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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the ABA Trust, Asset Management, and Marketing Conference

by Robert L.D. Colby

Deputy Director, Division of Market Regulation
U.S. Securities & Exchange Commission

San Francisco, California
January 31, 2001

Thank you for inviting me to join you here today. Before I begin, I must remind you that my remarks represent my own views, and not necessarily those of the Commission or my colleagues on the staff. I would like to talk to you today about our initial thinking on the bank exceptions from broker-dealer regulation in the Gramm-Leach-Bliley Act, and particularly, the trust exception. This exception, just like all the other exceptions from broker-dealer regulation, amends the Securities Exchange Act of 1934. As a result, the Commission is statutorily charged with interpreting these exceptions from broker-dealer registration. As you know, there has been much discussion about the trust exception -- probably more so than any other exception. In fact, we just received a request from the American Bankers Association this past Friday seeking our interpretation of some of these issues, which we have not had time to digest. We hope to talk with you more about the issues raised by these exceptions.

Let me say at the outset that, even if your activity does not fit within the letter of an exception, we are willing to grant additional exemptions where broker-dealer registration does not make sense for bank securities sales activities. For example, we are considering how to accommodate older trust relationships that may not fit within the trust exception. We are also prepared to listen to the particular concerns of small banks without broker-dealer affiliates.

Some have expressed concerns about intrusive SEC regulation of traditional trust activities. Let me assure you that this is not our intention. We do not envy trust examiners' jobs, and do not wish to join their ranks. We never thought that traditional trust management activities raised broker-dealer issues, and the Gramm-Leach-Bliley Act provisions were not intended to disrupt these activities.

That said, it is possible that Gramm-Leach-Bliley may impact bank activities, including those of trust departments, if such departments conduct the equivalent of traditional brokerage activities. The statute was not designed to protect everything that could have been conducted in the bank at the time. Though the ABA and ABASA worked very hard to avoid any "pushouts," as they were wont to call them, they, like us, did not get everything they wanted. Thus, while we do not expect to impact traditional trust activities, we recognize that some bank brokerage activities must shift to a registered broker-dealer after the functional regulation provisions take effect, and that this transition may affect some of your business lines. If you decide that your bank may be engaged in some activities that need to be conducted through a registered broker-dealer, and you need more guidance or time to shift those activities, we are willing to work with you to get this accomplished. We are interested in making sure that everybody gets this right, even if we need some more time in order to make this transition work smoothly.

Now, let me turn to the trust exception. The Act excepts banks that engage in securities transactions for their trust clients from being required to register as a broker or dealer so long as they comply with a five-part test. This test focuses on: 1) the nature of the securities business that a bank conducts in the trust department; 2) the compensation that a bank charges in connection with that securities business; 3) how the bank executes securities transactions for its customers in the trust department; 4) how bank regulators examine that securities business; and 5) how banks advertise those securities services.

The discussion to date has centered on two issues. The first issue is when is a bank acting as a fiduciary. This issue is important because the trust exception in the Act is limited to banks that act as trustees or in one of eleven categories of fiduciary activities, including acting as an investment adviser if the bank receives a fee for its investment advice and acting in any capacity in which the bank possesses investment discretion on behalf of another.

The second issue that has generated much discussion is how we intend to interpret the limits to bank trust compensation set out in the trust exception.

Before I discuss our proposed interpretation of the trust exception, I would like to explain some basic premises of what the bank trust exception is - and is not - designed to accomplish. The trust exception allows banks to execute securities trades for investors through their trust departments without having to register as a broker-dealer, or follow key broker-dealer rules designed to protect investors. For example, broker-dealers are subject to explicit supervisory requirements and sales practice standards. They also must comply with requirements regarding training, experience, and competence, as well as requirements related to dispute resolution. Bank sales of securities that qualify for the trust exception do not have to meet any of these investor protection requirements.

The Congressional formulation of this exception appears to reflect a judgment that banks may engage in securities transactions as part of trust relationships without the investor protection standards found in the federal securities laws when banks are acting as bona fide fiduciaries and investors are protected by strong fiduciary principles under trust law. The most fundamental trust principles are the duty of undivided loyalty and the prudent person rule, which together provide a high level of customer protection. But to have the protection of these principles, the relationship between the bank and the customer must be a bona fide fiduciary relationship, namely a relationship where the customer places trust and confidence in the bank, and where the bank has invited that trust and confidence. The best example of this kind of relationship is the traditional bank-as-trustee/client-as-beneficiary relationship.

However, the traditional trustee/beneficiary relationship is only one of several types of fiduciary relationships that Congress envisioned a bank could conduct in its trust department without broker-dealer regulation. A relationship of trust and confidence could also be found, for example, between an investment adviser and a client who expressly relies upon the adviser to manage his assets or select his securities. The trust exception is not designed, however, to allow a regular full-service brokerage business to operate in a bank trust department without any of the investor protections afforded by the federal securities laws. To argue otherwise would ignore the statutory language, since the definition of fiduciary capacity in the Gramm-Leach-Bliley Act that applies to the trust exception does not include "broker," despite the fact that many times a broker is acting in a fiduciary capacity. This is consistent with our overall view that Congress generally intended the trust exception to apply to those "trust and confidence" fiduciary relationships that are protected by the fiduciary principles that I have previously mentioned.

This Congressionally designed distinction between the fiduciary relationships of brokers and investment advisers raises a familiar and fundamental issue for securities regulators. When does a broker-dealer who gives advice to its brokerage clients stop acting merely as an agent and begin acting as an adviser under a relationship of trust and confidence?

This might be a good place to step back and to give you some background about the federal securities laws. Both broker-dealers and investment advisers effect securities transactions for investors. Whether an entity is required to register as one, the other, or both, depends on the specific nature of the entity's activities. The Investment Advisers Act of 1940, which governs the conduct of investment advisers, defines an investment adviser as "any person who for compensation engages in the business of advising others."

Because the definition of investment adviser could capture broker-dealers, who may also advise clients as part of their brokerage business, the Advisers Act excepts any broker-dealer who provides advice that is solely incidental to the conduct of its business as a broker-dealer and who does not receive any special compensation for its investment advice.

In recent years, the activities of investment advisers and broker-dealers have begun to converge. In determining whether a person must register as an investment adviser or a broker-dealer, the Commission staff has traditionally considered the type of compensation received in connection with securities activities. A broker-dealer, who is in the business of "effecting transactions in securities," generally receives transaction-based compensation for its securities business. Receipt of transaction-based compensation gives a broker-dealer a salesman's stake in its customers' transactions so that the interests of the broker-dealer and its customers may not be aligned. Thus, broker-dealers are subject to a regulatory framework, including sales practice rules and rules of fair practice, to ensure that those customers' interests are protected. In contrast, investment adviser compensation, typically based on assets under management, more closely aligns the interests of the investment adviser and its client. This distinction between broker-dealer and investment adviser compensation arrangements is reflected in the compensation limits that Congress crafted in the trust exception.

Now, just to complicate the landscape a bit more, you should know that a number of broker-dealers have dually registered as investment advisers. The push towards dual registration stems from a push for new compensation structures such as wrap fee programs or execution-only programs. These programs in the language of the Investment Advisers Act are ways for broker-dealers to charge "special compensation" for their advisory functions. In reality, however, these broker-dealers may really just be administering the same brokerage accounts but for different remuneration.

As you can imagine, as business practices evolve, the line between broker-dealer and investment advisory activity can be hard to draw. Because of the increasing uncertainty, the Commission proposed in 1999 to recast the broker-dealer exception from the definition of investment adviser. Under the Commission's proposal, the nature of the services provided, rather than the form of compensation charged, would be the primary distinguishing characteristic of an advisory account.

For banks, Congress preserved compensation as a key indicator of whether a bank is acting as a broker-dealer or a fiduciary within the trust exception. So, while the compensation component to the investment adviser versus broker-dealer test may become less important in the non-bank context, the compensation component will continue to drive the test in the bank context.

So the threshold test to determine whether a bank qualifies for the trust exception will be a two-pronged one: 1) is the bank acting as a bona fide fiduciary in one of the enumerated fiduciary capacities; and 2) is the bank being compensated in an eligible manner? A bank must meet both prongs to qualify for the trust exception.

Under the first prong, the key question to ask in determining whether a particular relationship is a bona fide fiduciary relationship that qualifies for the trust exception is, for example, whether the advisory activity reflects substantially all of the securities relationship between the customer and the client. The question obviously turns on the facts and circumstances of a specific relationship. A bank trust officer may have some relationships with some clients that are substantially all advisory, and relationships with other clients that are substantially all brokerage. I cannot tell you today every relationship that will create an advisory fiduciary relationship without better understanding your business models. As an initial matter, however, I would like to suggest that you ask yourself, is your customer relying on your advice or does she tend to keep her own counsel? Do you have effective control over direction of your client's assets?

Of course, a bank that engages in a course of arm's length dealing with a customer should not be able to claim to be acting in a "fiduciary" capacity. For example, a bank program that offers customers the ability to effect a continuing series of trades for a flat annual fee may well not be acting in a bona fide fiduciary capacity within the meaning of the trust exception. However, a bank that permits that client to trade on her own occasionally through a single advised account for which the bank exercises fiduciary responsibility should continue to be able to rely on the trust exception.

Another issue that has generated much interest is whether a bank that acts in a custodial capacity for its customers qualifies to use the trust exception. Congress was clear to distinguish custody from fiduciary activities listed in the trust exception by creating a specific exception for custody accounts. The custody exception is designed to allow banks to safekeep or facilitate the transfer of assets, assist clients in lending or borrowing securities held at the bank, facilitate the pledging of securities, and provide custody and administrative services for IRAs and benefit plans. It is not generally designed to allow banks to act as broker-dealers, in addition to this custody role, under the rubric of "administrative services." Of course, banks may act as custodians pursuant to the trust exception under a uniform gift to minor act because it is listed as a permissible fiduciary capacity. The fact that banks should not generally rely on the custody exception to act as broker-dealers for their clients does not mean that banks cannot effect trades for their investors in a custody account. In that situation, banks should effect those trades using the exception designed for effecting transactions in regular brokerage accounts the networking exception.

This brings me to a general point. If a client opens an account that is principally a self-directed account, even if it is labeled a "trust" or "private banking" account, we intend to analyze the relationship functionally. In fact, the label "private banking" does not tell us much other than that the bank is dealing with high net-worth investors. If that account is, based on the analysis that I just described, a regular brokerage account, the bank would need to use the networking exception and manage the account through a registered representative. That does not mean that we would require the trust department to shift the account out of the department. Trust employees, like other bank employees, may become dually registered with the NASD to service a brokerage account within a bank. We will expect, however, a trust bank employee who becomes dually registered with the NASD to be supervised by a broker-dealer and for the books and records pertaining to that securities account to be maintained as required under the securities laws.

Adequate supervision is critical to ensure compliance with the securities laws. Securities firm supervisors are the first line of defense, and securities regulators are the last line of defense, against potential self-dealing by salesmen. Adequate supervision requires a broker-dealer to have full access to all of the securities accounts managed by its registered representatives and in turn, securities regulators to have full access to the accounts managed by broker-dealers and their associated persons. Otherwise, securities firm supervisors and securities regulators cannot detect securities fraud such as allocation of favorable trades to trust clients at the expense of brokerage clients, trading ahead on behalf of trust clients at the expense of brokerage clients, or using a combination of accounts to manipulate the price of a security.

Compensation Limits

There are two limits on compensation. First, banks may only charge fees that are consistent with fiduciary principles and standards. Second, banks must be chiefly compensated through the receipt of annual, administration, or assets under management fees, fees that equal direct execution costs, or a combination of such fees. These sources of payments reflect that bank trust departments, like broker-dealers, receive payments from both investors and third-parties.

A key question is what does "chiefly" mean. For purposes of analyzing which fees count towards being "chiefly" compensated in one of the enumerated ways, we think fees should be categorized into two categories fees which count towards the "chiefly" requirement and fees which do not count towards that requirement. We think other fees should be excluded from the calculation.

I was at the table when the term "chiefly" was chosen. I distinctly remember that it was chosen because of its freedom from baggage, unlike terms such as "principally" or "predominantly." In our view, "chiefly" means two things. First, a majority, or 51 percent or more of the payments for securities transactions must derive from the enumerated categories of fees. Second, we tend to think the highest single source of payments should not be from brokerage services. That would mean that a bank that combines a number of enumerated sources of fees to arrive at the 51 percent threshold compensation requirement but derives 49 percent of its fees come from brokerage activities would not meet the compensation requirement. This should not affect traditional trust accounts in any way because banks acting as trustees typically charge a minimum annual fee and an asset under management fee rather than a transaction fee.

This approach is also consistent with Congressional intent -- and our desire -- not to disturb traditional trust activities, while at the same time requiring regular brokerage activity to take place in a registered broker-dealer that is subject to the federal securities laws. For example, if a bank is actively trading an account over which it has or shares investment discretion with a customer, then we would expect the management fee to clearly predominate and exceed any separate execution costs charged to the customer.

Of course, a trust department also is paid for non-securities related activities. For example, a bank trust department may administer real estate, prepare tax accounting, or provide legal advice. Payments that are not related to the securities business should not be counted as part of its "chiefly" calculus.

In determining how fees should be categorized, there are difficult questions concerning how incentives paid by third-parties to distribute their shares, such as trail commissions, Rule 12b-1 fees, or referral fees, should be counted. One approach would be to treat these third-party payments as brokerage commissions and not as enumerated bank trust fees, in determining whether banks are being chiefly compensated from the enumerated sources of fees. The reason for treating third-party distribution fees this way is that, if an issuer, including a mutual fund, pays a distribution channel to distribute securities, it is creating a conflict of interest between the securities salesman and investors. It is precisely those divided loyalties or conflicts of interests faced by securities salesmen that drive much of securities regulation, and particularly the sales practice standards. That would not mean that a bank cannot receive those fees. These fees are an important source of compensation for many broker-dealers, as well as trust departments. It would only affect how these fees are counted.

Another approach would be to not include third-party sales incentives as part of the "chiefly" calculus at all, either for or against.

Payments by third parties could, of course, be related to providing administrative services for securities accounts, such as shareholder accounting or forwarding of proxies. Under either approach, we do not think that third-party payments that are clearly for servicing a customer account should count in the "chiefly" calculus. These fees are not paid for by the bank trust client and thus, do not present evidence that the client is seeking a "trust and confidence" relationship with the bank.

Let me turn to execution costs. A bank may count as one of the enumerated sources of fees "a flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers." This means that these transaction fees may recover banks' direct costs for executing these transactions, but no more. Broker-dealer style transaction-based compensation, as the Commission has previously stated, is "monetary profit above cost recovery for brokerage execution services." Therefore, we do not believe that bank cost recovery fees should include any profit component or incentive compensation to employees.

The next issue is on what basis should the compensation requirement in the trust exception be administered. It seems to us that the compensation requirement should be administered on an account-by-account basis. This formulation appears to reflect the statutory requirement that a bank must be "chiefly compensated for such transactions" through the receipt of eligible fees.

Let me analyze how these compensation limits would work. Let us assume that the bank and the customer have entered into a bona fide fiduciary relationship. The question then becomes what part of the payments that the bank receives should count as permissible under the "chiefly" limitation? Let me give you an example. Mutual funds compensate the bank for selling their shares to trust clients. The bank also charges trust clients an asset under management fee for managing the accounts. Occasionally, a client may engage in some self-directed trading. The bank should first set aside non-securities related payments as well as third-party securities-related servicing payments. Those payments would not be counted in any calculation. The bank would then compare commissions, execution payments that exceed direct costs, and possibly referral fees and trail commissions, with the management fees paid by the client and execution fees billed on a cost recovery basis, to determine whether it was being "chiefly" compensated in a permissible manner.

As I wind up, I would like to respond to a question that is being asked more and more. How can a bank get ready for the May 12th functional regulation implementation deadline? The best way for a bank to prepare for May 12th is to take an inventory of its business lines and decide whether all of its activities meet the conditions of the various exceptions. We are willing to work with banks that need a little more time to get their houses in order but we need to know of any problems before the implementation date. After that point, a bank that does not comply with the trust exception or any of the other exceptions will be operating as an unregistered broker-dealer.

In conducting its inventory, a bank needs to look past the label on the activity and consider the activity itself. Look at what services you are actually performing for your clients. The key test will be whether the investment advisory relationship between the bank and the customer accounts for substantially all of the relationship, with any self-directed trading that occurs being simply incidental to the advisory relationship.

It is also important to remember that the exceptions from broker-dealer regulation are limited to "banks" as defined in the Exchange Act. The trust exception has one additional requirement in this regard. The exception only applies to any office of a bank that is regulated and examined pursuant to fiduciary principles. That does not mean that a bank has to create a separate trust department in order to house its trust activities. That does mean, however, that the bank must house the trust business, including the solicitation activities, in an office or department that is examined by bank trust examiners for fiduciary principles. Similarly, a "trust company" does not necessarily qualify for the trust exception for all the activities that it conducts. We think the best way for a bank to look at the securities activities is on an activity-by-activity and account-by-account basis to determine whether it qualifies for the trust exception.

A bank also may not publicly solicit brokerage business except as part of advertising its trust business. And remember that another section of the Gramm-Leach-Bliley Act requires that most securities trades exempted under the trust exception must still be effected through a registered broker-dealer.

I would like to say just a word about our coordination efforts with the banking regulators. The Gramm-Leach-Bliley Act sets out standards for who should examine financial holding companies and their affiliates, and clearly enshrines the principle of functional regulation in these examinations. For our part, we have had a series of meetings with the bank regulators to reduce duplicative exams and strengthen coordination. We are working on an MOU with the Federal Reserve Board. We do not view the SEC as a bank regulator, and we do not expect to be attending conventions of trust examiners in the future.

In conclusion, I would like to thank you for the chance to discuss our current thinking as we implement the Gramm-Leach-Bliley broker-dealer provisions. We view ourselves at the outset of a dialogue on these issues. We at the SEC recognize that there will probably be more questions as we progress in this new era. We want to work with you to make this process much more workable and effective.