Skip to Content

Proposed Rule

Definitions of Terms and Exemptions Relating to the “Broker” Exceptions for Banks

Document Details

Information about this document as published in the Federal Register.

Published Document

This document has been published in the Federal Register. Use the PDF linked in the document sidebar for the official electronic format.

Start Preamble Start Printed Page 77522

AGENCIES:

Board of Governors of the Federal Reserve System (“Board”) and Securities and Exchange Commission (“SEC” or “Commission”) (collectively, the Agencies).

ACTION:

Proposed rule.

SUMMARY:

The Board and the Commission jointly are issuing, and requesting comment on, proposed rules that would implement certain of the exceptions for banks from the definition of the term “broker” under Section 3(a)(4) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended by the Gramm-Leach-Bliley Act (“GLBA”). The proposed rules would define terms used in these statutory exceptions and include certain related exemptions. In developing this proposal, the Agencies have consulted with the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of Thrift Supervision (“OTS”). The proposal is intended, among other things, to facilitate banks' compliance with the GLBA.

DATES:

Comments should be received on or before March 26, 2007.

ADDRESSES:

Board: You may submit comments, identified by Docket No. R-1274, by any of the following methods:

All public comments are available from the Board's Web site at http://www.federalreserve.gov/​generalinfo/​foia/​ProposedRegs.cfm as submitted, unless modified for technical reasons. Accordingly, your comments will not be edited to remove any identifying or contact information. Public comments also may be viewed electronically or in paper form in Room MP-500 of the Board's Martin Building (C and 20th Streets, NW) between 9 a.m. and 5 p.m. on weekdays.

SEC: Comments may be submitted by any of the following methods:

Electronic Comments

Paper Comments

  • Send paper comments in triplicate to Nancy M. Morris, Secretary, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549-1090.

All submissions should refer to File Number S7-22-06. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (http://www.sec.gov/​rules/​proposed.shtml). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 100 F Street, NE., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

Start Further Info

FOR FURTHER INFORMATION CONTACT:

Board: Kieran J. Fallon, Assistant General Counsel, (202) 452-5270, Andrew Miller, Counsel, (202) 452-3428, or Andrea Tokheim, Senior Attorney, (202) 452-2300, Legal Division, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551. Users of Telecommunication Device for Deaf (TTD) only, call (202) 263-4869.

SEC: Catherine McGuire, Chief Counsel, Linda Stamp Sundberg, Senior Special Counsel, Richard C. Strasser, Attorney Fellow, John Fahey, Special Counsel, Haimera Workie, Special Counsel, at (202) 551-5550, Office of the Chief Counsel, Division of Market Regulation, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549.

End Further Info End Preamble Start Supplemental Information

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Background

II. Networking Arrangements

A. Proposed Definitions Related to the Payment of Referral Fees

1. Proposal Definition of “Nominal One-Time Cash Fee of a Fixed Dollar Amount”

2. Proposed Definition of “Contingent on Whether the Referral Results in a Transaction”

3. Proposed Definition of “Incentive Compensation”

B. Proposed Exemption for Payment of More Than a Nominal Fee for Referring Institutional Customers and High Net Worth Customers

1. Definitions of “Institutional Customer” and “High Net Worth Customer”

2. Conditions Relating to Bank Employees

3. Other Conditions Relating to the Banks

4. Provisions of Written Agreement

a. Customer and Employee Qualifications

b. Suitability or Sophistication Analysis by Broker-Dealer

c. Notice From Broker-Dealer to Bank Regarding Customer Qualification

5. Referral Fees Permitted under the Exemption

6. Permissible Bonus Compensation Not Restricted

C. Scope of Networking Exception and Institutional/High Net Worth Exemption

III. Trust and Fiduciary Activities Exception

A. “Chiefly Compensated” Test and Bank-Wide Exemption Based on Two-Year Rolling Averages

B. Proposed Definition of “Relationship Compensation”

C. Advertising Restrictions

D. Proposed Exemptions for Special Accounts, Transferred Accounts, and a De Minimis Number of Accounts

IV. Sweep Accounts and Transactions in Money Market Funds

A. Proposed Sweep Account Definitions

B. Proposed Exemption Regarding Money Market Fund Transactions

V. Safekeeping and Custody

A. Overview of Statutory Exception

B. Proposed Exemption

1. Employee Benefit Plan Accounts and Individual Retirement or Similar Accounts

a. Employee Compensation Restriction

b. Advertisements and Sales Literature

c. Other Conditions

d. Non-Fiduciary and Non-Custodial Administrators or Recordkeepers

2. Accommodation Transactions

a. Accommodation Basis

b. Employee Compensation Restriction

c. Bank Fees

d. Advertising and Sales Literature

e. Investment Advice or Recommendations

f. Other Conditions

3. Evasion

VI. Other Proposed Exemptions Start Printed Page 77523

A. Proposed Exemption for Regulation S Transactions With Non-U.S. Persons

B. Proposed Securities Lending Exemption

C. Proposed Exemption for the Way in Which Banks Effect Transactions in Investment Company Securities

D. Proposed Temporary and Permanent Exemption for Contracts Entered Into by Banks From Being Considered Void or Voidable

E. Extension of Time and Transition Period

VII. Withdrawal of Proposed Regulation B and Removal of Exchange Act Rules 3a4-2 — 3a4-6, and 3b-17

VIII. Administrative Law Matters

A. Paperwork Reduction Act Analysis

B. Consideration of Benefits and Costs

C. Consideration of Burden on Competition, and on Promotion of Efficiency, Competition, and Capital Formation

D. Consideration of Impact on the Economy

E. Initial Regulatory Flexibility Analysis

F. Plain Language

IX. Statutory Authority

X. Text of Proposed Rules and Rule Amendments

I. Introduction and Background

The GLBA amended several federal statutes governing the activities and supervision of banks, bank holding companies, and their affiliates.[1] Among other things, it lowered barriers between the banking and securities industries erected by the Banking Act of 1933 (“Glass-Steagall Act”).[2] It also altered the way in which the supervisory responsibilities over the banking, securities, and insurance industries are allocated among financial regulators. Among other things, the GLBA repealed most of the separation of investment and commercial banking imposed by the Glass-Steagall Act. The GLBA also revised the provisions of the Exchange Act that had completely excluded banks from broker-dealer registration requirements.

In enacting the GLBA, Congress adopted functional regulation for bank securities activities, with certain exceptions from Commission oversight for specified securities activities. With respect to the definition of “broker,” the Exchange Act, as amended by the GLBA, provides eleven specific exceptions for banks.[3] Each of these exceptions permits a bank to act as an agent with respect to specified securities products or in transactions that meet specific statutory conditions.

In particular, Section 3(a)(4)(B) of the Exchange Act provides conditional exceptions from the definition of broker for banks that engage in certain securities activities in connection with third-party brokerage arrangements; [4] trust and fiduciary activities; [5] permissible securities transactions; [6] certain stock purchase plans; [7] sweep accounts; [8] affiliate transactions; [9] private securities offerings; [10] safekeeping and custody activities; [11] identified banking products; [12] municipal securities; [13] and a de minimis number of other securities transactions.[14]

On October 13, 2006, President Bush signed into law the “Financial Services Regulatory Relief Act of 2006 (“Regulatory Relief Act”).” [15] Among other things, the Regulatory Relief Act requires that the SEC and the Board jointly adopt a single set of rules to implement the bank broker exceptions in Section 3(a)(4) of the Exchange Act.[16] It also requires that not later than 180 days after the date of enactment of the Regulatory Relief Act, the SEC and the Board jointly issue a single set of proposed rules to implement these exceptions.

Section 401 of the Regulatory Relief Act also amended the definition of “bank” in Section 3(a)(6) of the Exchange Act to include any Federal savings association or other savings association the deposits of which are insured by the FDIC. Accordingly, as used in this proposal, the term “bank” includes any savings association that qualifies as a “bank” under Section 3(a)(6) of the Exchange Act, as amended.

In accordance with these statutory provisions, the SEC and Board are jointly requesting comment on proposed rules to implement the broker exceptions for banks relating to third-party networking arrangements, trust and fiduciary activities, sweep activities, and safekeeping and custody activities.[17] The proposed rules include certain exemptions related to these activities, as well as exemptions related to foreign securities transactions, securities lending transactions conducted in an agency capacity, the execution of transactions involving mutual fund shares, the potential liability of banks under Section 29 of the Exchange Act, and the date on which the GLB Act's “broker” exceptions for banks will go into effect.[18] The proposed rules are designed to accommodate the business practices of banks and protect investors.

Any additions or changes to these rules that may be appropriate to implement Section 3(a)(4)(B) of the Exchange Act will be adopted jointly by the SEC and Board in accordance with the consultation provisions in Section 101(b) of the Regulatory Relief Act. Identical sets of the final rules will be published by the SEC in Title 17 of the Code of Federal Regulations and by the Board in Title 12 of the Code of Federal Regulations.

In developing this proposal, the Agencies considered, among other things, the language and legislative history of the “broker” exceptions for banks adopted in the GLBA, the rules previously issued or proposed by the Commission relating to these exceptions and the comments received in connection with those prior rulemakings. The Agencies request comment on all aspects of these proposals as well as on the specific provisions and issues identified below. Start Printed Page 77524In addition, the Agencies request comment on whether it would be useful or appropriate for the Agencies to adopt rules implementing the other bank “broker” exceptions in Section 3(a)(4)(B) of the Exchange Act that are not addressed in this proposal. If any rules (including exemptions) related to these other exceptions are adopted in the future, they would be adopted jointly by the SEC and Board.

As required by the GLBA, the Board, OCC, FDIC, and OTS (collectively, the Banking Agencies) will develop, and request public comment on, recordkeeping rules for banks that operate under the “broker” exceptions in Section 3(a)(4) of the Exchange Act.[19] These rules, which will be developed in consultation with the SEC, will establish recordkeeping requirements to enable banks to demonstrate compliance with the terms of the statutory exceptions and the final rules ultimately jointly adopted and that are designed to facilitate compliance with the statutory exceptions and those rules.

II. Networking Arrangements

The third-party brokerage (“networking”) exception in Exchange Act Section 3(a)(4)(B)(i) permits a bank to avoid being considered a broker if, under certain conditions, it enters into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to bank customers (“networking arrangement”).[20] The networking exception does not address the type or amount of compensation that a bank may receive from its broker-dealer partner under a networking arrangement. However, the networking exception generally provides that a bank may not pay its unregistered employees [21] incentive compensation for referring a customer to the broker-dealer or for any securities transaction conducted by the customer at the broker-dealer. Nevertheless, the statutory exception does permit a bank employee to receive a “nominal one-time cash fee of a fixed dollar amount” for referring bank customers to the broker-dealer if payment of the referral fee is not “contingent on whether the referral results in a transaction.” [22] Congress included the limitation on incentive compensation to reduce securities sales practice concerns regarding unregistered bank employees.[23]

A. Proposed Definitions Related to the Payment of Referral Fees

The proposed rules define certain terms used in the networking exception in the Exchange Act related to referral fees and terms used in these proposed definitions. The proposed rules also provide an exemption from certain of the requirements in the networking exception with respect to payment for referrals of certain institutional customers and high net worth customers.

1. Proposed Definition of “Nominal One-Time Cash Fee of a Fixed Dollar Amount”

Under the proposal, the term “nominal one-time cash fee of a fixed dollar amount” would be defined as a cash payment for a referral in an amount that meets any one of three alternative standards.[24] The Agencies believe that these alternatives provide useful and appropriate flexibility to banks of all sizes and locations to use different business models and to take into account economic differences around the country in assessing whether a cash referral fee paid in a particular instance is a “nominal” amount for purposes of the networking exception. The three alternatives are consistent with the statutory “nominal” fee requirement because the amount of compensation permitted under each of the three formulations would be small in relation to the employee's overall compensation and therefore unlikely to create undue incentives for bank employees to pre-sell securities to bank customers.

Under the first alternative, a referral fee would be considered nominal if it did not exceed either twice the average of the minimum and maximum hourly wage established by the bank for the current or prior year for the job family that includes the relevant employee, or 1/1000th of the average of the minimum and maximum annual base salary established by the bank for the current or prior year for the job family that includes the relevant employee.[25] The proposed rules define a “job family” for these purposes as a group of jobs or positions involving similar responsibilities, or requiring similar skills, education or training, that a bank, or a separate unit, branch or department of a bank, has established and uses in the ordinary course of its business to distinguish among its employees for purposes of hiring, promotion, and compensation.[26] Depending on a bank's internal employee classification system, examples of a job family may include tellers, loan officers, or branch managers. A bank should not deviate from its ordinary classification of jobs for purposes of determining whether a referral fee would be considered nominal under this standard.

Under the second alternative, a referral fee would be considered “nominal” if it did not exceed twice the employee's actual base hourly wage.[27] Thus, unlike the first option, this alternative is based on the actual hourly base wage of the employee receiving the referral fee.

Under the third alternative, a referral fee would be considered “nominal” for purposes of the networking exception if the payment did not exceed twenty-five dollars ($25).[28] This dollar amount would be adjusted for inflation on April 1, 2012, and every five years thereafter, to reflect any changes in the value of the Employment Cost Index For Wages and Salaries, Private Industry Workers (or any successor index thereto), as published by the Bureau of Labor Statistics, from December 31, 2006.[29] The Agencies selected this index because it is a widely used and broad indicator of increases in the wages of private industry workers, which includes bank employees.

A bank employee may receive a referral fee under the networking exception and Proposed Exchange Act Rule 700 for each referral made to a broker-dealer, including separate referrals of the same individual or entity. Referral fees paid under the networking exception must be paid in cash and fixed. The networking exception and the proposed rules do not permit a bank to pay referral fees in non-cash forms, such as vacation packages, stock grants, annual leave, or consumer goods.[30] We request comments on whether these alternatives provide banks sufficient flexibility to pay nominal referral fees without creating inappropriate incentives.

Start Printed Page 77525

2. Proposed Definition of “Contingent on Whether the Referral Results in a Transaction”

Under the statutory networking exception, a nominal fee paid to an unregistered bank employee for referring a customer to a broker or dealer may not be contingent on whether the referral results in a transaction. The objective is to reward bank employees for furthering the relationship with the broker without creating concerns about the securities sales practices of unregistered bank employees. Under the proposal, a fee would be considered “contingent on whether the referral results in a transaction” if payment of the fee is dependent on whether the referral results in a purchase or sale of a security; whether an account is opened with a broker or dealer; whether the referral results in a transaction involving a particular type of security; or whether the referral results in multiple securities transactions.[31] The proposed rules, however, also recognize that a referral fee may be contingent on whether a customer (1) contacts or keeps an appointment with a broker or dealer as a result of the referral; or (2) meets any objective, base-line qualification criteria established by the bank or broker or dealer for customer referrals, including such criteria as minimum assets, net worth, income, or marginal federal or state income tax rate, or any requirement for citizenship or residency that the broker or dealer, or the bank, may have established generally for referrals for securities brokerage accounts.[32]

3. Proposed Definition of “Incentive Compensation”

As noted above, the networking exception prohibits unregistered employees of a bank that refer customers to a broker or dealer under the exception from receiving “incentive compensation” for the referral or any securities transaction conducted by the customer at the broker-dealer other than a nominal, non-contingent referral fee. To provide banks and their employees additional guidance in this area, Proposed Rule 700(b) defines “incentive compensation” as compensation that is intended to encourage a bank employee to refer potential customers to a broker or dealer or give a bank employee an interest in the success of a securities transaction at a broker or dealer.[33]

The proposed “incentive compensation” definition excludes certain types of bonus compensation. The purpose of the exclusions is to recognize that certain types of bonuses are not likely to give unregistered employees a promotional interest in the brokerage services offered by the broker-dealers with which the bank networks and to avoid affecting bonus plans of banks generally. The proposal excludes compensation paid by a bank under a bonus or similar plan that is paid on a discretionary basis and based on multiple factors or variables. These factors or variables must include significant factors or variables that are not related to securities transactions at the broker or dealer.[34] In addition, a referral made by the employee to a broker or dealer may not be a factor or variable in determining the employee's compensation under the plan and the employee's compensation under the plan may not be determined by reference to referrals made by any other person.[35]

In addition, the proposed rule provides that the definition of incentive compensation shall not be construed to prevent a bank from compensating an officer, director or employee on the basis of any measure of the overall profitability of (1) the bank, either on a stand-alone or consolidated basis; (2) any of the bank's affiliates (other than a broker or dealer) or operating units; or (3) a broker or dealer if such profitability is only one of multiple factors or variables used to determine the compensation of the officer, director, or employee and those factors or variables include significant factors or variables that are not related to the profitability of the broker or dealer.[36] Under this definition, banks would be permitted to take account of the full range of business for high net worth or institutional customers that an employee has brought to the bank and its partner broker-dealers. Comment is solicited on whether existing bank bonus programs would fit, or could be easily adjusted to fit, within the proposed exclusions from the definition of incentive compensation discussed in this Section.

B. Proposed Exemption for Payment of More Than a Nominal Fee for Referring Institutional Customers and High Net Worth Customers

The proposal also includes a conditional exemption that would permit a bank to pay an employee a contingent referral fee of more than a nominal amount for referring to a broker or dealer an institutional customer or high net worth customer with which the bank has a contractual or other written networking arrangement.[37] Banks that pay their employees only nominal, non-contingent fees in accordance with Proposed Rule 700 for referring customers—including institutional or high net worth customers—to a broker or dealer would not need to rely on this exemption for these purposes.

The purpose of the proposed exemption and its conditions is to recognize that sizable institutions and high net worth individuals, when provided appropriate information, are more likely to be able to understand and evaluate the relationship between the bank and its employees and its broker-dealer partner and any resulting securities transaction with the broker-dealer. To take advantage of the proposed exemption, the bank must comply with the conditions in the proposed exemption as well as the terms and conditions in the statutory networking exception (other than the compensation restrictions in Section 3(a)(4)(B)(i)(VI) of the Exchange Act's networking exception). The conditions in the proposed exemption are designed, among other things, to help ensure that institutional and high net worth customers receive appropriate investor protections and have the information to understand the financial interest of the bank employee so they can make informed choices. The following summarizes the conditions included in the proposed exemption.

1. Definitions of “Institutional Customer” and “High Net Worth Customer”

The proposed exemption defines an “institutional customer” to mean any corporation, partnership, limited liability company, trust, or other non-Start Printed Page 77526natural person that has at least $10 million in investments or $40 million in assets. A non-natural person also may qualify as an “institutional customer” with respect to a referral if the customer has $25 million in assets and the bank employee refers the customer to the broker or dealer for investment banking services.[38] The lower asset threshold for referrals 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” is defined to mean any natural person who, either individually or jointly with his or her spouse, has at least $5 million in net worth excluding the primary residence and associated liabilities of the person and, if applicable, his or her spouse.

The dollar amount threshold for both institutional customers and high net worth customers would be adjusted for inflation on April 1, 2012, and every five years thereafter, to reflect changes in the value of the Personal Consumption Expenditures Chain-Type Price Index, as published by the Department of Commerce, from December 21, 2006. The Agencies selected this index because it is a widely used and broad indicator of inflation in the U.S. economy.

A bank would be required to determine that a non-natural person referred to a broker or dealer under the exemption is an institutional customer before the referral fee is paid to the bank employee. In the case of a customer that is a natural person, the bank, prior to or at the time of any referral, would be required either to (1) determine that the customer is a high net worth customer; or (2) obtain a signed acknowledgment from the customer that the customer meets the standards to be considered a high net worth customer. The purpose of this condition is to provide the bank with a reasonable basis to believe the person meets the requirements of the exemption.[39]

2. Conditions Relating to Bank Employees

For a bank employee to receive a contingent or greater-than-nominal referral fee under the proposed exemption, the bank employee must meet other conditions designed to help ensure that the referral occurs in the ordinary course of the unregistered bank employee's activities and that the employee has not previously been disqualified under the Exchange Act. In particular, the bank employee—

  • May not be qualified or otherwise required to be qualified pursuant to the rules of a self-regulatory organization (“SRO”); [40]
  • Must be predominantly engaged in banking activities other than making referrals to a broker-dealer; [41]
  • Must not be subject to a “statutory disqualification” as that term is defined in Section 3(a)(39) of the Exchange Act (other than subparagraph (E) of that Section); [42] and
  • Must encounter the “high net worth customer” or “institutional customer” in the ordinary course of the bank employee's assigned duties for the bank.[43]

3. Other Conditions Relating to the Banks

The proposed exemption also would require that the bank provide the high net worth customer or institutional customer being referred to the bank's broker-dealer partner certain written disclosures about the employee's interest in the referral prior to or at the time of the referral.[44] These disclosures would have to clearly and conspicuously disclose (1) the name of the broker or dealer; and (2) that the bank employee participates in an incentive compensation program under which the employee may receive a fee of more than a nominal amount for referring the customer to the broker or dealer and that payment of the fee may be contingent on whether the referral results in a transaction with the broker or dealer.[45]

In addition, to allow verification before the referral fee is paid to the bank employee, the bank would be required to provide the broker or dealer the name of the employee and such other identifying information that may be necessary for the broker or dealer to determine whether the bank employee is associated with a broker or dealer or is subject to statutory disqualification (as defined in Section 3(a)(39) of the Exchange Act, other than subparagraph (E)).[46]

The proposed exemption also provides that a bank that acts in good faith and that has reasonable policies and procedures in place to comply with the requirements of the proposed exemption would not be considered a “broker” under Section 3(a)(4) of the Exchange Act solely because the bank fails, in a particular instance, to determine that a customer is an institutional or high net worth customer, provide the customer the required disclosures, or provide the broker or dealer the required information concerning the bank employee receiving the referral fee within the time periods prescribed. If the bank is seeking to comply and takes reasonable and prompt steps to remedy the error, such as by promptly making the required determination or promptly providing the broker or dealer the required information, the bank should not lose the exemption from registration in these circumstances. Similarly, to promote compliance with the terms of the exemption, the bank must make reasonable efforts to reclaim the portion of the referral fee paid to the bank employee for a referral that does not, following any required remedial actions, meet the requirements of the exemption and that exceeds the amount the bank otherwise would be permitted to pay under the statutory networking exception and proposed Exchange Act Rule 700.[47]

4. Provisions of Written Agreement

The proposed exemption also would require that the bank and its broker-dealer partner include certain provisions in their written agreement that obligate the bank or the broker or dealer to take certain actions. These provisions are designed to help ensure that banks and broker-dealers operate within the terms of the exemption and provide appropriate protections to customers referred under the exemption. Banks, brokers and dealers are expected to comply with the terms of their written networking agreements. Start Printed Page 77527If a broker or dealer or bank does not comply with the terms of the agreement, however, the bank would not become a “broker” under Section 3(a)(4) of the Exchange Act or lose its ability to operate under the proposed exemption.[48] A bank should not be required to register as a result of the actions of the broker or dealer.

a. Customer and Employee Qualifications

First, the proposed exemption provides that the written agreement between the bank and the broker or dealer must provide for the bank and the broker-dealer to determine, before a referral fee is paid to a bank employee under the exemption, that the employee is not subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act (other than subparagraph (E) of that Section). In addition, as noted above, the written agreement must provide for the broker-dealer to determine, before the referral fee is paid, that the customer being referred is an institutional or high net worth customer.[49]

b. Suitability or Sophistication Analysis by Broker-Dealer

As a method of providing additional investor protections, the proposed exemption requires that the written agreement between the bank and broker or dealer must provide for the broker or dealer to perform a suitability or sophistication analysis of a securities transaction or the customer being referred, respectively. The type and timing of the analysis needed to be conducted by the broker or dealer depends on whether the referral fee is contingent on the completion of a securities transaction at the broker or dealer.

For contingent fees, the written agreement between the bank and the broker-dealer must provide for the broker or dealer to conduct a suitability analysis of any securities transaction that triggers any portion of the contingency fee in accordance with the rules of the broker's or dealer's applicable SRO as if the broker or dealer had recommended the securities transaction.[50] This analysis must be performed by the broker or dealer before each securities transaction on which the referral fee is contingent is conducted.

For a non-contingent referral fee, the written agreement must provide for the broker or dealer to conduct, before the referral fee is paid, either (1) a “sophistication” analysis of the customer being referred; or (2) a suitability analysis with respect to all securities transactions requested by the customer contemporaneously with the referral. Under the “sophistication” analysis option, the broker or dealer would be required to determine that the customer has the capability to evaluate investment risk and make independent decisions, and determine that the customer is exercising independent judgment based on the customer's own independent assessment of the opportunities and risks presented by a potential investment, market factors, and other investment considerations.[51] This “sophistication” analysis is based on elements of NASD IM-2310-3 (Suitability Obligations to Institutional Customers).

Alternatively, the broker or dealer could perform a suitability analysis of all securities transactions requested by the customer contemporaneously with the referral in accordance with the rules of the broker's or dealer's applicable SRO as if the broker or dealer had recommended the securities transaction.[52] Thus, the proposed exemption gives a broker or dealer the flexibility to perform a suitability analysis in connection with all referrals made under the exemption (regardless of whether the referral fee is contingent or not) if the broker or dealer determines that such an approach is appropriate for business reasons.

c. Notice From Broker-Dealer to Bank Regarding Customer Qualification

Under the proposed exemption, the written agreement between the bank and the broker-dealer would also be required to provide that the broker-dealer must promptly inform the bank if the broker-dealer determines that (1) the customer referred to the broker-dealer is not a “high net worth customer” or an “institutional customer,” as applicable; (2) the bank employee receiving the referral fee is subject to statutory disqualification, as that term is defined in Section 3(a)(39) of the Exchange Act, except subparagraph (E) of that Section; or (3) the customer or the securities transaction(s) to be conducted by the customer do not meet the applicable standard set forth in the suitability or sophistication determination Section above.[53] The notice will help banks monitor their compliance with the exemption and take remedial action when necessary.

5. Referral Fees Permitted under the Exemption

If the foregoing conditions are met, the proposed exemption would allow a bank employee to receive a referral fee for referring an institutional or high net worth customer to a broker or dealer that is greater than a “nominal” amount and that is contingent on whether the referral results in a transaction at the broker or dealer. The exemption places certain limits on how such a referral fee may be structured to reduce the potential “salesman's stake” of the bank employee in securities transactions conducted at the broker-dealer. Specifically, the exemption provides that the referral fee may be a dollar amount based on a fixed percentage of the revenues received by the broker or dealer for investment banking services provided to the customer.[54]

Alternatively, the referral fee may be a predetermined dollar amount, or a dollar amount determined in accordance with a predetermined formula, so long as the amount does not vary based on (1) the revenue generated by, or the profitability of, securities transactions conducted by the customer with the broker or dealer; (2) the quantity, price, or identity of securities purchased or sold over time by the customer with the broker or dealer; or (3) the number of customer referrals made.[55] For these purposes, “predetermined” means established or fixed before the referral is made.

As the exemption provides, these restrictions do not prevent a referral fee from being paid in multiple installments or from being based on a fixed percentage of the total dollar amount of assets placed in an account with the broker or dealer. Additionally, these restrictions do not prevent a referral fee from being based on the total dollar amount of assets maintained by the customer with the broker or dealer, or from being contingent on whether the customer opens an account with the broker or dealer or executes one or more transactions in the account during the initial phases of the account. A bank employee also may receive a permissible referral fee for each referral Start Printed Page 77528made under the exemption. We request comment on all aspects of the definition of a referral fee.

6. Permissible Bonus Compensation Not Restricted

The proposed exemption for high net worth and institutional customers expressly provides that nothing in the exemption would prevent or prohibit a bank from paying, or a bank employee from receiving, any type of compensation under a bonus or similar plan that would not be considered incentive compensation under paragraph (b)(1), or that is described in paragraph (b)(2), of proposed Exchange Act Rule 700 (implementing the networking exception).[56] As explained above, these types of bonus arrangements do not tend to create the kind of financial incentives for bank employees that the statute was designed to address.

C. Scope of Networking Exception and Institutional/High Net Worth Exemption

Nothing in the statutory networking exception or the proposed rules limits or restricts the ability of a bank employee to refer customers to other departments or divisions of the bank itself, including, for example, the bank's trust, fiduciary or custodial department. Likewise, the networking exception and the proposed rules do not apply to referrals of retail, institutional or high net worth customers to a broker or dealer or other third party solely for transactions not involving securities, such as loans, futures contracts (other than a security future), foreign currency, or over-the-counter commodities.

III. Trust and Fiduciary Activities Exception

Section 3(a)(4)(B)(ii) of the Exchange Act (the “trust and fiduciary exception”) permits a bank, under certain conditions, to effect securities transactions in a trustee or fiduciary capacity without being registered as a broker.[57] Under this exception from the definition of “broker,” a bank must effect such transactions in its trust department, or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards.[58] The bank also must be “chiefly compensated” for such transactions, consistent with fiduciary principles and standards, on the basis of: (1) An administration or annual fee; (2) a percentage of assets under management; (3) a flat or capped per order processing fee that does not exceed the cost the bank incurs in executing such securities transactions; or (4) any combination of such fees.[59] These fees are referred to as “relationship compensation” in the proposed rules.

Banks relying on this exception may not publicly solicit brokerage business, other than by advertising that they effect transactions in securities in conjunction with advertising their other trust activities.[60] In addition, a bank that effects a transaction in the United States of a publicly traded security under the exception must execute the transaction in accordance with Exchange Act section 3(a)(4)(C).[61]

This section requires that the bank direct the trade to a registered broker-dealer for execution, effect the trade through a cross trade or substantially similar trade either within the bank or between the bank and an affiliated fiduciary that is not in contravention of fiduciary principles established under applicable federal or state law, or effect the trade in some other manner that the Commission permits.[62] The purpose of the rules in this area is to explain the Agencies' interpretation of certain terms and concepts used in the statute and to implement the exception. The trust and fiduciary exception recognizes the traditional securities role banks have performed for trust and fiduciary customers and includes conditions to help ensure that a bank does not operate a securities broker in the trust department.

A. “Chiefly Compensated” Test and Bank-Wide Exemption Based on Two-Year Rolling Averages

The proposed rules provide that a bank meets the “chiefly compensated” condition in the trust and fiduciary exception if the “relationship-total compensation percentage” for each trust or fiduciary account of the bank is greater than 50 percent.[63] The “relationship-total compensation percentage” for a trust or fiduciary account would be calculated by (1) dividing the relationship compensation attributable to the account during each of the immediately preceding two years by the total compensation attributable to the account during the relevant year; (2) translating the quotient obtained for each of the two years into a percentage; and (3) then averaging the percentages obtained for each of the two immediately preceding years.[64] Under the proposal, a “trust or fiduciary account” means an account for which the bank acts in a trustee or fiduciary capacity as defined in section 3(a)(4)(D) of the Exchange Act.[65]

The proposed rules also include an exemption that would permit a bank to follow an alternate test to the account-by-account approach to the “chiefly compensated” condition. Under this exemption, the bank may calculate the compensation it receives from all of its trust and fiduciary accounts on a bank-wide basis. The alternative is designed to simplify compliance, alleviate concerns about inadvertent noncompliance, and reduce the costs and disruptions banks likely would incur under the account-by-account approach.

To use this bank-wide methodology, the bank would have to meet two conditions. First, the bank would have to comply with the conditions in the trust and fiduciary exception (other than the compensation test in Section 3(a)(4)(B)(ii)(I)) and comply with Section 3(a)(4)(C) (relating to trade execution) of the Exchange Act.[66] In addition, the “aggregate relationship-total compensation percentage” for the bank's trust and fiduciary business as a whole would have to be at least 70 percent.[67] We chose this percentage to ensure that a bank's trust department is not unduly dependent on non-relationship compensation from securities transactions. We invite comments generally on the appropriateness of the proposed exemption as well as this percentage Start Printed Page 77529and the other specific terms of the exemption.

The “aggregate relationship-total compensation percentage” of a bank operating under the bank-wide approach would be calculated in a similar manner as the “relationship-total compensation percentage” of an account under the account-by-account, except that the calculations would be based on the aggregate relationship compensation and total compensation received by the bank from all of its trust and f