Speech by SEC Staff:
Opening Remarks at SEC Open Meeting: Adoption of Regulation R — The Bank Broker Provisions of the Securities Exchange Act of 1934
Erik R. Sirri
Director, Division of Market Regulation
U.S. Securities and Exchange Commission
September 19, 2007
Thank you, Chairman Cox. Good morning Commissioners.
Today we recommend that the Commission adopt Regulation R, which implements the bank broker provisions of the Exchange Act. Regulation R would be adopted jointly with the Board of Governors of the Federal Reserve System.
The Agencies received approximately 60 comments on proposed Regulation R. Staff from the Commission and the banking agencies have worked closely together to consider the comments and draft the final rules that we recommend today. This collaborative process has resulted in a set of rules that — while largely similar to those proposed — have been modified and clarified to address commenters' concerns. The revised rules are consistent with the language of the bank broker exceptions established by the GLBA and the underlying policies of functional regulation and investor protection. They also take into account banking industry implementation and compliance concerns.
The rules define terms used in the exceptions relating to networking, trust and fiduciary activities, safekeeping and custody, and sweep accounts. They also provide conditional exemptions from certain of the statutory requirements of these exceptions. In addition, they provide banks with the targeted exemptions for particular securities activities that were proposed as well as one new exemption pertaining to employee stock plans. Finally, these rules provide banks with additional time to come into compliance with the GLBA, and grant limited relief for banks from possible third-party rescission rights.
The networking exception permits banks to pay their unregistered employees — such as tellers, loan officers, and private bankers — incentive compensation to refer bank customers to their networking broker-dealer partners. The statute limits these payments to a "nominal one-time cash fee of a fixed dollar amount" when "the payment of the fee is not contingent on whether the referral results in a transaction." The rules define certain terms used in the networking exception, and provide an exemption to allow banks to pay higher fees for referrals of certain institutional and high net worth customers.
In particular, the rules define "incentive compensation" to better accommodate typical bank bonus programs while also clarifying the types of bonus plans that do not constitute "incentive compensation" and therefore can be freely used. A bank may generally pay bonuses that are based on the overall profitability or revenues of the bank, its affiliates or operating units — as long as the unit over time does not predominately engage in making referrals to broker-dealers. The bank regulators will examine bank bonus programs for compliance with these requirements.
The rules also include a high net worth/institutional referral exemption, which has been expanded from the proposal, to encompass referrals for a broader range of institutional customers, including certain institutions controlled by other institutions. Bank employees may orally provide a customer with information about the bank/broker relationship, if either the bank or the broker follows up with written disclosure. A key safeguard of this exemption is the requirement that the broker-dealer perform a suitability analysis when a referral fee is contingent on a transaction and a suitability or sophistication analysis for other referrals. Taken together, the conditions applicable to this exemption provide additional investor protections in those circumstances where the bank employee making the referral may receive a higher-than-nominal referral fee. A bank may rely on the exemption if it has a reasonable basis to believe the customer qualifies as high net worth or institutional.
II. Trust and Fiduciary
The trust and fiduciary exception permits a bank to effect securities transactions in a trustee or fiduciary capacity if, among other things, it is "chiefly compensated" for those transactions, consistent with fiduciary principles and standards, on the basis of specifically enumerated types of fees, which are referred to as "relationship compensation." These fees may be considered "relationship compensation" even if paid by a service provider rather than directly by an investment company. The rules establish a test to determine how a bank is "chiefly compensated," and permit a bank to choose either an account-by-account or bank-wide approach. Either alternative allows banks to exclude the compensation associated with a securities transaction conducted in accordance with any of the other exceptions or exemptions as long as the bank excludes that compensation from both relationship compensation (if applicable) and total compensation. The revenues of certain foreign branches of U.S. banks are excluded for purposes of the "chiefly compensated" test. Notably, a bank that does not have trust powers may rely on the trust and fiduciary exception if its appropriate federal regulator examines its fiduciary accounts for compliance with trust and fiduciary principles.
III. Custody and Safekeeping
The custody and safekeeping exception permits banks to perform certain securities-related services if they constitute "customary banking activities." The rules permit a bank to accept orders for securities transactions from employee benefit plan accounts and individual retirement accounts for which the bank acts as a custodian, recordkeeper or administrator, and to accept certain accommodation orders, as well.
The rules also permit a bank to rely on these provisions when it acts as a directed trustee without investment discretion, and extends the exemptions to subcustodians. Administrators, recordkeepers and subcustodians will be able to engage in cross-trades to the same extent that the custodian bank could — meaning they can cross or net orders between the accounts of a particular custodian bank, but not among the accounts of multiple banks. In response to comments, the release identifies the circumstances under which a bank might be considered an impermissible "carrying broker."
IV. Sweep Accounts
The sweep account exception permits a bank to sweep funds from bank accounts into no-load money market funds without registering as a broker-dealer. The rules define terms used in the exception and conditionally allow sweeps into money market funds that charge more than no-load funds.
V. Other Provisions
Moving now to other provisions, in 2003, the Commission adopted an exemption for banks that engage in securities lending activities as a broker or as a dealer. Regulation R reproposed the broker portion of that exemption, which was negated by the Regulatory Relief Act. The rule will continue to allow a bank to engage in certain securities lending transactions as agent when it either does not have custody of the securities, or has custody of the securities for less than the entire period of the transaction. In response to comments, the release solicits additional comment on banks' transactions involving repurchase agreements.
Regulation R also includes an exemption to allow banks to effect certain agency transactions involving Regulation S securities. Banks may rely on the rule if they have a reasonable belief that securities were initially sold in compliance with Reg S when they effect resales of a security obtained from a broker-dealer for one of its non-U.S. customers who is not in the U.S.
The final rules also include an exemption that permits banks to effect mutual fund trades through a clearing agency system or transfer agent, rather than routing those trades to a broker-dealer. The exemption also includes transactions in registered variable insurance products. Moreover, the rules provide a new exemption permitting banks to effect certain "company stock" transactions for employee stock plans.
Banks will have until the first day of their first fiscal year commencing after September 30, 2008, to come into compliance with the Exchange Act bank broker provisions.
VI. SEC-Only Release
We also recommend that the Commission adopt a number of SEC-only proposals. These companion rules provide a conditional exemption from the definition of "dealer" for banks' Regulation S transactions, renumber the current exemption from the definition of "dealer" for banks' securities lending activities, and eliminate outdated rules.
In conclusion, we recommend that the Commission with the Board adopt Regulation R jointly. In addition, we recommend that the Commission adopt the rules and rule amendments discussed in the companion release. We would be happy to answer any questions you may have.