The Board of Governors of the Federal Reserve (Federal Reserve Board) and the Securities and Exchange Commission (SEC) adopted Regulation R in October 2007 to define certain statutory terms and to implement limited exceptions within the definition of a "broker" under the Securities and Exchange Act of 1934 (Exchange Act), as amended by the Gramm-Leach-Bliley Act (GLBA). For most banks, Regulation R became fully effective on January 1, 2009.
Adopted in 1999, the GLBA amended the Exchange Act to more closely align the securities-related activities with the jurisdiction of the functional regulator, the SEC. The statutory amendments accomplished this by eliminating the long-enjoyed blanket exception for banks from the Exchange Act's broker registration requirements and, instead, creating limited exceptions intended to cover many common securities-related activities of banks. Those common securities-related activities remain within the regulatory jurisdiction of federal banking regulators. The effect of the GLBA's amendments, implemented by Regulation R, is to "push out" all other securities-related from the bank into a broker-dealer registered and regulated as such with the SEC. Regulation R's rules mainly concern four categories of bank activities that involve securities transactions or broker-dealers: networking activities, fiduciary or trust account activities, sweep account activities, and custody or safekeeping account activities. Each of these rules is summarized below.
Initially proposed in 2004 by the SEC as "Regulation B," the rulemaking process was highly contentious, pitting the SEC against all of the federal banking agencies and the banking industry. Following several more years of deadlock, in 2007 Congress directed that the SEC and the Federal Reserve Board, in consultation with the other federal banking regulators, resolve their long-standing policy differences and issue an entirely new set of rules. Regulation R reflects the resulting political compromise among these regulatory agencies and the banking industry. Like most political compromises, the end result "isn't pretty." Many aspects of the rules draw arbitrary distinctions, resulting in greater complexity and administrative compliance costs.
II. NETWORKING ACTIVITIES
Regulation R addresses several issues that arise in the context of bank networking activities with broker-dealers.
A. Nominal One-Time Referral Fees
Under the Exchange Act, bank employees who refer customers to broker-dealers that have networking agreements with the bank may not receive incentive compensation based on securities transactions, but may receive a one-time nominal referral fee. Referral fees must be a fixed dollar amount and must be in the form of cash rather than gifts or perks. Rule 700 of Regulation R enumerates several alternatives banks may choose from to measure whether a referral fee is nominal. The simplest measure is a fixed $25 fee for each referral. A referral fee is also considered nominal if it is no greater than two times the average of the minimum and maximum hourly wages in the particular "job family" to which the referring employee belongs. A referral fee also meets the nominal standard if it is less than or equal to 0.1 percent of the average of the minimum and maximum yearly base salaries in the job family to which the referring employee belongs. Finally, a fee meets the nominal standard if it is no greater than 0.1 percent of the actual yearly base salary or twice the actual hourly wage of the employee making the referral. For the purposes of Rule 700, "job family" means a category of employment positions that are similar in skill set, training, duties, and responsibilities that a bank ordinarily uses to differentiate employees of different levels. A bank may not create artificial job families by grouping together employees of variant salaries in order to manipulate the nominal fee rule.
Under Rule 700, nominal referral fees cannot be contingent on whether the customer opens an account or completes a transaction with a broker-dealer. However, the fees may be contingent on whether a customer makes or keeps an appointment with a broker-dealer as well as threshold qualifications of the customer such as a minimum net worth requirement. Only bank employees who directly participate in the customer referral may receive fees. Therefore, a bank supervisor who does not directly participate in the referral may not receive a referral fee.
Rule 700 includes a provision that does allow for bonus compensation plans as long as bonuses are discretionary, based on multiple factors including several factors unrelated to securities transactions, and do not depend on employee referrals to broker-dealers. Bonus plans may be based on overall profitability or revenue of the bank or its affiliates. In addition, bonus plans may consider the profitability or revenue of a broker-dealer, as one factor of a multifactor bonus compensation scheme if the plan relies on other significant factors that are unrelated to the profitability or revenue of the broker-dealer, and if referrals are not factors in the compensation plan.
B. Institutional or High Net Worth Referrals
Rule 701 of Regulation R allows referral fees to exceed the nominal dollar amount for referrals of institutional or high net worth customers. Under this rule, institutional customers include companies, corporations, and partnerships with any of the following: (1) at least $10 million in investments, (2) $20 million in revenues, or (3) $15 million in revenues if the customer is referred for investment banking services from a broker or dealer. High net worth customers must have at least $5 million in net worth, excluding residence and related liabilities. Revocable living trusts are included in measuring high net worth. Employees receiving these fees must not be registered with a self regulatory organization (SRO), such as the Financial Industry Regulatory Authority (f/k/a NASD), must primarily perform banking activities apart from making referrals, and must not be otherwise statutorily disqualified under the Exchange Act. In addition, the referring employee must make the customer referral within normal scope of his or her job duties. These referral fees may be made contingent on customer transactions with the broker-dealer but must be based on a predetermined amount or formula that does not change due to the level of revenue or profitability related to the customer's securities transactions or the price, quantity, or kind of the customer's securities transactions. Under Rule 701, these fees can be based on a fixed percentage of revenues that the broker-dealer receives for providing investment services to the customer.
A bank must disclose to institutional or high net worth customers the name of the broker-dealer having a networking agreement with the bank, as well as the fact that the referring bank employee stands to receive a higher than nominal fee that could be contingent on whether the customer makes a transaction with the broker-dealer. The bank must also provide the broker-dealer with information about the referring employee so that the broker or dealer can determine whether the employee is qualified to receive the fee. Before the referral fee is paid, the broker-dealer must perform a suitability analysis of the securities transactions that complies with its SRO if the referral fee is contingent on whether the referral results in a transaction. If the referral fee is not contingent on a transaction, the broker-dealer must either determine that the customer has the capacity to assess risk and is using independent judgment (sophistication analysis) or perform a suitability analysis on the customer-requested transactions. A bank will not lose this exemption from broker status because it misidentifies a customer as institutional or high net worth if it makes a good faith attempt to comply with the rule and take reasonable action to recoup fees paid to referring employees on the basis of such an error.
III. FIDUCIARY AND TRUST ACCOUNT ACTIVITIES
Under the Exchange Act, a bank may effect securities transactions in its capacity as fiduciary or trustee without registering as a broker-dealer if the transactions are performed from a trust or analogous department and the bank is "chiefly compensated" as a trustee or fiduciary based on either an account-by-account or bank-wide measure. For both measures, "chiefly compensated" is based on a two-year average of "relationship compensation" divided by "total compensation."
"Relationship compensation" refers to particular fees related to trust or fiduciary accounts, namely (1) administrative and annual fees; (2) fees based on a percentage of assets under management; (3) capped or flat order processing fees that are do not exceed the cost of executing trust or fiduciary securities transactions; as well as (4) any combination of these fees. Administrative fees include fees stemming from fiduciary or trust accounts for personal services, real estate settlements, or tax preparation; fees related to recording payments to or disbursing funds; fees related to securities borrowing or lending transactions; and fees for custody services. Annual fees may be collected quarterly, monthly or otherwise, and include fees for evaluating investment performance as well as applicable restrictions and guidelines. Percentage of assets under management fees includes 12b-1 fees, as well as fees connected to investment company shares and maintenance of shareholder accounts. Also included are fees related to providing transfer, sub-transfer, or sub-accounting services; fees for aggregating and processing purchase and redemption orders; fees for processing dividend payments for investment company shares; fees for providing account statements or forwarding notices from investment companies such as shareholder reports; fees for proxies executed by investment company share owners; and fees based on the financial performance of account assets.
Rule 721 states that a bank is chiefly compensated under the account-by-account basis if the average of the "yearly compensation percentage" for an account over the last two years exceeds 50 percent. This measure is called the relationship-total compensation percentage. Yearly compensation percentage is measured as the relationship compensation related to a trust or fiduciary account over a year divided by the total compensation related to that account over a year. Yearly compensation percentages are to be calculated within 60 days of the end of the year.
The bank-wide approach will likely be the preferred test for determining if a bank falls under the trust or fiduciary exception because it allows a bank to measure the relationship-total compensation percentage aggregately within its fiduciary or trust department. Under the bank-wide approach in Rule 722, a bank's fiduciary or trust business must have an "aggregate relationship-total compensation percentage" greater than or equal to 70 percent to meet the chiefly compensated standard. The aggregate relationship-total compensation percentage is measured as an average over the last two years of: the annual relationship compensation of the trust and fiduciary business of a bank as a whole divided by the total compensation related to trust and fiduciary business as a whole. The aggregate relationship total compensation percentage must be calculated within 60 days of the end of the year.
Under Regulation R, a bank may only advertise that it provides fiduciary or trust securities brokerage services as part of broad advertisements related to its fiduciary or trust services as a whole. Also, any parts of a fiduciary or trust account advertisement that relate to securities services may not be displayed more prominently than information related to other trust or fiduciary services.
To provide for flexibility in meeting the chiefly compensated test, Rule 723 provides that several kinds of accounts may be excluded from calculating whether a bank meets the chiefly compensated test. If a bank does not meet the account-by-account chiefly compensated test, it can avoid classification as a broker under Rule 723 if it transfers applicable accounts to a broker-dealer or an unaffiliated entity that is not required to register as a broker-dealer within three months of the end of the year in which the accounts did not meet the chiefly compensated standard. A bank using the account-by-account basis may exclude accounts from the chiefly compensated test the lesser of 500 accounts or 1 percent of the number of fiduciary or trust accounts at the bank. Under the bank-wide basis, a bank may exclude accounts of non-shell foreign branches if the bank reasonably believes that less than 10 percent of the foreign branch's trust and fiduciary accounts are held for the benefit of a U.S. person. Under either basis, a bank may exclude compensation from trust or fiduciary accounts that were open for less than three months during either of the last two years, and may exclude accounts obtained through a merger, acquisition, or similar transaction for 12 months. It should be noted that if a bank chooses to exempt compensation from transactions falling under an exception or exemption in the Exchange Act or Regulation R, other than Rule 721 or 722, such compensation must be excluded from calculating relationship compensation as well as total compensation for the purposes of meeting the chiefly compensated test.
IV. SWEEP ACCOUNT AND MONEY MARKET ACTIVITIES
The Exchange Act provides an exception from broker status for sweep transactions—the investment or reinvestment of deposits into registered "no-load" money market funds. Rule 740 of Regulation R defines "no-load" to mean classes of securities a bank effects in the context of money market funds that are not subject to a sales charge or deferred sales charge and do not carry service charges against net assets that exceed 0.25 percent of average net assets annually. However, applicable service charges against net assets do not include certain services performed for beneficial owners or an investment company including providing sub-accounting services; transfer or sub-transfer agent services; processing and aggregating purchase or redemption orders; processing dividends; providing account statements; sending investment company notifications or communications to owners; or certain service charges related to proxies.
Rule 741 of Regulation R provides that a bank may effect money market transactions for a customer without registering as a broker so long as the bank also provides another service to the customer that does not require the bank to register as a broker, or such money market transactions are effected for another bank as part of a sweep account program. Under Rule 741, if the class of securities effected does not meet the definition of no-load, the bank (or other bank if the transaction is on behalf of another bank) must provide the customer with a prospectus before or at the time the customer authorizes the applicable transaction, and the class of securities may not be classified to the customer as no-load.
V. CUSTODY ACCOUNTS AND SAFEKEEPING ACTIVITIES
The Exchange Act recognizes an exemption for banks from broker status for custody and safekeeping activities such as exercising warrants on behalf of customers; acting as a clearing house for settling customer securities transactions; "effecting securities lending or borrowing transactions" for customers or investing collateral for those transactions; holding securities that relate to a purchase agreement or pledge involving a customer; as well as providing custodian administrative services relating to IRA accounts, bonus plans, and other benefit plans. Rule 760 of Regulation R provides detailed exemptions for a bank in accepting orders for securities transactions that are part of an employee benefit plan and for accommodation transactions made for other kinds of custodial accounts.
A bank may accept orders for securities transactions made for an employee benefit plan subject to certain bank employee compensation restrictions for such transactions. Bank employees may not receive compensation based on the identity, price, or quantity of securities in a custodial account order or whether a custodial transaction is executed. However, this does not include compensation for making a referral or eligible bonus plans under Rule 700 as discussed above.
A bank may advertise securities services for employee benefit accounts only as one part of broad advertising related to custodian or safekeeping services generally. Advertisements mentioning IRA accounts or similar accounts must not promote securities order services more prominently than other services related to custody and safekeeping accounts. Also, advertisements may not suggest that custody accounts are brokerage accounts or suitable substitutes for such accounts.
A bank may also take orders for securities transactions for custody accounts other than employee benefit plan accounts if the orders are merely an accommodation for the customer. Custody account activities involving accommodation transactions are subject to several restrictions. Fees associated with accommodation securities transactions may not fluctuate due to the price or quantity of the securities in an order, or whether the bank accepts the order. Also, a bank may not advertise that it accepts orders in accommodation of other custody accounts. Sales literature may not state that the bank accepts accommodation orders apart from describing custody or safekeeping account services generally, and may not describe accommodation order services more prominently than it describes other custody related services. A bank may not solicit securities transactions from this sort of custody account customers or give investment suggestions, advice, or securities research to custody account customers whose securities transactions are based on accommodation. However, a bank may respond to customer inquiries about custody account services by providing sales literature and advertising materials that do not violate the provisions mentioned above, and may also give the customer the prospectus of an investment company. In addition, a bank may provide research and recommendations concerning another account a customer has such as a trust or fiduciary account. Banks may also market their other services or accounts to custody account customers. The employee compensation restrictions that apply to employee benefit accounts also apply to custody accounts that utilize accommodation orders.
For both employee benefit and other custodial accounts, a bank may take securities transaction orders as a custodian only if it is not acting in a fiduciary or trustee capacity, unless it is acting as a directed trustee—a trustee that does not have discretion in making investments. A bank accepting securities transaction orders must direct the orders to brokerage firms for execution unless the order is for a cross-trade to be made by the bank or between the bank and a fiduciary consistent with fiduciary principles under state or federal law or unless the order is consistent with other SEC provisions and rules. Also, an unregistered bank may not engage in carrying broker arrangements whereby the bank "carries" the accounts of a broker-dealer in order to reduce the financial responsibility of the broker-dealer. Broker-dealers may not use unregistered banks as carriers of accounts to execute essential brokerage functions to evade the rules and regulations of the Exchange Act. However, banks and brokerages may agree to various "back office" functions such as sending trade confirmations without triggering a carrying broker status.
A bank that takes orders while acting in a noncustodial and non-fiduciary recordkeeping or administrative capacity for another bank's employee benefit custody account is exempt from broker status if both banks follow the general provisions for employee benefit plans listed above. Also, the record keeper or administrator bank may not net orders or execute cross trades for the employee benefit account except for orders for open-end investment company shares that are not on an exchange or for crossing orders between or netting orders for the accounts of the custodian bank. A bank acting as record keeper or administrator for more than one custodian bank may not execute cross-trades or net orders between accounts from different custodian banks. These provisions also apply to a bank acting as subcustodian to a custody account of another bank. These standards are intended to decrease costs by reducing the number of circumstances where a bank must go through a brokerage firm to execute orders. Banking agencies will monitor accounts to ensure that a bank does not attempt to evade the provisions or run brokerage service operations under the guise of custody accounts.
VI. ADDITIONAL EXEMPTIONS
Rule 775 of Regulation R provides an important exemption from broker status for a bank effecting certain securities transactions related to mutual funds, variable life insurance policies, and variable annuity contracts and lifts the broker execution requirement for those transactions. Securities falling under this exemption must not be traded through a national securities exchange, a national securities association's facilities, or an interdealer quotation system. In addition, either a broker-dealer must distribute the securities, or the sales charge associated with such transactions must not exceed the amount allowed for a broker-dealer under the rules of a registered securities association such as FINRA. Under Rule 775, the securities must be effected through a transfer agent or insurance company or through the National Securities Clearing Corporation.
Rule 776 provides an exemption from the Exchange Act's broker-execution requirement under certain conditions for a bank effecting securities transactions in the securities of a company specifically for that company's employee benefit plan. The transactions under this exemption must be commission-free and made only for the bank's own employee benefit plan. The securities must be obtained from an employee benefit plan of the company or the company itself and may only be transferred to an employee benefit plan or the company itself.
Rule 781 provides for a limited time exemption from broker status for all banks. A bank will not be designated a broker under the Exchange Act until the start of its first fiscal year after September 30, 2008. For most banks, this means Regulation R becomes effective on January 1, 2009.
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This summary of Regulation R is for general information only and is not intended to render legal advice to any person. Receipt of this summary does not create an attorney-client relationship. If you have any questions or for more information about the permissible scope of securities activities of banks under Regulation R, as well as other banking or securities regulation, please contact a member of the Financial Services Practice Group or the Broker-Dealer and Investment Adviser Practice Group at Warner Norcross & Judd LLP, 616.752.2000, or on the Internet at www.wnj.com.