August 1, 2001
Securities and Exchange Commission,
450 5th Street, N.W.,
Washington, D.C. 20549-0609.
Attention: Mr. Jonathan G. Katz
Re: Release No. 34-44291 (File No. S7-12-01): 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
Ladies and Gentlemen:
The member banks of The New York Clearing House Association L.L.C. (the "Clearing House")1 are writing to comment on Rules 3a4-2, 3a4-3, 3a4-4, 3a4-5, 3a4-6, 3a5-1, 3b-17, 3b-18, 15a-7, 15a-8 and 15a-9 adopted by the Securities and Exchange Commission (the "SEC") as interim final rules (the "Interim Rules") under the Securities Exchange Act of 1934 (the "Exchange Act"). The Interim Rules interpret the terms of the exceptions for banks from the definitions of broker and dealer in Sections 3(a)(4) and 3(a)(5) of the Exchange Act and purport to provide additional exemptions to banks from the Exchange Act's broker-dealer registration requirements.
The Clearing House appreciates the SEC's solicitation of comments in the adopting release2 (the "Release") and the opportunity to provide its comments on the Release and Interim Rules. We also appreciate the SEC's subsequent action on July 18, 2001, taken in light of preliminary comments on the Interim Rules, to exempt banks by order from the definitions of "broker" and "dealer" in the Exchange Act until May 12, 2002.3 As is discussed in more detail in this letter, however, the Clearing House believes that the Interim Rules are seriously flawed, impose unnecessarily burdensome and in some cases impossible requirements on banks, and are in places inconsistent with the language and legislative history of the Gramm-Leach-Bliley Act ("GLBA") and the concept of functional regulation that is fundamental to GLBA. We have sought in our comments to suggest specific revisions to the Interim Rules that would address these issues.
According to the Release, the Interim Rules were designed to clarify the terms of the exceptions from the definitions of broker and dealer in the Exchange Act and to provide additional exemptions therefrom for the purpose of aiding banks in complying with the provisions of GLBA. As the SEC observes in the Release, one of the purposes behind GLBA was achieving functional regulation of the financial services industry. Functional regulation means that a particular function or activity is subject to regulation by the same expert regulator, regardless of whether that function or activity is performed by a broker, dealer, bank, savings association, or other financial institution. Consistent with this approach, GLBA provides that banks that engage in certain securities activities will be subject to the requirement to register as brokers or dealers and will thereby become subject to regulation by the SEC. GLBA accomplished this by removing the blanket exemption for banks from the definitions of broker and dealer in the Exchange Act, and introducing instead a number of limited exceptions for certain securities and securities-related activities that historically were within the ambit of the business of banking.
GLBA sought to apply broker-dealer regulation to banks when banks' activities did not qualify for certain newly established exceptions from the definitions of broker and dealer. In eliminating the status exceptions banks had from the definitions of "broker" and "dealer", however, Congress recognized that the business of banks -- unlike the business of any other type of business enterprise -- necessarily intersects with the securities business, and therefore adopted a series of exceptions from the definitions of broker and dealer available only to banks.
Although the SEC is correct that Congress sought to achieve functional regulation when it repealed the outright exceptions for banks from the definitions of broker and dealer, the Clearing House believes that the SEC has failed to give adequate weight to the other way in which Congress sought to ensure functional regulation -- by ensuring through these exceptions that banks would continue to be regulated by the banking agencies and not the SEC when they conduct activities within the exceptions. The Interim Rules have an effect opposite to what Congress intended by making it virtually impossible for banks to continue to conduct a number of traditional banking activities within a bank and by imposing unreasonable burdens on banks attempting to do so.
II. Timing and Process Concerns
In the July Release the SEC stated that it anticipates amending the Interim Rules and that it does not expect banks to develop compliance systems until it amends the Interim Rules.
The SEC also noted that the banks have indicated that they will need "as much as a year" to develop compliance systems to comply with these provisions of the GLBA, and stated that it expects to extend the compliance date further than the May 12, 2002 date adopted in the July Release so that banks will have additional time to respond to the changes it adopts.
The Clearing House appreciates the SEC's recognition of the importance of these issues, but wishes to stress that it believes one year after the effective date is the minimum period that banks will need to develop appropriate systems for compliance with the SEC's final rules. In addition, Section 204 of GLBA requires the federal bank regulatory agencies to adopt recordkeeping rules that have not yet been proposed. Banks should be allowed sufficient time to develop compliance systems for the recordkeeping rules at the same time as they are developing systems for compliance with the SEC's rules, given the close relation between the two sets of rules.
Even if the Interim Rules are substantively amended, major changes in bank information systems and, possibly, business models will be required. The task of building the systems required to gauge compliance with the tests in the final rules is likely to be extremely expensive and time consuming, and will require the diversion of limited technological resources from other projects of comparable importance.
For these reasons, the Clearing House urges the SEC to determine that the exemptions from the definitions of "broker" and "dealer" will continue for a period of at least one year after the later of the promulgation of final rules under GLBA and the promulgation of recordkeeping requirements by the banking agencies.
We also believe that it is of critical importance that the next step in the process should be for the SEC to propose new rules, not issue revised final rules. The Interim Rules (and in some cases language in the Release) raises so many issues that banks will need another opportunity to comment before final rules can be promulgated.
III. Bank Fiduciary Activities
The Clearing House has major concerns about the interpretation in the Interim Rules of the exception from the definition of "broker" for banks engaged in trust and fiduciary activities.4 Specifically, our comments are focused on (a) the test used in the Interim Rules to define "chiefly compensated" and its implementation, (b) the definition of "trustee capacity", (c) the treatment of transfer agents, (d) the definition of "investment adviser if the bank receives a fee for its investment advice" and (e) the SEC's interpretation of the requirement that a trust department or other department relying upon the exemption for trust activities be "regularly examined by bank examiners."
A. "Chiefly Compensated" Test (Interim Rule 3b-17(a)).
1. Definitional Issues
Under Interim Rule 3b-17(a), the determination of whether a bank is "chiefly compensated" in the manner permitted by GLB must be made on an account-by-account basis. This calculation is both difficult and expensive for a number of reasons. The task will be an enormous one -- one of our banks has over 80,000 trust and fiduciary accounts. The test does not allow banks to rely on existing systems, which do not characterize revenues in the way that the Interim Rule does; it will require development of new tracking technology, a process which is both time-consuming and expensive. For example, most banks do not currently allocate fees received from common trust funds or Rule 12b-1 fees received from mutual funds on an account-by-account basis, because the investments are carried in omnibus accounts. The Clearing House believes that the complexity of the chiefly compensated calculation set forth in the Interim Rules imposes a tremendous hardship on banks.
The Clearing House also believes that the account-by-account test is contrary to the clear language, as well as the intent, of the statute. Section 3(a)(4)(B)(ii) creates an exception when a "bank effects transactions" in a trust or fiduciary capacity and is "chiefly compensated for such transactions" with what the SEC refers to as "relationship compensation." The statute refers to transactions in the plural, and makes no mention of accounts or even customers. Rather, the statute refers to a bank's trust department or similar department. We do not understand the reasoning, nor do we agree with the conclusion, of the statement in the Release that "[i]n referring to 'such transactions,' the statute focuses on the compensation at the level at which the transactions occurred, which is the account level."5 We therefore believe the plain meaning of "chiefly compensated" is that a majority of the compensation earned by a bank from its trust and fiduciary activities is of the permissible sort.6
We also believe that the SEC's imposing an account-by-account compliance requirement is in effect an imposition of recordkeeping requirements on banks, which, under Section 204 of the GLBA, is the province of the federal banking agencies, not the SEC. We believe, in general, that the SEC should not adopt interpretations of Sections 3(a)(4) and (5) of the Exchange Act except in consultation with the banking agencies, who have special expertise in this regard, but the SEC should be particularly circumspect about adopting substantive interpretations that impinge on the bank regulatory agencies' authority over recordkeeping requirements.
Of equal concern is that Interim Rule 3b-17 is not clear on the allocation of revenues earned from fiduciary activities. We believe that the definition of "sales compensation" in Interim Rule 3b-17(j) is too broad and that the definition of "relationship compensation" in Interim Rule 3b-17(i) is too narrow. The chiefly compensated test in Section 3(a)(4)(b)(ii)(I) of the Exchange Act applies to all revenues earned in a trustee or fiduciary capacity. Banks acting in such capacity may also manage investments other than securities, such as real estate, and be compensated therefor. We believe that the Interim Rules, as currently drafted, may be interpreted to exclude, as "unrelated compensation", the revenues derived by a bank in a trustee or fiduciary capacity from such non-securities activities and restrict the bank to a calculation based solely on securities transactions. The Release indicates that this additional revenue is not intended to be excluded from the calculation so long as such fees are not "charged separately." However, the Rules, as currently drafted, do not make this distinction clear and may be incorrectly interpreted to exclude all revenues charged for managing non-securities assets. More important, however, we believe that all such revenues should be included in the calculation. There is no basis for distinguishing between fees "charged separately" and those that are not. The meaning of "charged separately" is unclear and the distinction may penalize a bank solely for the method in which its bills are rendered. No basis in GLBA exists for excluding any revenues from managing non-securities assets or for drawing distinctions between fees based on the way in which they are charged.
We also believe the definition of relationship compensation inappropriately excludes revenues that should be included even if not earned directly by a bank. For example, a discretionary trustee that invests assets in a proprietary mutual fund is required under the Employee Retirement Income Security Act of 1974 ("ERISA")7 to waive its investment management fee in respect of those assets if the fund's adviser is an affiliate of the trustee and receives an investment management fee. Moreover, certain state fiduciary laws8 require that all account level fees be waived if any fees are earned by affiliates at the mutual fund level. These waiver requirements apply when a discretionary trustee receives fees under a Rule 12b-1 plan. In each case, under the Interim Rules, this reduces the trustee's "relationship compensation". The reduction in relationship compensation is particularly troubling in the latter case because the receipt of Rule 12b-1 fees will also increase a bank's "sales compensation." These results are anomalous and unfair.
The chiefly compensated test also fails to take account of the way banks do business. Banks have negotiated their fee structures for many years without being subject to the chiefly compensated test. In many cases, these fees can not be changed without a court order. Some fees are set by state laws. Many trust fees were negotiated under the assumption and with the knowledge that the bank would receive fees from investment companies directly. A necessary consequence of these historical facts is that a bank's ability to adjust its operations to ensure compliance with the chiefly compensated test, as currently drafted, is limited. Finally, we believe some customers may prefer to be subject to a lower trustee fee in exchange for higher per-transaction fees. These trade-offs have no impact on the services performed by the trustee, but they can skew the chiefly compensated equation.
The Clearing House proposes six modifications to Interim Rule 3b-17 to address the foregoing concerns.
First, permit each bank to determine whether it will apply the "chiefly compensated" test at the business unit or department level.9 Banks should be permitted to apply the test consistent with the manner in which the business of a bank is managed. If a bank or unit thereof is chiefly compensated by relationship compensation, and it complies with the other requirements of the trust exemption (in particular, that it does not publicly solicit brokerage business and that transactions are effected in a trustee capacity or in a fiduciary capacity in a department that is regularly examined by bank examiners), Congress' purpose will be satisfied. We note that this modification to Interim Rule 3b-17(a) would make Interim Rule 3a4-2 unnecessary.
Second, clarify the definition of "relationship compensation" and the concept of "unrelated compensation." In particular, the Clearing House proposes that all trust and fiduciary compensation other than sales compensation be explicitly included as relationship compensation. This should include fees from managing non-securities assets, such as real estate, even if such fees are charged separately. In addition, (i) to the extent that fiduciary or other laws require relationship compensation to be waived, or (ii) in states where such waiver is not required, if a bank has agreed with a customer that it will waive certain relationship compensation when sales or other compensation is received by the bank or its affiliate, the Clearing House proposes that such other compensation should be included as relationship compensation and not as sales compensation.
Also in connection with the definition of relationship compensation, the SEC should eliminate the requirement in Rule 3b-17(i) that fees be "received directly from a customer or beneficiary, or directly from the assets of the trust or fiduciary account" in order to qualify as relationship compensation. This requirement is not supported by the language of the statute and ignores the common practice of customers and banks negotiating fees on the basis that the bank will receive fees from others, whether from the recordkeeper under a 401(k) plan, a mutual fund under a Rule 12b-1 fee or otherwise.
Third, the SEC should treat all Rule 12b-1 fees received in connection with trust and fiduciary accounts as "relationship compensation". These fees are not calculated on a transactional basis; they represent a portion of assets invested in a fund. As the SEC recognized in connection with Rule 3a4-3, bank trust departments are frequently compensated for their services pursuant to Rule 12b-1 plans.
We note that under Section 21 of the Glass-Steagall Act banks may not "distribute" (as that term is defined for purposes of Glass-Steagall) securities, and thus, at least for Glass-Steagall purposes, such fees are not viewed as being for distribution but instead are viewed as being for providing administrative services. While we recognize that, for purposes of the rules of the National Association of Securities Dealers, Inc. (the "NASD"), the portion of Rule 12b-1 fees that may be for administrative services is limited to 25 basis points, we do not believe that that should be the relevant standard when interpreting the bank fiduciary exception. We believe that in interpreting the chiefly compensated test, which applies only to banks, it is more appropriate to refer to the understanding of the Rule 12b-1 fees under the Glass-Steagall Act than it is to refer to the NASD rules that were developed for entirely different purposes.
Even if the SEC does not agree that all Rule 12b-1 fees should be treated as relationship compensation, there can be no basis to treat the portion of Rule 12b-1 fees that are considered service fees under the rules of the NASD as anything other than relationship compensation. Even the NASD considers service fees to be paid for shareholder service or the maintenance of shareholder accounts. These services are comparable to trust administrative services, which are treated as relationship compensation. They have nothing to do with the execution of transactions, and they satisfy the statutory requirement of being calculated "on the basis of . . . a percentage of assets under management." We see no basis for characterizing fees the NASD considers to be service fees as sales compensation, as Interim Rule 3b-17(j)(6) does, merely because they happen to be paid under a Rule 12b-1 plan.10
Fourth, the SEC should provide that sales compensation must be less than 50% of total fiduciary compensation (i.e., the total of sales and relationship compensation). In particular, the Clearing House suggests that Interim Rule 3b-17(a) be revised to read, in relevant part, as follows:
"The term chiefly compensated means that the aggregate sales compensation received by a bank from its trust and fiduciary activities during the immediately preceding year shall not exceed 50% of the sales compensation and relationship compensation received by the bank from such activities during that year."
This approach both simplifies the application of the test as well as enhancing fairness.
Fifth, the Rule should be revised to eliminate the requirement in Rule 3b-17(b) that banks exclude expenses of resources not "dedicated" to the trust department in determining whether a flat or capped per order fee exceeds the "cost incurred by the bank in executing securities transactions." The clear language of GLBA refers to the cost of providing this service, without any limitation on type of cost. The Release does not even attempt to justify this clear deviation from the statutory language, and there can be no justification.
Sixth, grandfather as "relationship compensation" revenues received under pre-existing fiduciary arrangements. As discussed above, we believe it would be unfair to apply the chiefly compensated test to trust and fiduciary arrangements that were entered into before the establishment of parameters for categorizing compensation. Moreover, it will be difficult, costly and time-consuming to require banks to seek to modify their existing arrangements. We recognize that developing appropriate standards for grandfathering accounts will be a complex process involving determinations as to eligibility, cut-off dates, sunset provisions and other matters, and we do not believe that these issues can be properly addressed until the SEC has responded to the other comments in this letter and the comments of other parties. We would be interested in meeting with the staff of the SEC to discuss standards for grandfathering after revised rule proposals have been published.
2. Alternative Bank-level calculation of Interim Rule 3a4-2.
The Clearing House believes that the bank-level calculation of chiefly compensated permitted by Interim Rule 3a4-2 is not workable. This is primarily because paragraph (a)(2) of Interim Rule 3a4-2 effectively requires an account-by-account analysis at various times.11 The requirement for procedures to ensure compliance when sales compensation "is reviewed . . . for purposes of determining employee's compensation" cannot possibly be complied with, given that this may be done numerous times by numerous people without any notice to those responsible for compliance with the chiefly compensated test. The requirements for procedures to ensure compliance when the account is opened and when compensation arrangements are changed are also burdensome, unless the only procedure required is to design appropriate fee schedules. Moreover, the rule is unclear with respect to how the chiefly compensated test would be applied at the time an account is opened (because there are no historical revenues to measure) or at the other specified times (because the chiefly compensated test in Interim Rule 3b-17(a) is applied on a fiscal year basis).
The 10% limit is arbitrarily low and bears no relation to the concept of "chiefly." Additionally, the 10% calculation excludes sales compensation from the denominator (i.e., sales compensation must be less than 10% of relationship compensation). We believe any test should be measured against the sum of sales compensation and relationship compensation, as is the case with Interim Rule 3b-17(a).
If the definition of "chiefly compensated" in Interim Rule 3b-17(a) is amended as we have proposed above, Interim Rule 3a4-2 may be rescinded as superfluous. We believe that is the appropriate outcome.
3. Retrospective application of the test.
Under the Interim Rules, banks must determine whether they were in compliance with the chiefly compensated test throughout each year. Given the complexity of the test, we believe that monitoring compliance in the course of a year will prove extremely difficult if not impossible.12 (This is a problem whether the measurement is account-by-account or by business line or department.) Thus, a bank may not know until sometime in the following year whether it was in fact in compliance with the chiefly compensated test in a given year.13 The Release is unclear about the consequences if a bank finds in one year that it was not in compliance in the preceding year. Is the bank in ongoing violation of the broker-dealer registration requirement? What is the effect on the validity of transactions entered into by the bank during and after that year? How can a bank cure the non-compliance?
The Clearing House has several suggestions to address these questions. First, if a bank adopts procedures reasonably designed to ensure compliance and complies with the chiefly compensated test in a given year, it should have the benefit of a safe harbor during the following year, and should be deemed to be in compliance with the test unless non-compliance results from its own bad faith. In addition, the final rules should provide that a bank is permitted to fail the chiefly compensated test once during every five years, again assuming that procedures reasonably designed to ensure compliance have been adopted and that the failure is not due to its own voluntary actions. Lastly, the Clearing House proposes that banks be given the option of calculating compliance on a "rolling four quarters" basis. In this way, a bank could monitor its compliance and make adjustments before it is too late.
B. Definition of "trustee capacity".
As noted above, Section 3(a)(4)(B)(ii) creates an exception for a bank effecting transactions in a "trustee capacity" or in a "fiduciary capacity." Congress chose to define the term fiduciary capacity in GLBA, but it did not define the term "trustee capacity." Nevertheless, in the Release the SEC raised questions regarding whether certain trustee capacities qualify for the statutory exception "because banks in these situations may not be subject to significant fiduciary responsibilities."14 Later in the Release the SEC states that
"The law is unclear as to whether banks acting in these three capacities [i.e., indenture trustees, ERISA and other similar trustees, and IRA trustees] should be covered by the trust and fiduciary activities exception because they are acting, at most, in a limited fiduciary capacity with regard to investors who direct their investments, despite their "trustee" label."15
To "alleviate" this purported "uncertainty", the SEC adopted Interim Rule 3b-17(k) (and related Rule 3b-17(c)), not as interpretive rules but as exemptive rules under Section 36(a)(1) of the Exchange Act. Interim Rule 3b-17(k) defines "trustee capacity" to "include" indenture trustees and trustees for certain tax-deferred accounts (e.g., ERISA and IRA accounts).
The adoption of Interim Rule 3b-17(k) as an exemptive rule and the language of Release (including that quoted above) call into question whether other types of trustee capacities that are not subject to the highest possible fiduciary standards (e.g., "Rabbi" trusts, estate planning trusts, viatical trusts, insurance trusts, and trusts where another (e.g., individual) trustee possesses the investment discretion) qualify for the statutory exception.
We believe that it is clear that Congress intended that all trustee capacities qualify for the trustee exception. First, Congress' decision not to define "trustee capacity," which contrasts to its decision to define fiduciary capacity,16 demonstrates that it meant the term trustee to be given its normal, plain meaning. The absence of a statutory definition is of particular significance given that the trustee capacities called into question by the SEC are well known and indeed provided for in other federal statutes, such as the Trust Indenture Act and ERISA. It is unimaginable that Congress did not intend such trustee capacities to be covered by the statutory exception; if its intention were to exclude those capacities it would have done so explicitly.
Second, the SEC provides no support in the language or legislative history of GLBA for questioning whether indenture and other trustees qualify for the exception on the grounds that they may be subject to lesser fiduciary responsibilities than other trustees. There is, in fact, no suggestion in the language or legislative history of the statute of any requirement that a trustee be subject to a certain level of fiduciary responsibility to qualify for the statutory exception. Indeed, the imposition of such a requirement flies in the face of the clear language of the statute, because even the SEC recognizes that such trustees have "fiduciary responsibilities."
Third, the SEC's attempt to call into question the eligibility of certain trustee capacities for the trust exception is contrary to the express instructions of Congress, as stated in the Conference Report on GLBA, that "[t]he Conferees expect that the SEC will not disturb traditional bank trust activities under this provision."17
The Clearing House therefore believes that GLBA does not distinguish among types of trustees. It covers "trustee capacity" without qualification and does not impose any investment discretion or other additional fiduciary requirement.18
If, as a result of the Interim Rules' restrictive definition of "trustee capacity," banks were to be required to "push out" certain trust accounts to broker-dealers, chaos would result. It is unclear how a trust account may be pushed out of a bank to a broker-dealer. A broker-dealer may not act as a trustee and thus will be unable to fulfill the duties required by the customer. Paradoxically, under the Interim Rules, the bank will also be unable to fulfill these duties because its capacity with respect to the trust is not recognized as qualifying for the exception. Even if this issue can be solved, the mechanics of the push-out are administratively difficult. If the trust document associated with an account names a bank specifically as the trustee, how can that account be transferred to a broker-dealer? In some cases trust documents may not be amended without a court order, which can be difficult and costly to obtain. Furthermore, even after push-out, customers would continue to give instructions to their bank, as trustee, rather than to the broker-dealer. Thus, the interest of GLBA in furthering functional regulation would not be served by pushing out such trust accounts. Furthermore, GLBA, in Section 3(a)(4)(C) of the Exchange Act, requires a trustee to execute securities transactions through a registered broker-dealer, thus imparting an additional layer of investor protection.
It is also unclear to us how push-out of a trust may be effected when part of the assets in the account are self-directed (under settlor-directed trusts for example) and part are managed by the bank. This splitting of accounts would be even more cumbersome in situations where a single trustee fee is charged on the entire trust corpus.
The Clearing House also believes that pushing out certain trustee or fiduciary accounts, even if it were possible, would impose fiduciary liability, state law, jury trials and unlimited statutes of limitations on broker-dealers, who have historically not been comfortable with such forms of liability. Moreover, although banks are for most purposes excepted from the definition of "investment adviser" in the Investment Advisers Act of 1940 (the "Advisers Act"), broker-dealers are not. If fiduciary accounts are pushed out to a broker-dealer, the provision of advisory services by brokerage employees may raise questions about the broker-dealer's obligation to register under the Advisers Act.19 All of these considerations discriminate against broker-dealers affiliated with banks (which may have little choice but to accept such liabilities and obligations) and is unfair, because broker-dealers that are not affiliated with banks will not be required to assume this type of liability unless they choose to.
To address the forgoing concerns, the Clearing House proposes that Interim Rule 3b-17(c) be rescinded and that Interim Rule 3b-17(k) be amended to provide that "trustee capacity" refers to any trustee capacity unless the trust is a sham that serves no purpose other than to evade broker-dealer registration requirements. We believe this is more than adequate to address the concern expressed in the Release that banks will use the trust exemption to conduct securities brokerage activities through their trust department without broker-dealer registration, while still complying with GLBA.
C. Definition of "investment adviser if the bank receives a fee for its investment advice".
The Clearing House objects to the SEC's inclusion of the requirements of a "duty of loyalty" and that advice be "continuous and regular" in the definition of "investment adviser if the bank receives a fee for its investment advice" in Interim Rule 3b-17(d). These requirements are inconsistent with the language of GLBA and with Part 9 of the regulations of the OCC,20 from which the statutory definition was derived. Including these additional requirements is contrary to functional regulation because it involves the SEC in regulation of bank's fiduciary activities. The requirements also increase the administrative burden on banks by requiring that any individualized non-standardized arrangements for the provision of investment advisory services, which historically have been viewed as involving a fiduciary capacity, be reviewed for compliance with the "continuous and regular" and "duty of loyalty" requirements. We propose that these requirements be eliminated.
D. Examination by banking regulators.
In the Release, the SEC stated that "all aspects" of securities transactions must be conducted in an area that bank examiners examine for compliance with fiduciary principles. The Release goes on to state that:
"Effecting transactions in securities includes more than just executing trades or forwarding securities orders to a broker-dealer for execution. Generally, effecting securities transactions can include participating in the transactions through the following activities: (1) Identifying potential purchasers of securities; (2) screening potential participants in a transaction for creditworthness; (3) soliciting securities transactions; (4) routing or matching orders, or facilitating the execution of a securities transaction; (5) handling customer funds and securities; and (6) preparing and sending transaction confirmations (other than on behalf of a broker-dealer that executes the trades). In other words, for purposes of qualifying for the trust and fiduciary activities exception, the bank must make sure that all of the key points in a transaction that it participates in are in a part of the bank that meets the examination conditions of the exception." (footnotes omitted).21
This language of the Release (which is not actually contained in any of the Interim Rules) establishes a standard that cannot possibly be met by any other than the smallest of banks. Sound business practices and efficiency demand that banks not establish duplicative operations. Thus, bank proprietary trading operations, municipal securities departments and bank fiduciary departments frequently share back offices for such functions as routing orders and sending out confirmations. Bank fiduciary departments frequently rely on bank's credit departments for screening potential participants in a transaction for creditworthiness and on bank marketing departments for advertising advice.22
Banks should not be required to set up parallel back offices and other facilities solely for the purpose of relying on the fiduciary exception. The Clearing House requests clarification that the examination requirement is intended to apply only to the part of a bank that manages fiduciary accounts.
It may also be the case that a fiduciary account at a bank was originally solicited by employees outside the bank's fiduciary department. In light of the language of the Release, we request clarification that "all aspects" does not extend to solicitation of fiduciary business, and that solicitation by a different department would not preclude reliance by the fiduciary department on the fiduciary exemption.
IV. Networking: Employee Compensation
The Interim Rules provide definitions of the terms "referral" and "nominal one time cash fee of a fixed dollar amount" for purposes of the statutory exception for third-party brokerage, or "networking," arrangements. The Clearing House believes that these definitions unduly restrict the ability of banks to establish compensation arrangements for their employees and are inconsistent with the principal of functional regulation because they constitute an effort to regulate banks' internal affairs.
A. Networking: Referral Fees.
We believe the definition of "referral" in Interim Rule 3b-17(h) is too narrow. Under GLBA, payment of a referral fee may not be contingent upon whether the referral results in a transaction. Interim Rule 3b-17(h), however, imposes further constraints upon the circumstances under which a referral fee may be paid. Under the rule, "referral" is limited to the arranging of the first securities-related contact with an investor, and the term excludes subsequent activity that is not excluded by GLBA or by established precedent. As a result, the rule permits referral payments to be based solely on the quantity of referrals made by an employee.
GLBA does not prohibit conditioning payment of a referral fee upon the opening of an account, as the Interim Rules do, or on the customer's completing a profile or providing other information.23 We believe that GLBA permits a referral fee to be based upon whether an account is actually opened and the size of the account, so long as it is not conditioned on, or calculated on the basis of, transactional activity. Referral payments for bank, trust and mortgage products may be based on closed referrals. We believe there is no need for the SEC to adopt rules for referral fees that narrow the language of GLBA.
We also take issue with the Interim Rules' definition of "nominal one time cash fee of a fixed dollar amount." Defining nominal, for purposes of referral fee payments, in terms of an employee's hourly salary discriminates against lower paid personnel, is burdensome to administer, does not foster team building and may force banks to use ineffective programs that rely on the safe harbor of the lowest-paid person. Moreover, requiring that a points-based system be structured so that securities referrals result in no more points than any other product is unfair. A securities referral is more valuable than, for example, a safe deposit box referral.
In addition, the SEC's discussion of referral fees in the Release is vague and confusing. For example, the Release states that a referral fee system may be impermissible, even if it follows all of the guidelines provided, if it is structured in such a way that referral fees constitute a "substantial portion" of an employee's total compensation.24 If one referral in a day is acceptable, we see no reason why multiple referrals should not also be. Since referral compensation is not transaction-based, it cannot give a bank employee a "salesman's stake" in the effecting of transactions.
Banks have operated for many years in reliance upon established principles relating to referral fees, and there is no reason for the SEC to introduce further restrictions on the circumstances under which banks may pay referral fees or the amounts thereof. The Interagency Statement on Retail Sales of Non-deposit Investment Products25 has governed bank practices with respect to referral fees since it was adopted in 1994. We are not aware of investor protection problems or other issues arising from banks paying referral fees in compliance with the Interagency Statement.
In the Chubb Securities letter26 (Nov. 24, 1993), the SEC staff did not object to referral fees that are "nominal," provided that there be no more than one fee per customer referred and that the amount of the fee "be unrelated to the volume of securities traded by the customer." The incoming letter requesting no-action relief stated that the referral fee would be "a one-time fee of nominal, fixed dollar amount, wholly unrelated to the execution of securities transactions or the volume of securities traded by the customer." Of particular importance is the fact that in the Chubb letter, the staff did not find it necessary to quantify the term "nominal," and did not prohibit the payment of referral fees based upon the opening of an account or on the amount of assets gathered. The amount of referral fees must be unrelated only to execution and trading activity.
Placing limits on referral fees beyond those established by the language of GLBA is also contrary to the legislative history of GLBA. As Congress considered GLBA, the NASD had pending proposals (revisions to Rule 1060) that would have limited payment of incentive compensation by banks. The Conference Report on GLBA states that:
"The Conferees provided for an exception for networking arrangements between banks and brokers. Revisions to Rule 1060 recently approved by the National Association of Securities Dealers ("NASD") are in conflict with this provision. As a consequence, revisions to the rule should be made to exempt banks and their employees from the provision's coverage."27
In addition, the House Report on GLBA indicates that this exception "follows" SEC no action letters, citing the Chubb letter.28 This legislative history demonstrates that Congress did not intend the SEC to impose restrictions on referral fees beyond those contained in the language of GLBA.
With respect to circumstances of referral, the Clearing House believes that GLBA already closely parallels the Chubb letter. We suggest that further definition of referral fees is not necessary. If the SEC wishes to address this issue, Interim Rule 3b-17(g) should be amended to clarify that the term "transaction" as used at the end of Section 3(a)(4)(B)(i)(VI) refers to the effecting of securities trades, consistent with Chubb, and not to the opening of an account or the completion of a customer profile. The Clearing House believes that no definition of the term "nominal" is necessary. This is consistent with long practice under the Chubb letter.
Lastly, in response to the SEC's question in the Release inviting comments on whether there is any need for an overall cap on referral fees, the Clearing House believes there is no such need and that any such cap would be inconsistent with the clear language of GLBA.
B. Networking: Bonus Plans.
The Clearing House is also very concerned about the discussion in the Release regarding bonus plans. This discussion appears to go beyond the issue of referral fees without any basis in GLBA for doing so.
The Release states that "by their very nature [bonus plans] are incentive compensation" and then goes on to state that unregistered bank employees may not "receive incentive compensation for any brokerage-related activity" other than permissible referral fees.29 Interim Rule 3b-17(g) provides a safe harbor only for bonus plans that are based on the overall profitability of the bank. Few, if any, bonus plans are based solely on the stand-alone profitability of a bank, although that is a component of many plans. The rule results in the SEC's taking jurisdiction over bank and holding company bonus compensation plans, a matter that we believe is within the jurisdiction of the bank agencies. We believe that the legislative history demonstrates that Congress did not intend the term "incentive compensation" to apply to normal company-wide bonus plans.
The Clearing House proposes that the rule permit any bonus plan so long as it is not merely an indirect conduit for the payment of specific transaction-related referral fees to bank employees. We believe this gives effect to the statutory limitation on "incentive compensation" without unduly interfering with bank operations.
V. Custody and Safekeeping
A. Statutory Exception Includes Order-Taking and Other Limited Execution Services.
The Clearing House is concerned that Interim Rule 3a4-5 unduly restricts the ability of banks to rely on the exception from the definition of "broker" contained in Section 3(a)(4)(b)(viii) of the Exchange Act by limiting the fees that banks may charge as custodians for order taking and other limited execution services.
The term "custody and safekeeping" has traditionally been understood to include order-taking.30 The Clearing House believes that GLBA does not change this aspect of custody and safekeeping and continues to permit custodial order-taking. This is demonstrated by the statute's reference to individual retirement accounts and other retirement accounts31 and its requirement that custody trades be executed through a registered broker-dealer.32 There is no basis for the SEC to impose restrictions on custodial order-taking that go beyond those contained in the statute.
We understand that the SEC is concerned that banks may offer custodial arrangements as a surrogate for a brokerage account. Custodial accounts, however, serve many important functions for which brokerage accounts are not suitable.33 Moreover, banks do not offer custodial services as a way to solicit trading activity; banks in the custodial business merely follow instructions. No salesman commissions are paid for trades, so there is no incentive to encourage trading activity. Custodial accounts may generate shareholder servicing fees, but these are paid on the basis of assets held in custody rather than per-transaction, and therefore create no incentive to encourage trading. Finally, we note that the ability of banks to advertise or promote their custodial services is severely restricted by paragraph (a)(5) of Interim Rule 3a4-5. The Clearing House has no objection to restricting such activities in the context of the custodial exemption.
In addition to order taking, certain execution services are inherent in the custody business. For example, in the case of stock splits and mergers, banks must sell shares to give their customers cash in lieu of fractional shares. Custody customers often look to their custodians to sell odd lots of securities. These services should also be recognized as qualifying for the custody and safekeeping exception.
We also believe that pushing order-taking and these other execution services out of banks will adversely affect customers. The effect would be to require duplicative accounts (bank and brokerage) with the resultant increase in administrative costs and no real benefit to consumers.
B. Interim Rule 3a4-5.
For these reasons, the Clearing House believes that Interim Rule 3a4-5 is unnecessary. Moreover, the rule contains a number of requirements that cannot be met without substantial and unnecessary burdens. These requirements have the effect of preventing bank custody departments from continuing to provide their order taking and limited execution services.
First, Interim Rule 3a4-5 requires that a bank not "directly or indirectly receive any compensation for effecting [order-taking] transactions." Bank custody departments traditionally have charged a settlement fee, securities movement fee or similar processing fee. These fees have nothing to do with whether the bank executes an order; they apply even where execution is effected by a third party, with the securities delivered to or by the bank as custodian. Given that the activities of settlement and clearance are authorized for banks under GLBA, fees for these services should not be disturbed, provided that the fee charged the client for these services is not increased as a result of the bank's taking the order. We understand that the SEC does not interpret the Interim Rules to prohibit such settlement fees, securities movement fees and other fees. If the SEC retains a rule addressing this issue, this interpretation should be clarified in the final rule. If such fees were not allowed under the rules, banks' inability to be paid for custodial services would have a significant impact on the viability of the safekeeping and custody exemption.34
Second, bank custodians frequently work out arrangements with their customers whereby one element, and in some cases the predominant element, of their compensation is fees under Rule 12b-1 plans. The prohibition on receiving compensation for effecting order-taking transactions would appear to prohibit receipt of such payments, given how the SEC interprets the Rule 12b-1 fees. Banks need to be able to continue to receive such payments in order to continue to provide their traditional custody services.
Third, Interim Rule 3a4-5(a)(2)(i) provides that a bank employee effecting securities transactions for a custodial account may not be an associated person of a broker-dealer, must primarily perform duties for the bank other than effecting securities transactions, may not receive certain compensation, and may not receive compensation for referring any customers to the broker or dealer. These requirements are burdensome and unnecessary, and should be eliminated.
The prohibition on using associated persons to effect transactions does not appear to further any purpose under the Exchange Act. It discourages banks from having their employees become registered, and is inconsistent with the networking exception. It creates a problem for banks, because banks and their affiliates commonly combine back office and other operations, resulting, for example, in the same person who serves as financial and operations principal of a registered broker-dealer managing or overseeing the management of the execution, clearance and settlement operations of the bank's custody department. The prohibition on use of associated persons would call this into question, given the SEC's broad view of what is included within the term "effect."
The requirement that bank employees who effect transactions for custody operations "primarily perform duties for the bank other than effecting transactions in securities for customers" is a problem for banks that have personnel dedicated to this function. Again, it is difficult to see what purpose this requirement serves under the Exchange Act.
Fourth, the flat prohibition on referral fees is particularly inappropriate, given that such fees would encourage the movement of clients to a registered broker-dealer. Given that a custody department by definition deals with persons (usually institutions) who already have holdings of securities large enough to warrant hiring a bank to serve as custodian, this would seem almost the least likely context for referral fees to raise concerns.
Fifth, we do not understand why Rule 3a4-5 requires a bank to make available securities of investment companies that are not affiliated persons of the Bank if it makes available securities of investment companies that are affiliated persons.
Sixth, we do not interpret the Rule to restrict the payment of incentive compensation to employees of a bank custody department who introduce new custodial customers to the bank, and we recommend that the Rule be revised to make it explicit that such payments are not restricted.
Finally, we believe that the restrictions on solicitation in paragraph (a)(5) should be limited by their terms to solicitation of securities transactions in accounts for which a bank acts as custodian, consistent with the overall purpose of the Rule. This could be accomplished by inserting the word "such" after "The bank does not solicit".
VI. Sweep Accounts
Interim Rule 3b-17(f) limits the money market fund sweep exception in GLBA35 by incorporating a modified version of the definition of "no load" in the NASD's rule regulating sales of mutual funds.36 Under Interim Rule 3b-17(f)(1)(ii), a mutual fund satisfies the "no load" requirement of the sweep exemption only if its total charges for sales promotion expense and personal service or the maintenance of shareholder accounts do not exceed 25 basis points of average net assets. The rule excludes enumerated services, such as subtransfer agent services and aggregation of orders,37 from the definition of "personal service or the maintenance of shareholder accounts," and the Release states that such fees do not count towards the 25 basis point maximum even if they are charged under a Rule 12b-1 plan.38
Leaving aside for the moment the appropriateness of the 25 basis point cap (which is addressed below), the Clearing House believes that it will be utterly impracticable in many cases to determine whether a mutual fund meets this definition of no load. A mutual fund may have a stated Rule 12b-1 fee in excess of 25 basis points, but still be "no load" if the excess over 25 basis points is used for services enumerated in paragraph (f)(2) of Rule 3b-17. Conversely, a mutual fund may have a stated Rule 12b-1 fee of 25 basis points or less, but nonetheless not be "no load" if its prospectus shows a separate shareholder servicing fee.39
The Release suggests that a bank may request confirmation from a fund that it meets the Interim Rule 3b-17(f) definition of no load before including the fund in a sweep program. We are highly skeptical, however, that most mutual funds would be willing or able to provide such confirmation. Rule 12b-1 prohibits mutual funds from financing their own distribution unless such financing is conducted in accordance with the rule, which requires the adoption of a Rule 12b-1 plan. Although a fee that is solely for shareholder servicing, as opposed to distribution, would not require a Rule 12b-1 plan, we understand that many mutual funds nonetheless pay shareholder servicing fees pursuant to their Rule 12b-1 plans because their plans were initially adopted prior to the promulgation of the NASD rule that introduced the distinction between service fees and distribution fees, and/or out of the concern that service fees might be argued to be paid in whole or in part for distribution services.
Under the circumstances, we believe it is extremely unlikely that mutual funds will either be in a position, or be willing, to quantify precisely how much of their Rule 12b-1 fees and other expenses are used for sales promotion expense and personal service or the maintenance of shareholder accounts. This would be particularly true for mutual funds that have "compensation" Rule 12b-1 plans, in which the level of payments made by a fund is not specifically related to the cost of identified services provided.40
We turn now to the appropriateness of the 25 basis point limit. The Clearing House strongly believes that the term "no load" should be given its plain meaning: no explicit front end or back end load. The term "load" is commonly understood to refer to an amount paid by an investor, not an amount paid by the fund such as a Rule 12b-1 fee.41 The SEC's own Form N-1A requires disclosure of "Sales Charge (Load)" and "Deferred Sales Charge (Load)" in investment company prospectuses but categorizes Rule 12b-1 fees of any size as "Annual Fund Operating Expenses." Virtually all money market funds indicate "none" after "Sales Charge (Load)" and "Deferred Sales Charge (Load)." NASD Rule 2830, on which Interim Rule 3b-17(f) is based, is irrelevant in this context.
There are several reasons for preferring the plain meaning of the term "no load." First, Congress did not adopt the NASD advertising rule definition, and there is no indication that it should be read into the law. Rather, the House Report on GLBA states that the sweep exception "has the effect of permitting banks to continue investing depositors' funds into no-load money market funds."42 Both Senator Gramm and Representative Leach have also indicated that they did not intend this provision to change current practice.
Second, both the SEC and the Division of Market Regulation have in the past referred to funds with no sales load upon purchase or redemption as "no load" funds, without reference to 12b-1 fees. Indeed, two rules promulgated by the SEC under the Exchange Act demonstrate the SEC's view that no load funds are those funds without front-end or deferred sales charges.
Rule 10b-10 under the Exchange Act was amended in 1983 to permit alternative periodic reporting (instead of confirmations of each transaction) for purchases and sales of money-market funds, provided that "no sales load is deducted upon the purchase or redemption of shares."43 The provision makes no reference to 12b-1 fees. The rule was amended in this way in part to accommodate broker-dealer sweep accounts by eliminating the requirement for daily confirmations. In the release adopting the amendment, which was issued more than two years after the adoption of Rule 12b-1, the SEC referred to funds without a sales load upon purchase or redemption as "no load" funds.44
Rule 3b-9 under the Exchange Act uses the term "no-load" in a sweep exemption that closely parallels the GLBA exemption. Its adopting release describes such funds as funds that "do not charge a sales load" and refers to "the absence of a sales load."45 Again, no reference is made to Rule 12b-1 fees. Moreover, a separate discussion of Rule 12b-1 fees in the same release identifies such fees as "transaction-related compensation" and indicates that, if a bank fails the first prong of Rule 3b-9 ("publicly solicits brokerage business for which it receives transaction-related compensation") in respect of fund shares because of Rule 12b-1 fees, it would still be able to take advantage of the no-load sweep exemption in respect of that fund.46 This clearly demonstrates that the SEC did not consider 12b-1 fees of any size to be "loads."
The SEC states in the Release that "[h]istorically, the term `no load' was viewed as meaning that neither investors in the fund, nor the fund itself, bore the costs of distributing the fund's shares". As we have shown above, the historical use of the term "no load" in fact focused exclusively on front-end and deferred sales loads paid by investors, without reference to costs paid by a fund. The only instance we have been able to find in which the SEC expressed the view stated in the Release was in a 1988 release proposing amendments to Rule 12b-1.47 However, those amendments were not adopted, and as far as we have been able to determine, the position was not clearly articulated thereafter until the Release.
A third reason to prefer a plain reading of the term "no load" is that sweep accounts are a benefit to bank customers that banks may be unwilling or unable to provide if the fees they earn are curtailed.48 Sweep accounts provide a way for bank customers to earn a return on their demand deposit balances, on which banks are prohibited by law from paying interest. Sweep accounts are expensive for banks to establish and maintain, because by definition they involve excess cash (i.e., cash that the depositor cannot profitably invest) and a high volume of daily transfers. Traditionally, the fees earned by banks are small compared to the cost to the bank and the benefit to customers. Moreover, the arrangements are entirely transparent to customers, who receive the money market fund's prospectus, which discloses the fee structure.
Fourth, the Release makes clear that a bank could charge a sweep fee directly to its customers and continue to rely on the "no load" exemption. (The restriction would apply only if fees imbedded in a mutual fund exceed 25 basis points.) If a higher total fee is permissible when a portion of it is charged directly by a bank, we see no reason whatsoever why the same total fee could not be charged entirely against fund assets. Charging sweep fees at the account level instead of the mutual fund level would be administratively burdensome, would increase banks' costs of providing the sweep service, and would impair the transparency of the current arrangements. Permitting a fee but then requiring that it be charged at the account level serves no purpose.
Fifth, we believe that requiring certain sweep accounts to be pushed out of the bank will adversely affect customers. Push-out would require duplicative accounts (bank and brokerage) and funds transfers between banks and brokers, with the resultant increase in unnecessary administrative costs and burdens, without any real benefit to customers, especially in the context of investments in money market mutual funds.
Finally, we wish to point out that, even if banks were to waive receipt of any fees in excess of the permitted 25 basis points, the waiver would not necessarily have the effect of reducing a mutual fund's overall fees to a permissible level. Rule 12b-1 fees are paid in equal amounts by all shares of a mutual fund (or all shares of a single class in the case of funds with multiple classes). Waiver of part or all of a 12b-1 fee by one or more recipients will reduce the overall fee level paid by the fund (or class) by less than the amount of the waiver.49
To address the foregoing concerns, the Clearing House urges the SEC to rescind clause (f)(1)(ii) of Interim Rule 3b-17, so that the term "no-load" is defined exclusively by reference to the absence of a front-end or deferred sales load, without reference to Rule 12b-1 fees. We note that the definitions in Interim Rule 3b-17 are by their terms limited to use under Section 3(a)(4), and we would not object to a statement in the amending release or in the rule itself to the effect that this definition of no load is not intended to have application in any other context.
VII. Dual Employees
Note 289 to the release suggests that the SEC expects the NASD to use NASD Rule 3040 to cause bank-affiliated broker-dealers to become involved in overseeing the bank activities of registered personnel of broker-dealers, and in doing so for the NASD to become involved in overseeing such activities. This contradicts the theory of functional regulation that is fundamental to GLBA, i.e., that bank activities should be regulated by the banking regulators.
The intent of Rule 3040 was not to cause the NASD to examine the activities of banks. Rather, by requiring prior notice of "private securities transactions" by registered personnel, Rule 3040 seeks to prevent registered personnel from conducting unlawful unregulated activity "off the books." The prospect of regulation by the NASD will be a disincentive to banks to cause their employees to become registered with a broker-dealer. This is contrary to the clear intent of GLBA to encourage dual functioning.
To address this concern, the Clearing House requests the cooperation of the SEC in obtaining an amendment to NASD Rule 3040. The amendment should (a) allow a securities firm to give blanket consent to its employees to be dual employees with the bank50 and (b) provide that bank activities may be supervised only by managers in the bank, subject to the broker-dealer's being informed if the employee engages in securities fraud in the bank.
VIII. Good Faith Compliance
The Clearing House is concerned that no provision has been made in the Interim Rules, other than Rule 15a-8, for failures to comply with the push-out provisions, despite good faith efforts to do so. The push-out requirements and statutory exceptions therefrom, along with the Interim Rules, are extremely complicated, and compliance will be quite difficult even if the changes to the Interim Rules we have proposed are made. Banks should not be penalized if they have appropriate procedures in place and fall out of compliance due to inadvertence or unforeseen circumstances. This is especially true in light of the potentially severe penalties for noncompliance, which may include criminal liability and the voiding of contracts.
The Clearing House urges that a new rule be adopted providing that a bank that attempts in good faith to conduct its securities activities in conformance with the push out requirements, and that has in place policies and procedures reasonably designed to result in compliance therewith, will not be considered a broker-dealer merely because some of its securities transactions do not satisfy all the conditions for an exception.
In addition, we are deeply concerned about the potential extent of the civil liability of a bank that falls out of compliance due to inadvertence or unforeseen circumstances. If a bank applying the chiefly compensated test on an account-by-account basis fails the test with respect to one account or a small number of accounts (and the de minimis exception is not available), we believe it would be draconian to subject the bank to potential civil liability, and the voiding of contracts, in respect of all of its accounts. Perhaps more ominously, if a bank inadvertently fails any one of the enumerated exceptions in Section 3(a)(4)(B), it potentially could be exposed to liability for its activities under all such exemptions. We strongly urge the SEC to adopt rules that limit a bank's civil liability for noncompliance with the final rules to the customer or group of customers that received the services, or were parties to the transactions, that resulted in noncompliance. These are the only parties in respect of which the bank acted as a broker-dealer, and they are thus the only parties that should be entitled to assert a claim for violation of the broker-dealer registration requirements.
With respect to Interim Rule 15a-8, we strongly support the exemption from Section 29(b) of the Exchange Act. In light of the complexity of the push-out requirements, we urge the SEC to extend the term of Interim Rule 15a-8 until at least one year after the final rules take effect.
IX. Mutual Fund Transactions: Interim Rule 3a4-6
The Clearing House appreciates the SEC's clarification in Interim Rule 3a4-6 regarding transactions with NSCC's Mutual Fund Services. We believe, however, that the rule also needs to provide an exemption for transactions directly with a mutual fund's transfer agent. This would address the fact that not all mutual fund transactions are effected through NSCC's Mutual Fund Services. In some instances, banks maintain an omnibus account with a mutual fund's transfer agent and send purchase and redemption orders directly to the transfer agent rather than through NSCC.
The Release states that using NSCC "simplif[ies] and automate[s] the process for purchasing and redeeming investment company securities without raising investor protection concerns" and implies that investor protection concerns are alleviated because registered clearing agencies such as NSCC are subject to the SEC's supervision and regulation.51 Since registered transfer agents are also subject to the SEC's supervision and regulation, the same policy considerations are applicable. Moreover, there is no clear benefit to investors, and there may be incremental costs, associated with the interposition of a registered broker-dealer in every mutual fund trade that is not effected through NSCC. We recognize that many mutual fund complexes have an arrangement with a registered broker-dealer that acts as principal underwriter or distributor; however, such distributors appear principally to provide a wholesaling function and have not in the past been involved in the placement of orders by banks.
The Clearing House accordingly proposes that Interim Rule 3a4-6 be amended to apply to transactions in investment company securities effected directly with a mutual fund or its transfer agent as well as to transactions effected through NSCC's Mutual Fund Services.
We note that Rule 3a4-6 is available only to a bank that meets the conditions for an exemption or exception from the definition of the term broker except that it does not direct trades to a broker-dealer for execution. To the extent that a bank relying upon Rule 3a4-6 is also relying upon the statutory exception for trust activities or custody and safekeeping, the comments we have made above regarding the Interim Rules relating to such exceptions also apply to transactions by a bank with NSCC or directly with a mutual fund or its transfer agent.
X. Recordkeeping Requirements
The SEC has requested comments on whether the bank regulatory agencies' recordkeeping requirements will be adequate to establish compliance with the exceptions under GLBA or whether the SEC should adopt its own recordkeeping rules. As discussed above, Congress explicitly gave the banking agencies responsibility for adopting recordkeeping requirements under Sections 3(c)(4) and (5) of the Exchange Act. We do not believe that the SEC has authority to do so, nor do we believe are any such SEC rules necessary or appropriate.
XI. Asset-backed securities: "Predominantly Originated"
The definition of "dealer" in the Exchange Act includes a limited exception for banks that engage in the issuance or sale of certain asset-backed securities, provided that the underlying obligations are "predominantly originated" by the bank, certain affiliates, or a syndicate of which the bank is a member.52 Interim Rule 3b-18(g) defines "predominantly originated" to mean that 85% of the obligations underlying asset-backed securities must have been originated by the bank and its non-broker-dealer affiliates or a syndicate of which the bank is a member. Under Interim Rule 3b-18(c), a bank is not a "member of a syndicate" unless it has contributed at least 10% of the money loaned by the syndicate.
The Clearing House is concerned that the 85% threshold in Interim Rule 3b-18(g) is too high. According to the Release, the SEC selected 85% by analogy to another provision of GLBA that uses the word "predominantly." Under that provision, a firm is "predominantly" engaged in financial activities if it derives 85% of its gross revenues (excluding revenues from banks) from financial activities. The Clearing House believes that this analogy is inappropriate. The concept of gross revenues from various financial activities bears no relation to the concept of a pool of mortgages. Different financial activities may generate different levels of revenues, so a higher test may be appropriate for the financial activities test. For a mortgage pool, where one component is similar to another, we believe that the plain meaning of "predominant" is a simple majority. Accordingly, we propose that predominantly be defined in Interim Rule 3b-18(g) to mean more than 50%.
The Clearing House is also concerned that the 10% test for syndicate membership in Interim Rule 3b-18(c) is too high. There is no reason to impose a minimum percentage on the concept of syndicate membership. The 10% test discriminates against smaller banks that may be unable to securitize loans individually and must participate in syndicates, but which individually constitute less than 10% of a syndicate. We propose that any percentage test or other definition for membership in a syndicate be eliminated. Membership in a syndicate is sufficiently unambiguous to require no definition.
* * *
The Clearing House would be pleased to discuss any of the points made herein in more detail. If you have any questions, please contact Norman Nelson, General Counsel, at (212) 612-9205.
Jeffrey P. Neubert Footnotes
|1||The member banks of the Clearing House are: Bank of America, National Association; The Bank of New York; Bank One, National Association; Bankers Trust Company; The Chase Manhattan Bank; Citibank, N.A.; European American Bank; First Union National Bank; Fleet National Bank; HSBC Bank USA; Morgan Guaranty Trust Company of New York and Wells Fargo Bank, National Association.|
|2||Release No. 34-44291, 66 Fed. Reg. 27760 (May 18, 2001). The deadline for submitting comments was extended on July 18, 2001 to September 4, 2001. Release No. 34-44569, 66 Fed. Reg. 38370 (July 24, 2001).|
|3||Release No. 34-44570, 66 Fed. Reg. ______ (July __, 2001) (the "July Release").|
|4||Section 3(a)(4)(B)(i) of the Exchange Act.|
|5||66 Fed. Reg. 27,760, 27,773 (2001).|
|6||Nor do we understand the statement in the Release that the SEC "considered, alternatively, whether this calculation should be made on a transaction-by-transaction . . . basis." Because revenues earned on a transactional basis are likely to be deemed sales compensation, such an approach would effectively have precluded banks that rely on the trust exception from engaging in any securities transactions. That is plainly not the intent of the statute.|
|7||Prohibited Transaction Class Exemption 77-4, 42 Fed. Reg. 18732 (April 8, 1977).|
|8||E.g., N.Y. Est. Powers & Trust Law, § 11-2.2(b)(i) (consol. 2001).|
|9||We are not opposed to permitting the determination to be made on an account-by-account basis as an alternative, but, for the reasons set forth earlier in this letter, we are doubtful that many banks would choose that approach.|
|10||A fee that is solely for shareholder servicing need not be paid under a Rule 12b-1 plan. We understand, however, that many mutual funds nonetheless pay shareholder servicing fees pursuant to their Rule 12b-1 plans, with the approval of their boards of directors or trustees, out of the concern that such fees might be argued to have been paid in whole or in part for distribution services.|
|11||As noted above, we believe that an account-by-account test is contrary to the statute, and this discussion of burden is not to suggest otherwise.|
|12||For example, for some accounts transaction fees may tend to be payable in clusters, whereas the payment of relationship fees charged as a percentage of assets will tend to be made periodically (usually quarterly). The would be the case with an account that seeks to replicate a stock index and rebalances its positions annually.|
|13||We doubt that this determination could be made conclusively before a bank's audited financial statements become available.|
|14||66 Fed. Reg. 27,760, 27,767 (2001).|
|15||Id. at 27,768.|
|16||The rule's narrow definition of "trustee capacity" stands in stark contrast to the broad statutory definition of "fiduciary capacity" in GLBA, which includes not only a thorough enumeration of various fiduciary capacities, but also a residual provision to capture banks acting in similar capacities that are not enumerated.|
|17||H.R. Rep. No. 106-434 at 164 (1999).|
|18||The SEC also requests comment on whether there are additional roles, functions or relationships of banks that should be considered as an "other similar capacity" for the purpose of the statutory definition of fiduciary capacity. We believe that banks performing an escrow function should be deemed to be acting in a fiduciary capacity, without prejudice, however, to a bank's ability to rely on the exemption for custodial activities.|
|19||The obligation might also arise if a broker-dealer is required under NASD Rule 3040 to supervise the investment advisory activities at a bank of its dual employees.|
|21||66 Fed. Reg. 27,760, 27,772-27,773 (2001).|
|22||With respect to the latter, the Clearing House is troubled by the suggestion in footnote 124 of the Release that advertising must be conducted in a part of a bank that "meets the examination conditions of the exception."|
|23||Bank employees traditionally have helped customers fill out certain account documentation that may also be used by their affiliated broker-dealers. This is well within the statutory language of "clerical or ministerial" and does not fall within the SEC's own definition of "solicitation" in Note 124 to the Release. (66 Fed. Reg. 27,760, 27,772)|
|24||66 Fed. Reg. 27, 760, 27, 766 (2001).|
|25||Interagency Statement on Retail Sales of Non-deposit Investment Products. (February 15, 1994), 7 Fed. Banking L. Rep. (CCH) ¶ 70-101.|
|26||Chubb Securities Corporation, SEC No-Action Letter, [1993-1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 76829 (Nov. 24, 1993).|
|27||H.R. Rep. No. 106-434, at 164 (1999). The proposed amendments to Rule 1060 provided that unregistered personnel of a broker-dealer could engage in limited marketing activities, such as inquiring whether a prospective customer wished to discuss investments with a registered person. Related interpretive material in proposed IM-3010(e) provided that unregistered marketers could be compensated on an hourly or salary basis only and could not receive any bonus or additional compensation or other incentives tied to transactions. Release No. 34-40784, 63 Fed. Reg. 70173 (Dec. 18, 1998). The Conference Report made it clear that these limitations were not to apply to networking arrangements.|
|28||H.R. Rep. No. 106-74, pt. 3, at 163.|
|29||66 Fed. Reg. 27,760, 27,766 (2001).|
|30|| "The principal duties of a custodian are (1) to receive, issue receipts for, and safely keep securities; . . . (8) to buy, sell, receive, or deliver securities on specific directions of the customer." I. A. Scott, The Law of Trusts § 8.1 (3rd Ed. 1967), citing a publication of the American Institute of Banking (Trust Business I, 315 (1944)) (emphasis added).
"In one type of agency the trust institution undertakes to look after the securities of the depositor deposited with it. Its duties, though important, are ministerial rather than discretionary in character. As to matters involving discretion it acts only on the orders of the customer. In such a case it is commonly said to be a custodian." Id. at § 8.1.
|31||Section 3(a)(4)(B)(viii)(I)(ee) of the Exchange Act.|
|32||Section 3(a)(4)(C) of the Exchange Act.|
|33||For example, customers may choose to open a custodial account because they desire the safety of having their assets held by a bank, or because they desire a centralized location to hold and settle their assets irrespective of where transactions are executed.|
|34||In addition, we request that the SEC clarify that a bank does not "indirectly receive any compensation" within the meaning of Interim Rule 3a4-5 if the bank's registered broker-dealer subsidiary receives such compensation. Our concern is that the use of the word "indirectly" might raise an issue with using a broker-dealer that is a subsidiary of the bank (as opposed to a brother/sister affiliate, or an unaffiliated broker-dealer) to execute orders.|
|35||Section 3(a)(4)(B)(v) of the Exchange Act.|
|36||NASD Rule 2830(d)(4).|
|37||We will refer to these for simplicity as "permitted services."|
|38||66 Fed. Reg. 27,760, 27,779 (2001).|
|39||In this regard, we wish to point out an inconsistency in the Interim Rules' treatment of shareholder servicing fees that are not paid under Rule 12b-1 plans. For purposes of the "chiefly compensated" test, they are relationship compensation (Rule 3b-17(j)(6)); but, for purposes of the definition of "no load," they are treated as a sales load, which is sales compensation.|
|40||See "Memorandum for Staff Use in Responding to Public Inquiries Regarding Disclosure and Other Issues Raised By Certain Types of 12b-1 Plans" (avail. June 4, 1986).|
|41||These are substantively different fees. The effect of a Rule 12b-1 fee on a short-term investment is far smaller than the effect of a front-end or back-end load. For example, $1 million invested for 10 days in a fund with a 75 basis point Rule 12b-1 fee would be subject to a fee of about $205. If the investment were instead subject to a 75 basis point front-end or back-end load, the charge on the same investment would be $7,500.|
|42||H.R. Rep. No. 106-74, pt. 3, p. 167 (emphasis added).|
|43||Rule 10b-10(b)(1) under the Exchange Act.|
|44||Release No. 34-19687, 48 Fed. Reg. 17583(April 18, 1983).|
|45||Release No. 34-22205, 50 Fed. Reg. 28385 (July 1, 1985).|
|46||Id. at text accompanying notes 41-42.|
|47||Release No. IC-16431, 53 Fed. Reg. 23258 (June 21, 1988).|
|48||It is certainly the case that, under the Interim Rule's definition of no load, banks would be able to offer their customers at most a far smaller menu of mutual funds for sweep purposes.|
|49||For example, assume a mutual fund has a Rule 12b-1 fee of 60 basis points, and half of its outstanding shares are held by bank sweep accounts and the other half by brokerage accounts. If all the banks waive their entire Rule 12b-1 fees, the effective fee rate paid by the fund will be reduced only to 30 basis points (because the shares held in brokerage accounts will continue to pay 60 basis points on half the fund's assets). Thus, even though the banks forego any compensation, the fund would still not be "no load" for purposes of Rule 3b-17(f).|
|50||Such a blanket consent should also be available to satisfy the notice requirements applicable to outside business activities of registered personnel in NASD Rule 3030 to the extent that such activities are subject to the regulation of a federal banking agency.|
|51||66 Fed. Reg. 27,760, 27,786 (2001).|
|52||Section 3(a)(5)(C)(iii) of the Exchange Act.|