July 16, 2001
Jonathan G. Katz, Secretary
Securities and Exchange Commission,
450 5th Street N.W.
Washington, D.C. 20549-0609
Re: Interim Final Rules for Banks, Savings Associations, and Savings Banks Under Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934 (the "Exchange Act"), Release File No. S7-12-01 ("Interim Final Rules")
Dear Mr. Katz:
Mellon Bank, N.A. ("Mellon") is the lead national bank subsidiary of Mellon Financial Corporation ("MFC"), a financial services company headquartered in Pittsburgh, Pennsylvania. MFC's subsidiaries offer traditional banking services for individuals and corporations and collectively are one of the world's leading providers of asset management, trust, custody and benefits consulting services. They have approximately $2.8 trillion in assets under management, administration or custody, including $530 billion in assets under management. MFC is a bank holding company and is the direct or indirect sole shareholder of three full service national banks (Mellon Bank, N.A., Mellon United National Bank, Mellon Bank (DE) National Association), one limited purpose national bank (Mellon Private Trust Company, National Association) and six trust companies chartered by the states of Illinois, Massachusetts, New York, California and Washington (Mellon Trust Company of Illinois, Boston Safe Deposit and Trust Company, Dreyfus Trust Company, Mellon Trust of New York, Mellon Trust of California, and Mellon Trust of Washington, respectively).
Mellon appreciates the opportunity to provide comments on the Interim Final Rules implementing provisions of the Gramm-Leach-Bliley Act (the "GLBA") issued by the Securities and Exchange Commission (the "Commission").
Generally, we believe that the implementation of the Interim Final Rules in a number of ways would be costly and extremely burdensome. In addition, one of the overriding purposes of the Congress in enacting the GLBA was to establish a common playing field for financial services providers. The Commission's Interim Final Rules in a number of instances fail to meet that objective and impose unnecessary burdens on banks. Many nonbank competitors, such as insurance companies and investment banks, are neither subject to these same burdens, nor are they subject to the same detailed bank examination supervision and review. This letter will address the major concerns we have with respect to specific exceptions.
In providing the "sweep exception" it was the intent of Congress to allow banks, as they had pre-GLBA, to sweep cash from deposit accounts into a "no-load" mutual fund. The Interim Final Rules generally adopt the definition of "no-load" that the NASD has adopted in its Rule 2830(d)(4). Specifically, Interim Final Rule 3b-17(e) provides that a fund is "no-load" if: (1) purchases of the mutual fund's shares are not subject to a sales load or a deferred sales load and (2) its total charges against net assets that provide for sales or sales promotion expenses and for personal services or the maintenance of shareholder accounts do not exceed 0.25 of 1% of average net assets annually and are disclosed in the mutual fund's prospectus.
However, Rule 2830(d)(4) was intended to address circumstances in which mutual funds can be advertised as "no load', which is a completely different context than the "sweep exception". With respect to the sweep exception, it is not necessary to impose the 25 basis point limit since bank customers already receive appropriate disclosure concerning fees charged in connection with a sweep account. In addition, this requirement could result in banks increasing the account fees they charge sweep customers to make up for the fees that they can no longer receive from money market mutual funds. Thus, the imposition of this limitation provides no significant benefit to sweep customers, could actually result in an additional cost to customers, and would prevent banks from operating sweep programs in the manner in which they have been operating for years.
Mutual Fund Purchases
Exchange Act Section 3(a)(4)(C) requires banks to execute through a registered broker-dealer (or internally cross) securities transactions effected pursuant to the trust and fiduciary activities exception, the safekeeping and custody exception, or the stock purchase plans exception. Many banks purchase and redeem shares of mutual funds through automated order entry provided through NSCC's Mutual Fund Services as well as through a direct interface with the mutual fund's transfer agent. Rule 3a4-6 provides an exemption to permit execution of investment company securities through NSCC's Mutual Fund Services; however, it does not provide an exemption for purchases through the fund's transfer agent. While it would be possible for banks to stop making purchases directly with the fund's transfer agent, such a solution would be highly disruptive. Banks could no longer use existing automated interfaces that they have with mutual funds' transfer agents. In addition, since not all fund complexes are available through NSCC Mutual Fund Services, those that are not available would need to enter into agreements with NSCC Mutual Fund Services. Once a fund is available through NSCC Mutual Fund Services, the bank would still need to enter into an agreement with the fund to trade through the NSCC Mutual Fund Services. Until such time that all funds are available through NSCC Mutual Fund Services, or with respect to those funds that choose not to be eligible to trade through NSCC Mutual Fund Services, banks would need to execute mutual fund trades through a broker-dealer. There are no benefits to bank customers in having the bank execute mutual fund shares through a broker-dealer rather than through the mutual fund. In fact, individual investors are not required to go through a broker-dealer to purchase mutual fund shares, but may purchase them through the mutual fund's transfer agent. Regardless of whether the purchase is through the mutual fund, or through a broker, the customer receives the shares at the same price. However, if a bank purchases mutual fund shares through a broker, its customers would incur additional brokerage expenses they would not incur if the purchase were through the mutual fund's transfer agent. Thus, we would request that Rule 3a4-6 be expanded to include execution through a mutual fund's transfer agent.
Trust and Fiduciary Service Exception
The "trust and fiduciary services exception" exempts banks that are effecting brokerage transactions in connection with trust or fiduciary activities, subject to certain compensation limitations.
In the discussion of the Final Interim Rules, the Commission and its staff have taken the position that it is not clear whether banks that act as Indenture Trustees, ERISA Trustees, or IRA Trustees and take direction from investors or outside managers are covered by the trust and fiduciary activities exception. We respectfully disagree with the interpretation that there is uncertainty here. The GLBA expressly provides that the trust and fiduciary services exception is available for transactions that a bank effects in a "trustee capacity", provided the bank complies with the other restrictions of the exception. Given the plain meaning of the statute, the term "trustee" includes all relationships in which a bank acts as a trustee. While we appreciate the efforts of the Commission and its staff to identify instances where the GLBA may be ambiguous, providing specific exemptions for specified trustee capacities could result in other trustee capacities being inadvertently excluded. For example, a bank could act as directed trustee for a client for all or a portion of a personal trust, insurance trust, nuclear decommissioning trust, rabbi trust, or a trust established by a foundation or endowment. The Commission's position raises the possibility that these traditional types of trustee services would be outside of the term "trustee capacity". We believe that the Commission should affirm that the term "trustee capacity" has its plain and ordinary meaning, and applies to any capacity in which a bank serves as trustee.
In addition, the GLBA provides that a bank acts in a "fiduciary capacity" when it acts as an investment adviser if the bank receives a fee for its investment advice. However, the Interim Final Rules provide that investment advice to the customer's account must be "continuous and regular". There is no basis for imposing this condition on fee-based investment adviser activities of a bank. The GLBA does not include this condition, and neither does Part 9 of the OCC's regulations from which the definition of "fiduciary capacity" in the GLBA was drawn. This requirement is overly broad and could prevent banks from relying on the "trust and fiduciary exception" in cases where the bank, in return for a fee, provides advice to a non-discretionary account with respect to a specific transaction after a review of the customer's portfolio, or where the bank's investment advice includes an asset-allocation program.
The GLBA's "trust and fiduciary services exception" requires that a bank be "chiefly compensated" for securities transactions that it effects for its trust and fiduciary customers on the basis of certain types of fees set forth in the statute. The Interim Final Rules refer to such fees as "relationship compensation", and provide that "relationship compensation" received from
each trust and fiduciary account must exceed the "sales compensation" received from the account during the immediately preceding year. "Unrelated compensation" includes fees charged separately for any activity of the bank not related to securities transactions, and must be excluded from the calculation. We believe that the threshold of 50% included in the Interim Final Rules is appropriate, and should be no higher.
However, the determination of relationship, sales and unrelated compensation on an account-by-account basis would require the development of highly sophisticated tracking systems. Mellon has in excess of 28,000 trust and fiduciary accounts. In order to perform the calculation on an account-by-account basis, each account would need to be coded in such a way that any compensation received from the account would be designated as either relationship, sales or unrelated compensation. The relationship and sales compensation would need to be monitored to ensure that relationship compensation, per account, is at least 50% of the total of relationship and sales compensation. The system would need to identify and ignore unrelated compensation when performing the calculation, including separate compensation charged on assets that are not securities, such as oil and gas or deposit holdings. Also, sales compensation received from third parties, rather than from the account, would need to be included. Finally, billing throughout the trust and fiduciary areas of the bank is not centralized, with different areas having varying degrees of automation depending, in part, on client demands and needs. This would require the development of separate tracking systems for each billing system. In addition, since sales compensation is transaction based, it is not always possible to predict initially what the sales compensation will be going forward for a specific account. For example, an account may initially be funded with a large number of securities which need to be liquidated to meet the investment needs and goals of the beneficiaries. This could result in a one-time violation by an account, which on an ongoing basis would easily come within the "chiefly compensated" test.
While it is not anticipated we would have a significant number of trust and fiduciary accounts that would fail to comply with the "chiefly compensated" test, proving this on an account-by-account basis would be extremely burdensome in the absence of the system modifications described above. We would incur unwarranted additional expense in enhancing our systems to permit the account-by-account tracking of compensation.
Such expense is not warranted since the purpose of the trust and fiduciary exception is to prevent a bank from conducting a "full-scale brokerage operation" through its trust department. This purpose can be achieved by requiring that the bank's aggregate revenue from its trust and fiduciary accounts be composed of relationship compensation. This approach would not require account specific system development nor would it substantially interfere with the traditional trust and fiduciary activities of the bank. Such an approach is supported by the language of the GLBA which requires only that the bank be chiefly compensated for the securities transactions that it effects for all of its trust and fiduciary customers from relationship compensation. There is no statutory requirement that the analysis be done on an account-by-account basis.
Recognizing the significant regulatory burdens on banks that an account-by-account analysis would impose, the Commission has adopted an exemption that permits banks to avoid the account-by-account analysis if they comply with certain SEC-imposed conditions. The bank must demonstrate that sales compensation received during the immediately preceding year for its total fiduciary activities is less than 10% of the total amount of relationship compensation and needs to maintain procedures designed to ensure compliance with the definition of "chiefly compensated" with respect to a trust or fiduciary account (i) when the account is opened (ii) when the compensation arrangement for the account is changed, and (iii) when sales compensation received from the account is reviewed by the bank for purposes of determining an employee's compensation. However, the exemption still requires that procedures be maintained to ensure that each trust and fiduciary account complies at certain stages of the customer relationship with the chiefly compensated requirement of the Interim Final Rules. Implementing such procedures would require the type of system developments discussed above and the attendant costs and burdens discussed above.
Finally, regardless of whether the "chiefly compensated test" is done on an aggregate or an account-by-account basis, "relationship compensation" has been defined too narrowly. Specifically, the Interim Final Rules provide that fees may be included in permissible "relationship compensation" only to the extent they are received directly from a customer or beneficiary or account. The GLBA places no such limit on "relationship compensation". This limitation, particularly, as it applies to administrative and 12b-1 fees received from third parties, limits bank trust departments' flexibility to maintain and develop particular fee arrangements with customers. For example, in place of receiving an account level fee from a customer, the Trustee of a 401(k) plan may negotiate a fee arrangement in which the Trustee does not charge any account level administrative fee, but rather receives a 12b-1 fee directly from a mutual fund for providing administrative services. Since the 12b-1 fee is received from a third party, the entire account level fee would be counted as "sales compensation" under the Interim Final Rules.
In addition, inclusion in a bank's "sales compensation" of "fees received in connection with a securities transaction or account, except for the finders' fees received pursuant to the networking exception", is overbroad. It implies that compensation received by an employee (other than that qualifying under the networking exception) could be considered part of the bank's "sales compensation". Again, the GLBA does not limit how a bank may compensate its employees that provide trust and fiduciary services. Thus, the Commission should clarify that "sales compensation" does not include compensation or fees received by, or paid to, bank employees.
In light of the complexities in making the "chiefly compensated" calculations, we strongly believe that the Commission should provide banks with a reasonable period of time to cure unforeseen or inadvertent violations. Such a cure period should be sufficiently long to allow banks to take appropriate action to address these kinds of situations.
Custody and Safekeeping Exception
The "custody and safekeeping exception" was intended to allow a bank to continue to provide its traditional custody services, including order taking which is a customary component of custodial services. The GLBA recognizes that a custodian may execute trades for its customers since it requires that such trades for publicly traded securities be directed to a registered broker-dealer. However, the Commission has taken the position that the custody and safekeeping exception does not permit banks to accept securities orders from their custodial customers, including custodial IRA customers and 401(k) and benefit plans that receive custodial and administrative services from the bank. This interpretation will unnecessarily interfere with banking activities that Congress intended to protect and is inconsistent with the GLBA and the purposes of the custody and safekeeping exception. This inconsistency is most evident with respect to IRAs and benefit plans. The GLBA, by its terms, permits a bank to provide custodial and other related administrative services "to any individual retirement account, pension, retirement, profit sharing, bonus, thrift, savings, incentive, or other plan". Providing securities execution services is an integral part of these custodial relationships and allows customers to avoid the expense and burdens associated with establishing a separate account at a broker-dealer.
Although the Commission has granted exemptions for the execution of custodial-related transactions, the conditions of these exemptions undermine their usefulness. For example, Rule 3a4-5's requirement that the bank not receive compensation for effecting such transactions would require banks effecting transactions at the directions of their customers to operate at a loss. This would prevent the banks from establishing pricing structures that charge customers appropriately for the services they use. In addition, the prohibition on a bank employee effecting trades from receiving incentive compensation is not necessary. A bank should be permitted to compensate employees for bringing business to the bank, since to the extent the trade is being directed by a customer the bank employee would not have a salesman's stake in any particular investment being sold. Finally, requiring that unrelated mutual funds be offered if affiliated mutual funds are offered would be disruptive of existing relationships as it could require restructuring of 401(k) plan investment options. It would also require banks to search out competitors' mutual funds to offer to customers who direct their own trades.
Prior to the GLBA, banks had been conducting third party brokerage or networking arrangements pursuant to the then existing standards - including guidance contained in several SEC no-action letters. When Congress visited this issue during the passage of GLBA, it had an opportunity to enact new restrictions, but instead Congress chose to model the GLBA third party brokerage exception on the then-existing networking arrangements. The Interim Final Rules defeat the clear intentions of Congress by "legislating" new restrictions into the GLBA networking exception, rather than implementing the legislative language. Because of the Interim Final Rules' new requirements on the amount that may be paid for referrals and how such payments may be structured, it will be fundamentally impractical for banks to offer existing referral programs that are otherwise consistent with the GLBA and industry practice.
While the Commission should be commended for attempting to structure a flexible approach in the Interim Final Rules, those rules place unwarranted restrictions on the ability of banks to compensate their employees that go far beyond removal of a "salesman's stake" in the sale of securities products. First of all, under the GLBA, bank employees are compensated only for referrals they make to registered broker-dealers, not actual securities transactions. Secondly, the bank customer will always be dealing with a registered broker-dealer representative who is responsible for ensuring compliance with suitability and other investor protection requirements. In this context, further restrictions aimed at removing inappropriate activity are excessive and have the effect of burdening legitimate, beneficial referral activity, with the likely result of reducing desirable diversification of investments owned by bank customers.
Under the Commission's hourly wage standard, banks must choose between paying different referral fees to different employees performing the same function or paying on a "least common denominator" basis that would under-compensate higher paid employees. Paying different fees for the same activity could hurt the team approach since employees making the same referral could be paid different fees. In addition, tracking employee compensation to compute referral fees would impose an additional administrative burden that would require system changes and threaten the privacy of employee wage and salary information. A bank could pay the same referral fee only by basing it on the lowest hourly wage of any eligible employee, thus setting the fee at a level unlikely to be meaningful to more highly paid employees.
The Commission should allow, as under current practice, banks to interpret the term in a manner that best fits their networking arrangements, so long as their plans focus on the prohibition that they cannot pay for a referral more than once; that the amount is not more than nominal; and that the payment is not contingent on the customer transacting with the broker. This standard is one that has worked for many years and gives flexibility to firms to fashion a program that works.
The alternative point program also appears to be an attempt to acknowledge the usefulness of flexible systems. However, the requirement that the points for a securities product referral be no greater than the points received for other products and services requires an "apples-and-oranges" comparison between referrals of securities products and sales of other products. For example, a bank might award 10 points for a securities referral, a sale of a bank deposit, or a successful application for a home equity loan. Would this program comply with the rule, or would the Commission take the view that a referral is easier to accomplish than a deposit sale or successful loan application? What if the bank placed minimums on the amounts of deposits and loans on which incentive would be earned? Such minimums could make good business sense. Presumably, a bank could not place a similar floor on sales resulting from securities product referrals. Would the disparity cause the Commission to say that the bank's program falls outside of the safe harbor? If that were the result, the uncertainty and impracticality associated with the points system safe harbor would make it practically useless.
Thus, our suggestion is that the rule be revised to reflect that point systems are a reasonable alternative to fixed cash payments provided that the principles of one time nominal nontransaction based compensation are reflected in the system. We see no requirement in the GLBA, however, that the points awarded for securities referrals be no more than the award for the referral of any other product.
The Commission has asked for comment on whether the rule should include gross compensation standards to prevent a bank from paying referral fees that constitute a substantial portion of an employee's total compensation. We see no basis in the GLBA for such limit and no need based on the industry's experience with networking arrangements and referral fees. Requiring that each referral fee be nominal is sufficient to satisfy the requirements of the GLBA, limit the salesman's stake and protect investors.
We request that the Commission clarify the Interim Final Rules' treatment of bonus programs. The rules provide that referral fees cannot be paid in the form of bonuses but the language could be read to apply to bonus or incentive programs and employees throughout a financial institution that are not transaction based, and also have no connection to a referral. Banks intend to adhere to the principle that they cannot indirectly pay transaction based incentive compensation such as commissions or loads through bonuses to unregistered persons, but there is concern that, as written, this provision could be interpreted to prevent an institution or its bank with a networking arrangement from paying any officer -- such as a senior executive of the financial institution in charge of the asset management area (which includes the broker-dealer) -- a bonus based on the success of a regional area or line of business that engages, among other things, in securities activities, even where there is no problematic connection to transactions.
Accordingly, we ask that the Commission clarify that the Interim Final Rules do not apply to financial institution bonus programs generally, but only to the specific issue of double counting referral credits within bonus plans in addition to the one time payment.
As noted in the letter of the Bank Agencies, dated June 29, 2001, Appendix pages 46-47, the potential for an expansive application of NASD Rule 3040 is a matter of concern. The use of dual employees will, practically speaking, be necessary for most institutions to operate within the bank exceptions and also continue providing the services they now provide. It would be an illogical extension of NASD Rule 3040 to require affiliated broker dealers utilizing dual employees to essentially duplicate the supervision and recordkeeping for otherwise exempt bank activities. Indeed, the GLBA exceptions from securities regulation would be defeated by this application without any corresponding benefit to the public.
Although Rule 3040 is not directly the subject of the Interim Final Rules, Mellon is concerned about its potential enforcement in the context of bank activities.
Mellon appreciates the opportunity to comment upon these Interim Final Rules. If we can be of any further assistance, please do not hesitate to call me at 412-234-1537 or William R. Nee, Associate Counsel, at 412-234-1087.
Michael E. Bleier
cc: Martin G. McGuinn, Mellon Financial Corporation
George J. Orsino, OCC
Frank J. Riccardi, Federal Reserve Bank of Cleveland
Sarah A. Miller, ABA Securities Association
Richard M. Whiting, Financial Services Roundtable