fee” equal to not more
than the cost incurred by the bank in connection with
executing securities transactions, or any combination
of such fees. The bank may not publicly solicit
brokerage business, other than stating in the context of
advertising its general fiduciary activities and services
that it effects securities transactions. The bank also
must direct transactions in the U.S. of publicly traded
securities to a registered broker-dealer for execution
or for handling in some other manner permitted under
SEC rules.
Exchange Act Section 3(a)(4)(D) defines “fiduciary
capacity” for these purposes to include (i) the capacity
of trustee, executor, administrator, registrar of stocks
and bonds, transfer agent, guardian, assignee, receiver,
custodian under a uniform gift to minor [sic] act,
investment adviser (if the bank receives a fee for its
investment advice), (ii) any capacity in which a bank
possesses investment discretion for another, or (iii) any
other similar capacity.10
2. Proposals Relating to the Statutory Exception
Proposed Rule 721 defines several key terms relating
to the “chiefly compensated” requirement. The
definitions contained in the Interim Final Rules and
Regulation B sparked some of the banking industry’s
most intense opposition to those proposals. This
time around, questions and complexity remain, but it
appears that the industry’s reactions to Regulation R’s
approach are likely to be favorable. A review of the
key definitions follows.
a. “Chiefly Compensated”
As noted above, the statutory exception requires that
the bank be “chiefly compensated” on the basis of
certain types of compensation and fees. Under the
proposal, “chiefly compensated” means that, with
respect to each trust or fiduciary account of the bank,
the “relationship-total compensation percentage”
10 This definition is substantially identical to the definition of
“fiduciary” in Regulation 9 (12 C.F.R. Part 9) of the Office of the
Comptroller of the Currency, the federal agency responsible for
regulation of national banks (“OCC”). The statutory exception,
however, does not refer or defer to Regulation 9. It is therefore
an open question if OCC interpretations of the Regulation 9
definition would be applicable to the statutory exception. Given
the obvious relationship between Exchange Act Section 3(a)(4)(D)
and Regulation 9, however, OCC interpretive guidance should carry
substantial weight and, to the extent any such guidance addresses
a particular “capacity” not described specifically in the statute, it
logically could be included within the “any other similar capacity”
category.
March 2007 | Regulation R Alert
is greater than 50%. This percentage is to be
computed for each account by dividing relationship
compensation attributable to the account by total
compensation attributable to the account during
each of the immediately two preceding years, and
averaging the two percentages.
A bank will have the option of satisfying either
this “account-by-account” test or, alternatively,
satisfying the “bank-wide” compensation test under
the new proposed exemption described below.
The proposal defines “year” to mean the calendar
year or fiscal year consistently used by the bank
for recordkeeping and reporting purposes. The
proposal is not completely clear, however, with
regard to the timing of the required computation.
It is logically implied that a bank normally would
perform the required computations after the end
of each year – hence the references in proposed
Rule 721(a)(2) to “the immediately preceding year”
and the “year immediately preceding that year”
– but there is no indication as to exactly when the
computations should or must be made. Presumably,
banks will be given an adequate amount of time
after the end of a year to perform the appropriate
computations.
b. “Relationship Compensation”
As indicated above, the statutory exception indicates
that the bank must be chiefly compensated on the
basis of (i) an administration or annual fee, (ii) a
percentage of assets under management, (iii) a flat
or capped per order processing fee equal to not more
than the cost incurred by the bank in connection
with executing securities transactions for trust and
fiduciary customers, or (iv) any combination of such
fees. As under prior SEC proposals, Regulation
R would define these types of compensation
collectively as “relationship compensation.”
The proposal also provides examples of specific
types of compensation that would be considered
“relationship compensation.”11
Administration Fee. This would include, without
limitation, a fee paid for personal services, tax
preparation, or real estate settlement services, or
a fee paid by a mutual fund for personal service,
11 Although the preamble to the proposal describes relationship
compensation as compensation that is “attributable to” a fiduciary
account, proposed Rule 721 itself contains no such condition.
maintenance of shareholder accounts, or other
services described in the “percentage of assets fee”
below.
Annual Fee. The proposal does not elaborate
this definition, other than to repeat the statutory
language that an annual fee may be payable on a
monthly, quarterly, or other basis.
Percentage of Assets Under Management Fee. This
would include, without limitation, a fee paid by
a mutual fund (i) pursuant to a Rule 12b-1 plan;
(ii) for personal service or the maintenance of
shareholder accounts; or (iii) based on a percentage
of assets under management for transfer agent or
sub-transfer agent services, processing purchase and
redemption orders, providing account statements
to shareholders, processing dividend payments,
sub-accounting services, forwarding mutual fund
communications to shareholders, and processing
shareholder proxies.
The inclusion of 12b-1 and similar fees paid by
mutual funds with respect to fiduciary accounts as
“relationship compensation” is a major, and from the
banking industry point of view favorable, departure
from prior SEC proposals. Proposed Rule 721 itself
describes these fees as fees “paid by an investment
company,” and omits to mention payments for such
services from other sources (e.g., the mutual fund’s
investment adviser). However, since the proposal
indicates that the examples described in the proposed
Rule are included “only for illustrative purposes,”
and the proposed Rule itself states that the examples
of permissible payments are “without limitation”
of what actually is permitted, payments from the
investment adviser or other sources also should be
within the scope of “relationship compensation.”
Nonetheless, the Agencies probably should clarify
that payments of this type need not be limited to
those paid by the mutual fund itself.
Flat or Capped Per-Order Processing Fee.
Consistent with the statutory exception, the proposal
provides that this type of fee may be considered
“relationship compensation” only if it does not
exceed the cost incurred by the bank in connection
with executing securities transactions for fiduciary
accounts. This “cost” may include commissions or
fees charged by the broker executing the transaction
as well as any other “fixed or variable processing
costs incurred by the bank.” If a bank includes
March 2007 | Regulation R Alert
the latter costs in its per-order processing fee, the
preamble to the proposal states that “the bank
should maintain appropriate policies and procedures
governing the allocation of these costs to the orders
processed for trust or fiduciary customers.” A
footnote to this statement indicates that a bank “may
use other divisions or departments of the bank, or
other affiliated or unaffiliated third parties, to handle
aspects of these transactions.” Although the point
is not elaborated, this could be read to suggest that
a per-order processing fee may include internal cost
allocations attributable to functions and services
performed by other bank departments or affiliates
or third parties.
The proposal states that the examples of the
“administration fee” and the “assets under
management fee” are provided for illustration
purposes only. Other types of fees for other types
of services could fall within these categories of
“relationship compensation.” Consequently, a
bank may need to identify whether it receives fees
attributable to fiduciary accounts not specifically
described in the proposal and assess whether the
fees fall within the categories listed above and,
if not, consider whether a comment requesting
clarification or relief should be submitted to the
Agencies.
The proposal also makes it clear that an
administration fee, annual fee, or assets under
management fee that is attributable to a trust/
fiduciary account is considered “relationship
compensation” regardless of what entity or person
pays the fee, and regardless of whether the fee is
related only to securities assets or non-securities
assets (e.g., real estate) of the account.
Thus, “relationship compensation,” as defined
by Regulation R, would have four primary
characteristics: (i) it should be “attributable to” a
trust or fiduciary account; (ii) it may be paid by
any entity or person (i.e., it does not have to be paid
solely from the fiduciary account or by the account
principal); (iii) it may relate to securities assets or
non-securities assets of the account; and (iv) it must
be an administration fee, annual fee, or assets under
management fee (or a per-order processing fee that
reflects the bank’s costs, etc.).
Although “total compensation” is integral to the
“chiefly compensated” requirement, the proposal
notably does not define “total compensation.”
Subject to further clarification from the Agencies
in response to comments, the characteristics of
“total compensation” logically would seem to
include the first three characteristics of “relationship
compensation” described immediately above.
c. Advertising Restrictions
Proposed Rule 721 also provides a safe harbor for
meeting the “advertising” restriction in the statutory
exception. Under the proposal, a bank would be
deemed to comply with the restriction if (i) the
bank does 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; and (ii) the bank’s
advertisement does not advertise the securities
brokerage services that the bank provides to trust
or fiduciary accounts more prominently than other
aspects of the trust or fiduciary services provided
to those accounts. The proposal notes that the
nature, context, and prominence of the information
presented should be considered in determining
whether an advertisement meets the safe harbor.
3.Exemption for “Bank-Wide” Chiefly
Compensated Computation
Proposed Rule 722 would provide an alternative –
undoubtedly welcome to many banks – to the accountby-account computation of the “relationship-total
compensation percentage” described above. Under
this exemption, a bank would be permitted to compute
its relationship-total compensation percentage on an
aggregate or bank-wide basis. This computation
would require a determination of relationship and
total compensation received from all trust and fiduciary
accounts on a bank-wide basis during each of the two
immediately preceding years, and averaging the two
percentages. The exemption applies if the bank’s
“aggregate relationship-total compensation percentage”
for its trust and fiduciary business is at least 70%.12
The proposal states that the 70% threshold was selected
to ensure that a bank’s trust department is not “unduly
dependent on non-relationship compensation from
securities transactions,” and that the exemption is
12 Technically, a bank satisfying proposed Rule 722 is exempt from
the “chiefly compensated” requirement of the statutory exception.
The Rule provides that the bank must satisfy all other conditions of
the exception.
March 2007 | 10
Regulation R Alert
designed to simplify compliance and reduce costs.
Regardless of whether a bank uses the account-byaccount or the bank-wide approach, the proposal
would permit the bank to choose between using the
calendar year or fiscal year to make the necessary
computations. The two-year rolling average of
the percentages is intended to allow for short-term
fluctuations that otherwise might cause a bank “to fall
out of compliance” with the statutory exception or Rule
722’s exemption from year to year.
4. Additional Exemptions for Particular Types of
Accounts
Proposed Rule 723 would permit a bank to exclude
certain types of accounts from its determination
of whether it satisfies the “chiefly compensated”
requirement under either the account-by-account or
the bank-wide test. These “excluded accounts” would
include (i) short-term accounts that have been open for
a period of less than three months during the relevant
year; and (ii) accounts acquired as part of a business
combination or asset acquisition, for a period of 12
months after the date of acquisition.
For purposes of the account-by-account test only, the
bank could exclude (i) accounts transferred to a brokerdealer or another entity that is not affiliated with the
bank and is not required to be registered as a brokerdealer within three months of the end of a year in which
the account fails the “account-by-account” test; and (ii)
accounts meeting certain de minimis requirements.
The proposal offers no explanation or rationale as to
why these exclusions are limited only to the accountby-account test.
5. Impact on Banks
A bank intending to rely on the carve out exception
for transactions effected for trust and fiduciary
accounts generally will need to identify and
categorize compensation attributable to trust and
fiduciary accounts in order to perform the “chiefly
compensated” computation. The bank also will need
to determine whether it will make this computation on
an account-by-account or bank-wide basis and develop
the associated policies, procedures, and systems for
making the computation. If the bank expects to rely
on the advertising safe harbor, it will need to review
and, if necessary, update advertising guidelines and
content.
C.Sweep Accounts
1 The Statutory Exception
This exception applies to transactions effected by
a bank as part of a program for the investment or
reinvestment (“sweep”) of deposit funds into a “no
load” mutual fund registered under the Investment
Company Act of 1940 (“1940 Act”) that holds itself
out as a “money market fund.”
2. Proposals Relating to the Statutory Exception
Proposed Rule 740 defines various terms under
the exception, the critical one being “no load.” As
proposed, “no load” means that the money market fund
shares involved in the sweep program (i) are not subject
to a sales charge or deferred sales charge, and (ii) may
be subject to charges for sales or sales promotion
expenses, personal service, or the maintenance of
shareholder accounts, if such charges are capped at 25
basis points annually.
In addition, charges for the following types of services
would not be considered charges subject to the 25
basis point cap: (i) transfer agent or sub-transfer agent
services for beneficial owners of fund shares; (ii)
aggregating and processing purchase and redemption
orders for fund shares; (iii) providing beneficial owners
with account statements which show their transactions
and positions in the fund; (iv) processing dividend
payments for the fund; (v) providing sub-accounting
services to the fund for shares held beneficially; (vi)
forwarding fund communications to the beneficial
owners, including proxies, shareholder reports,
dividend and tax notices, and updated prospectuses;
and (vii) receiving, tabulating, and transmitting proxies
executed by beneficial owners of fund shares.
3. New Exemption for “Non-No-Load” Funds
A controversy associated with prior SEC proposals
relating to the sweep exception has centered on the
definition of “no load” and banks’ desire to use sweep
funds not conforming with the definition. Although
the “no-load” definition has not been modified in
Regulation R (as described above), proposed Rule 741
provides a new exemption for transactions involving
1940 Act-registered money market funds that do not
satisfy the “no-load” definition.
Unlike the statutory exception, the proposed exemption
would apply to transactions involving customer funds
of any kind, not just sweep programs for “deposit”
March 2007 | 11
Regulation R Alert
funds. The proposed exemption would be subject to
a number of conditions. First, the bank must provide
the customer with some other product or service (apart
from money market fund transactions) that would not,
by itself, trigger broker-dealer registration for the bank.
In addition, the bank must (i) provide the customer
a prospectus for the fund no later than the time the
customer authorizes the transactions; and (ii) not refer
to or characterize the fund as a “no load” fund.
D.Safekeeping and Custody Activities
1. The Statutory Exception
This exception is intended to permit 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 a custodian or a 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 invest cash
collateral pledged in such transactions; (iv) engage
in certain activities in connection with securities
pledged by customers; and (v) act as custodian or
provider of other related administrative services to
individual retirement account or pension, retirement,
profit-sharing, bonus, thrift savings, incentive, or other
similar benefit plans.
2. Proposals Relating to the Statutory Exception
Regulation R contains no rules that would implement
the statutory exception. Significantly, however, and
somewhat surprisingly, given the Fed’s involvement
in the proposal, the Agencies accept by implication the
interpretation adopted by the SEC in the Interim Final
Rules and Regulation B – that the activities permitted
under the statutory exception do not include accepting
customer orders for securities transactions.
As noted above, Congress’ intent in enacting the
GLBA’s carve-out provisions was to permit banks
to continue to engage in “certain activities in which
banks traditionally have engaged.” A report issued for
Congress in 1977 by the SEC’s own staff reflected a
general understanding that order taking was an integral
part of traditional bank custody activities long before
the GLBA was enacted. The report, entitled “Initial
Report on Bank Securities Activities,” presented
detailed information relating to bank securities services
similar to services provided by broker-dealers, based
on a survey of bank securities activities.13 One of
the services – “customer transaction services” – is
described as a service “in which a bank accepts orders
from customers for the purchase or sale of a corporate
stock selected by the customer and transmits those
orders to a broker-dealer for execution.”14 The Report
further indicated that:
[h]istorically, banks have assisted their customers, both
individual and institutional, in purchasing and selling
securities. Banks have long played a major role in
customer purchases and sales of Treasury securities,
federal agency securities, tax-exempt securities and
money market instruments. Depending on the security
involved, banks may act either as principal or as agent.
In addition, solely in an agency capacity, banks assist
their customers in the purchase and sale of corporate
stock.15
In any case, the Agencies have found it appropriate
to propose a separate exemption to permit banks
providing custody services to accept customer orders
to buy or sell securities – subject to certain restrictions
and conditions. Proposed Rule 760 consists of three
separate conditional exemptions for these activities,
one for employee benefit plan accounts and individual
retirement accounts (“IRAs”) or similar accounts, the
second for non-employee benefit plan or IRA accounts,
if the bank accepts orders on an “accommodation”
basis only, and the last applicable to accounts for which
the bank acts “as a non-fiduciary and non-custodial
administrator or recordkeeper” for an employee benefit
plan for which another bank acts as custodian. The
first two exemptions apply to an “account for which the
bank acts as a custodian,” which is defined to include,
13 Securities and Exchange Commission, “Initial Report on Bank
Securities Activities” (January 3, 1977) (the “Report”). The Report
was the second in a series of three reports the SEC presented to
Congress in accordance with Exchange Act Section 11A(e), which
directed the SEC to conduct a study of the extent to which banks
maintain accounts on behalf of public customers for buying and
selling publicly-traded securities and whether the blanket exemptions
for banks from “broker” and “dealer” status under the Exchange Act
were consistent with the purposes of the Exchange Act.
14 Report at 3, n. 2. The SEC’s final report stated, “[t]he common
element of the bank securities services studied is that banks providing
the services, like brokers, are engaged in ‘effecting transactions in
securities for the account of others.’” Securities and Exchange
Commission, “Final Report on Bank Securities Activities” (July
5, 1977), at 3.
15 Report at 77.
March 2007 | 12
Regulation R Alert
in addition to employee benefit and IRA accounts, other
accounts established pursuant to written agreements
governing the rights and obligations of the bank
regarding the safekeeping or custody of securities.
3. Exemption for Employee Benefit Plan and IRA
Accounts
The exemption would permit a bank to accept orders
to effect transactions in securities in an “employee
benefit plan account” or an “individual retirement or
similar account” for which the bank acts as custodian
if the bank meets various conditions and restrictions
designed to “protect investors and prevent a bank from
using the exemptions to operate a securities broker in
the bank.”
Employee Compensation Restriction. Bank employees
may not receive compensation that is based on “whether
a securities transaction is executed” for the account
or the “quantity, price, or identity of the securities
purchased or sold by the account.” The Agencies
explain that this restriction is intended to minimize
financial incentives to bank employees to encourage
clients’ placement of securities orders. This restriction
would not prevent an employee from receiving
compensation based on whether customers establish
custody accounts or the amount of assets in such
accounts or other types of compensation permissible
under the proposed networking rules described
above (i.e., payments under a bonus or similar plan,
profitability-based compensation, and referral fees for
referring customers to a broker or dealer to engage in
transactions unrelated to the custody account).
Advertisements and Sales Literature Restriction. Bank
“advertisements” (defined as described below) may not
advertise that the bank accepts orders for securities
transactions, other than as part of advertising the
bank’s “other custodial or safekeeping services,” that
its employee benefit plan and IRA custody accounts
are “securities brokerage accounts” or that the bank’s
safekeeping and custody services “substitute for a
securities brokerage account.” In addition, the bank’s
advertisements and “sales literature” (defined as
described below) may not describe the bank’s ordertaking services provided to IRAs and similar accounts
more prominently than other aspects of its custody
or safekeeping services. (The latter restriction is
inapplicable to advertisements and sales literature
relating to employee benefit plans.)
Other Conditions. The exemption does not apply to
accounts within the scope of the trust and fiduciary
activities exception – i.e., the bank cannot be acting
in a trustee or fiduciary capacity (defined as described
above for purposes of the fiduciary activities exception)
with respect to the account. The bank also must
direct transactions in U.S. securities to registered
broker-dealers (pursuant to Exchange Act Section
3(a)(4)(C)) and comply with restrictions on “carrying
broker” activities described in Exchange Act Section
3(a)(4)(B)(viii)(II).
4. Exemption for “Accommodation” Transactions
Proposed Rule 760 also would permit banks to effect
securities transactions in other types of custody
accounts subject to the following conditions.
Accommodation Transactions Only. The bank may
accept orders for securities transactions only as “an
accommodation” to the customer. The proposal itself
does not define the term “accommodation.” Instead,
the federal banking agencies are expected to develop
guidance describing “the types of policies, procedures
and systems that a bank should have in place to help
ensure that the bank accepts securities orders for other
custodial accounts only as an accommodation to the
customer and in a manner consistent with both the
terms and purposes of the custody exemption and the
GLB Act.” Presumably, this guidance will provide
that “accommodation” transactions are those that are
initiated at the request or direction of the customer.
Employee Compensation Restriction. The same
restrictions on employee compensation in the
context of employee benefit plan and IRA accounts
described above are applicable to “accommodation”
transactions.
Bank Fee Restriction. Fees charged or received by
the bank for effecting a securities transaction for the
account may not vary depending 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. Presumably, such fees may vary based on
other characteristics of the transactions (e.g., whether
the security in question is traded on U.S. or foreign
markets).
Advertising Restrictions. In contrast to the employee
benefit plan/IRA exemption, the proposal for
“accommodation” transactions for “other” custody
accounts establishes separate restrictions for bank
March 2007 | 13
Regulation R Alert
advertisements and sales literature. Advertisements
cannot state that the bank accepts orders for securities
transactions for the account. An “advertisement”
is defined as any material published or used in any
“electronic or other public media,” including any Web
site, newspaper, magazine or other periodical, radio,
television, telephone or tape recording, videotape
display, signs or billboards, motion pictures, or
telephone directories (other than “routine listings”).
Sales Literature Restrictions. In contrast to
advertisements, bank sales literature may not state
that the bank accepts orders for securities transactions
except as part of describing the bank’s other custodial
or safekeeping services. Sales literature also may
not describe the bank’s order-taking services more
prominently than other aspects of its custody or
safekeeping services. “Sales literature” is defined as
any “written or electronic communication, other than
an advertisement,” generally distributed or available
to bank customers or the public, including circulars,
form letters, brochures, telemarketing scripts, seminar
texts, published articles, and press releases concerning
the bank’s products and services.
First impressions are that it may be difficult to distinguish
“advertisements” from “sales literature.” For example,
although it appears generally that “advertising” is
focused on material distributed through public media,
both definitions include “electronic” communications.
In the absence of additional guidance identifying
clearer or more precise distinctions between them,
banks in many cases may conclude that compliance
with the more restrictive “advertising” restrictions in
all cases is the more practical approach. In this regard,
proposed Rule 760 also cautions that, in considering
whether a bank satisfies the conditions of the ordertaking exemptions, the focus will be on the “form
and substance” of the relevant accounts, transactions,
and activities, “(including advertising activities),” in
order to prevent evasion of the requirements of the
exemptions.
Investment Advice and Recommendations Restriction.
The bank may not, subject to certain exceptions,
provide “investment advice or research concerning
securities,” make “recommendations” regarding
securities, or otherwise “solicit securities transactions”
to or from the account.
Other Conditions. The “other conditions” described
above with respect to employee benefit plan and
IRA accounts are applicable to “accommodation”
transactions.
5. Exemption for Non-Fiduciary,
Non-Custodial Accounts
The proposal would permit a bank acting as a
non-fiduciary and non-custodial administrator or
recordkeeper for an employee benefit plan for which
another bank acts as custodian to accept orders
for securities transactions if both banks satisfy the
requirements of the proposed exemption for employee
benefit plan and IRA accounts described above and the
“administrator or recordkeeper” bank does not execute
a cross-trade with or for the employee benefit plan or
net orders for securities for the plan, other than orders
for mutual fund shares.
6. Impact on Banks
A bank that intends to rely on the safekeeping and
custody exemptions should develop guidelines for
advertising and sales literature that meet the restrictions
of the respective exemptions, or consider establishing
a single set of guidelines consistent with the most
restrictive limitations. Pending federal banking
regulatory guidelines defining “accommodation,”
a bank that intends to rely on the exemption for
accommodation transactions should consider reviewing
any transaction-based compensation programs to
determine if they are based in any way on the execution
of a securities transaction, and establish policies and
procedures to restrict employees from providing advice,
recommendations, and solicitations with respect to
such transactions (other than for those exempt from
restriction).
March 2007 | 14
Regulation R Alert
E. Exemptions for Other Transactions
1. Regulation S Transactions
Proposed Rule 771 is a conditional exemption permitting
banks to offer and sell “eligible securities” in so-called
“Regulation S transactions.” Essentially, a bank may
engage in an initial sale or resale under specified
conditions of “eligible securities” if the offering
complies with Regulation S under the Securities Act of
1933, namely the transaction takes place offshore with
non-U.S. persons. The term “eligible securities” is
defined for this purpose as securities that are not (i) sold
from the inventory of the bank (which would appear
to be a dealer, not broker, activity) or bank affiliate;
and (ii) underwritten by the bank or bank affiliate on a
firm commitment basis (unless the bank acquired the
securities from an unaffiliated distributor that did not
otherwise acquire the security from the bank or bank
affiliate). This exemption is a departure from the
SEC’s long-standing view that persons engaging in
broker or dealer activities from the United States are
subject to Exchange Act regulation as a broker-dealer,
even if all securities sales activities involve non-U.S.
persons residing outside of the United States.
2. Securities Lending Transactions and Services
Proposed Rule 772 would allow a bank not having
custody of securities to conduct certain securities
lending transactions and provide certain securities
lending services in connection with those transactions
“as agent.” This exemption applies if the bank engages
in these activities with or on behalf of a person the
bank reasonably believes is a “qualified investor” or
an employee benefit plan that owns and invests $25
million or more in investments on a discretionary
basis.16 “Securities lending services” an agent bank
would be permitted to provide in connection with
securities loans include (i) selecting, and negotiating
loans with, the borrower; (ii) receiving or delivering (or
directing the receipt or delivery of) loaned securities
and collateral for loans; (iii) providing mark-to-market,
corporate action, recordkeeping, or other services
incidental to the administration of securities loans;
(iv) investing, or directing the investment of, cash
collateral; or (v) indemnifying the lender of securities
with respect to various matters.
16 A “qualified investor” under Exchange Act Section 3(a)(54)(A)
generally includes institutional investors or individual investors with
more than $25 million in investments.
Thus, a bank may engage in securities lending
activities under either the statutory exception for
safekeeping and custody activities described above
or the proposed exemption for “agency” securities
lending activities. The statutory exception applies
where the bank has custody of the securities to be
loaned. The proposed exemption applies where the
bank does not have custody of the securities at all
or does not have custody for the entire period of a
securities loan. Thus, the typical situation in which the
exemption applies is where the bank is acting only as
“agent,” while another “expert entity” selected by the
customer handles custodial functions.
The proposed exemption reinstates an exemption
originally adopted by the SEC in 2003 in connection
with the “broker” and “dealer” carve outs. Since the
Regulatory Relief Act voided that exemption with
respect to “broker” only, the proposal would reinstate
the exemption as it relates to broker activities, leaving
the “dealer” exemption in place.
The exemption originally was intended to provide
“legal certainty” to banks providing securities lending
services solely as “agent” without custody.17 However,
one might ask why securities lending services should
be limited to customers meeting restrictive qualification
standards described above (i.e., “qualified investor,”
etc.), none of which appear in the statutory exception
permitting the same services.18
When it initially proposed the exemption, the SEC
stated that it would be “available for banks’ current
securities lending business. The exemption would
be limited to transactions with ‘qualified investors’
as defined in Exchange Act section 3(a)(54).”19 This
apparently was based on the SEC’s understanding that
banks typically provided securities lending services
to “institutional customers.”20 The general counsels
of the federal banking agencies (“General Counsels”)
submitted a comment letter expressing the view that
the customer qualification standards were “inconsistent
with the statutory framework and should be deleted
17 68 Fed. Reg. 8686, 8692 (Feb. 24, 2003).
18 The Agencies, correctly, did not suggest that the statutory
exception is subject to restrictions or limitations, such as those
imposed in connection with the proposed exemption.
19 67 Fed. Reg. 67496, 67503 (Nov. 5, 2002).
20 Id. at 67502.
March 2007 | 15
Regulation R Alert
because Congress did not place any such restriction
in the statutory exception.”21 In responding, the SEC
noted that the General Counsels “conceded that the
securities lending market is institutional in nature,”
and simply concluded that “we plan to retain the
requirement that securities lending transactions be
conducted only with qualified investors.”22
The SEC’s approach is clearly in keeping with its
proclivity for establishing bright-line tests to enhance
compliance with (and enforcement of) its rules. One
might legitimately ask, nonetheless, whether the
General Counsels’ analysis of the statutory framework
still makes more sense in this context. Whether banks
find it necessary or advisable to question the SEC’s
rationale on this point again perhaps will depend
mainly on a practical assessment of the extent of the
opportunities to be gained if the customer qualification
requirements were deleted. A practical consideration
that may dim the SEC’s enthusiasm for any changes is
that, if and to the extent the Agencies were to modify
the exemption for purposes of the “broker” rules,
similar action probably would be required with respect
to the “dealer” equivalent of the exemption.
3. “Fund/SERV” Exemption
Exchange Act Section 3(a)(4)(C)(i) requires that
securities transactions effected pursuant to the trust/
fiduciary, stock purchase plan, and safekeeping and
custody exceptions be executed through a registered
broker-dealer. Prior to the enactment of the GLBA,
banks participated in the mutual fund clearing and
settlement system of the National Securities Clearing
Corporation, known as “Fund/SERV,” or executed
mutual fund share transactions directly with a fund’s
transfer agent. In apparent recognition of banks’ longstanding involvement in this limited execution activity,
proposed Rule 775 would exempt a bank from having
to comply with Section 3(a)(4)(C)(i) with respect to
mutual fund share transactions that are effected through
Fund/SERV or directly with the fund’s transfer agent
in the absence of a broker-dealer intermediary. The
21 68 Fed. Reg. 8686, 8693-94 (Feb. 24, 2003). The General
Counsels also questioned the need for an exemption in the first place,
arguing that the safekeeping and custody exception was sufficiently
broad to encompass “agency without custody” situations. Id. at
8693. The SEC retorted simply, “We disagree with the interpretation
of the Exchange Act bank exceptions advanced in this comment
letter.” Id.
22 Id. at 8693-94. The SEC reiterated its earlier belief that the
exemption would be available for “banks’ current securities lending
business.” Id. at 8692.
funds cannot be exchange-traded funds or otherwise
quoted on Nasdaq or an interdealer quotation system.
In addition, the fund’s shares must be distributed by a
registered broker-dealer or, if self-underwritten, any
sales charges assessed must be no more than what is
permissible under NASD Conduct Rule 2350.
4. Exchange Act Section 29(b) Relief
Proposed Rule 780 contains transitional and permanent
exemptions from Exchange Act Section 29(b), which
provides that contracts made in violation of the
Exchange Act or its associated rules and regulations
are void or voidable. Section 29(b) affords parties to
a securities transaction a right of rescission when a
party to the transaction was required to be registered
as a broker or dealer, but was not so registered. The
exemptions are intended to give banks a transition
period for compliance with the final rules under
Regulation R and thereafter to provide permanent relief
for inadvertent violations in certain situations.
Under the transitional exemption, no contract to which
a bank is a party and that is entered into before 18
months after the effective date of the final rules would
be void or voidable under Exchange Act Section 29(b)
because the bank violated the Exchange Act’s brokerdealer registration requirements, any other applicable
provision of the Exchange Act, or any associated rules
or regulations, based solely on the bank’s status as a
broker when the contract was created.
Under the permanent exemption, no contract would
be void or voidable under Exchange Act Section 29(b)
based solely on the bank’s unregistered status if, at
the time the contract was created, (i) the bank acted in
good faith and had reasonable policies and procedures
in place to comply with the brokerage “push-out”
provisions of the Exchange Act and associated
regulations; and (ii) any violation by the bank of the
registration requirement did not result in any significant
harm, financial loss, or cost to the person seeking to
void the contract.
NASD CONSIDERATIONS
I. “SELLING AWAY”
An issue that has largely been sidestepped to date is
the extent to which NASD-regulated broker-dealers
may be required under NASD Conduct Rule 3040 to
exercise oversight over “dual employees,” as defined
March 2007 | 16
Regulation R Alert
below, who are engaged in bank securities activities
permissible under the carve outs described above.
Banks first questioned the potential application of
Rule 3040 in the context of the Interim Final Rules.
Jurisdiction of the NASD over otherwise excepted
bank securities activities does not appear consistent
with the intent of the GLBA or, for that matter, the
authority vested in the NASD under the Exchange Act.
The proposal’s failure to address or even mention the
issue may, and perhaps should, generate comments
from affected banks.
A. NASD Conduct Rule 3040
The NASD adopted Conduct Rule 3040 (previously
Rule 40 of the Rules of Fair Practice) in 1985,
well before the enactment of the GLBA and its
modernization of the financial services marketplace.
Rule 3040 generally prohibits any person associated
with an NASD member firm from engaging in
a “private securities transaction” 23 for “selling
compensation,”24 unless certain reporting and oversight
conditions are satisfied. The Rule requires notice
to, and prior approval of, the member firm for each
private securities transaction in which an associated
person engages. Rule 3040 also imposes oversight
functions on the member firm if an associated person
receives selling compensation. That is, a member
firm must record each private securities transaction
on its books and records and supervise the transaction
as if the transaction were being effected on behalf of
the member firm. It is this latter obligation of Rule
3040 – recordkeeping and oversight by the brokerdealer – that creates thorny issues for banks and bank
employees who are registered associated persons of
the bank’s captive or affiliated broker-dealer (so-called
“dual employees”).
23 “Private securities transaction” is defined broadly to include
“any securities transaction outside the regular course or scope of an
associated person’s employment with a member, including, though
not limited to, new offerings of securities which are not registered
with the [SEC] . . . .” NASD Conduct Rule 3040(e)(1). The Rule
excludes from the definition certain securities transactions related
to an associated person’s own account or his or her investments
in mutual funds or variable insurance contracts, as well as certain
securities transactions effected by such associated persons as an
accommodation to family members.
24 “Selling compensation” is defined broadly to include “any
compensation paid directly or indirectly from whatever source
in connection with or as a result of the purchase or sale of a
security . . . .” NASD Conduct Rule 3040(e)(2). The NASD has
emphasized that the definition is deliberately broad and basically
extends to “any item of value received or to be received directly or
indirectly.” NASD Notice to Members 85-54 (Aug. 13, 1985).
Rule 3040 was adopted against the backdrop of
professionals “selling away” from their firms in private
offerings of securities outside of any apparent SEC
or NASD regulation of the actual offering or sales
efforts themselves. Hence, Rule 3040 presumably
clarified, in part, that which should have already been
evident, namely that many securities sales, even private
offerings, are subject to a comprehensive set of brokerdealer and customer-protection regulations under the
federal securities laws. The NASD is not limited to
applying Rule 3040 solely in the context of private
offerings, and it has broadly applied Rule 3040 to
activities that are subject to alternative regulatory
structures.
B. Impact on Banks
Because of the breadth with which the NASD
interprets Rule 3040, particularly the term “selling
compensation,” banks have been concerned about
the possible unintended effects of Rule 3040 on the
activities of dual employees of banks and affiliated
broker-dealers. For example, banks may engage in
securities trading and sales activities within the statutory
“carve out” for trust and fiduciary activities described
above. However, if trust department employees are
dual employees, the bank’s trust activities could be
subject to NASD oversight because Rule 3040, by
its terms, would require all securities transactions of
the dual employees to be supervised by and reflected
on the books and records of the broker-dealer with
which the dual employee is associated. The reach
of Rule 3040 potentially can extend beyond a bank’s
trust activities to other permissible excepted securities
activities in which dual employees may participate.
This can lead to the anomalous result of the NASD
potentially having greater jurisdiction over permissible
bank securities activities than the SEC, a result not
contemplated or authorized by the Exchange Act,
inasmuch as the NASD’s authority is derivative of
SEC authority.
II. REFERRAL INTERPRETATIONS
About two years prior to the enactment of the GLBA,
the NASD proposed a rule that basically codified
its long-standing interpretation that “locating,
introducing, or referring retail customers come within
the definition of representative,” and that persons who
receive compensation for such activities are subject
March 2007 | 17
Regulation R Alert
to registration and qualification with the NASD.25
Although this proposed rule was never adopted, the
NASD has not modified its underlying interpretation in
light of the networking exception. The proposed NASD
rule (and presumably the interpretation) applies broadly
to prohibit members from directly or indirectly making
referral payments or permitting them to be made absent
the recipient becoming a registered representative
and associated person of the broker-dealer. Thus, the
prohibition arguably could apply even to payments
made by banks, not just broker-dealers, to the extent
that the networking broker-dealer engaged in securities
transactions with the referral customer.
Clearly, this interpretation is not consistent with the
networking exception and the Agencies’ notions of
permissible payments to unregistered bank employees,
and raises questions of permissible NASD jurisdiction
similar to those raised by potential application of Rule
3040.
25 See NASD Notice to Members 97-11 (March 1997); and NASD
Notice to Members 89-3 (Jan. 1989).
K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name Kirkpatrick & Lockhart Preston Gates Ellis LLP qualified
in Delaware and maintaining offices throughout the U.S., in Berlin, and in Beijing (Kirkpatrick & Lockhart Preston Gates Ellis LLP Beijing Representative
Office); a limited liability partnership (also named Kirkpatrick & Lockhart Preston Gates Ellis LLP) incorporated in England and maintaining our London
office; a Taiwan general partnership (Kirkpatrick & Lockhart Preston Gates Ellis) which practices from our Taipei office; and a Hong Kong general
partnership (Kirkpatrick & Lockhart Preston Gates Ellis, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations
in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office.
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.
Data Protection Act 1998—We may contact you from time to time with information on Kirkpatrick & Lockhart Preston Gates Ellis LLP seminars and with our
regular newsletters, which may be of interest to you. We will not provide your details to any third parties. Please e-mail london@klgates.com if you would
prefer not to receive this information.
©1996-2007 Kirkpatrick & Lockhart Preston Gates Ellis LLP. All Rights Reserved.
March 2007 | 18