The provisions of Regulation R adopted jointly by the Federal Reserve Board (FRB) and the Securities and Exchange Commission (SEC) become effective for banks, thrifts, and trust companies commencing on the first day of their fiscal year beginning after September 30, 2008. Banks and thrifts with a fiscal year based on the calendar year, compliance will begin on January 1, 2009. The banking industry strongly advocated that traditional banking activities, including trust and custody activities, should remain in the bank and not be subject to broker regulation by the SEC. Under the new regulation, most banks should be able to continue to conduct their trust and custody activities within the bank, free from the oversight of SEC and other securities regulatory authorities.
Regulation R has resulted from the passage of the Gramm-Leach-Bliley Act (GLBA) which was designed to modernize regulation of the financial services industry and to encourage competition by allowing financial services providers to offer products and services under the theory of functional regulation (i.e., bank products to be offered through a bank subject to bank regulatory supervision and securities products to be offered through a broker-dealer subject to SEC supervision). In moving toward functional regulation, GLBA eliminated the blanket exemption from registration for securities activities conducted in banks. In its place, the GLBA provided for several securities activity–based exceptions from broker-dealer registration.
I. REGULATION R
Regulation R exempts banks from broker-dealer registration for securities activities falling within a set of specifically defined exceptions. All non-excepted securities brokerage activities will need to be “pushed out” into an affiliated or third-party broker-dealer firm.
II. TRUST AND FIDUCIARY EXCEPTION
The trust and fiduciary exception under Regulation R applies to all personal, institutional, charitable, and corporate trust accounts. It also applies to all managed agency and investment advisory accounts – essentially any account for which a national bank would be required to conduct an annual review.
A bank is exempt from registering as a broker-dealer for securities transactions effectuated in a trustee or fiduciary capacity if it is “chiefly compensated” for those transactions on the basis of specific types of “relationship compensation.” For purposes of Regulation R, “relationship compensation” is defined to include assets under management fees; administrative fees; annual fees; 12b-1 fees; shareholder services fees; fees for personal services, tax preparation, or real estate settlement services; fees associated with securities lending or borrowing transactions; wire transfer and other fees associated with dispersing funds from, or for recording receipt of payments to, a trust or fiduciary account; custody service fees; and performance based fees.
Regulation R established a test to determine how a bank is “chiefly compensated” and provides banks with the flexibility to elect to perform the test on either an account-by-account or bank-wide basis. For the bank-wide test, “relationship compensation” must be divided by total compensation and the quotient must be at least 70 percent. For the account-by-account approach, “relationship compensation” divided by total compensation must be greater than 50 percent.
Both options use a two-year rolling average of the compensation attributable, depending on the test, to either the specific trust or fiduciary account or the bank’s trust and fiduciary business. As a result, banks with a fiscal year based on the calendar year will need to initially demonstrate compliance with the applicable test on January 1, 2011. Exempted from the relationship-total compensation percentage are fees that are not earned on an account, such as soft dollars, trust departments credits for deposits made on the commercial side of the bank, and revenue from the sale of assets. Banks may also exclude any compensation associated with a securities transaction conducted in accordance with any of the other statutory exceptions or Regulation R exemptions as long as the bank excludes that compensation from both relationship compensation and total compensation. For example, a bank functioning as a directed trustee with respect to a particular account or line-of-business treating those accounts as exempt under the custody exemption, would not include revenue earned on that account or line-of-business in either relationship or total compensation.
Initial exemptions from the “chiefly compensated” test include accounts that are open for less than 3 months; accounts that were acquired as part of a business combination or asset acquisition; or a certain de minimis number of accounts.
III. SAFEKEEPING AND CUSTODY EXCEPTION
The GLBA provided an exemption from broker registration for banks to the extent they offer safekeeping and custodial services, including clearance and settlement services, and conduct securities lending and borrowing transactions on behalf of these accounts. Regulation R further exempts banks that accept securities orders from their custodial account holders or their advisors. Orders for securities transactions from employee benefit plan accounts, individual retirement accounts (IRAs), and similar accounts, including Health Savings Accounts (HSAs), can be accepted under less restrictive conditions than all other types of accounts for which the bank acts as custodian.
In order to qualify for the safekeeping and custodial exemption, no bank employee may receive compensation, including 12b-1 fees, from the bank, the executing broker or dealer, or anyone else based on whether a transaction is executed for the account or on the quantity, price, or identity of the securities purchased or sold by the account. Notwithstanding the prohibition against bank employees from receiving compensation based on order-taking services provided to the account, the bank employee may receive bonus compensation based on the opening of the custody account, assets held in the account, or revenue generated by the account. Certain advertising restrictions prohibit a bank from marketing order-taking services, separate and apart from its other custodial services.
When a bank accepts securities orders for non-employee benefit, IRA, and HSA custodial accounts, it does so on an accommodation basis. Thus, for example, a bank may accept securities orders for accounts for which the bank acts as escrow agent, issuing and paying agent, tender agent, or disbursement agent on an accommodation basis.
Order taking as an accommodation is subject to further restrictions, including a prohibition on providing investment advice or research, while making recommendations concerning securities in the account or otherwise soliciting the securities transactions from the account holder. However, the bank would not be precluded from providing investment research generated by the trust department as a tool to market its trust in fiduciary services. The bank’s charges for effecting a transaction for the account, such as a security settlement fee, cannot vary based on whether the bank accepted the order for the transaction, or on the quantity or price of the securities to be bought or sold. The securities settlement fee can, however, vary based on the type of security – for example, public vs. private, or foreign vs. domestic.
Banks acting as directed trustees without investment discretion, non-fiduciary recordkeepers and administrators, and subcustodians may also rely on the safekeeping and custody exemption and offer order-taking services to their clients.
Under both the safekeeping and custody exception, all orders for securities, other than non-exchange-traded mutual funds and variable annuities, must be directed to a broker-dealer for execution.
IV. NONCUSTODIAL SECURITIES LENDING
Regulation R allows a bank to engage in “securities lending transactions” and “securities lending services” with “qualified investors” or employee benefit plans that own and invest, on a discretionary basis, not less than $25 million in investments.
V. NETWORKING EXCEPTION
Unlicensed bank employees – including employees of bank trust and custodial departments – may receive compensation for referring bank customers to a broker-dealer. The referral fee must be “nominal” and not tied to the success of the transaction. Under Regulation R, “nominal” is defined as twice the average of the minimum and maximum hourly wage for the employee’s job family; 1/1000th of the average minimum and maximum annual base salary for that employee’s job family or, alternatively, 1/1000th of the employee’s actual annual base salary; twice the employee’s actual base hourly wage, or $25. The regulation clarifies that non-cash referral programs for securities referrals are prohibited. More than one bank employee may receive payment for a single referral, as long as the payments go only to employees personally involved in the referrals.
Banks may also pay non-licensed employees referral fees that do not meet the definition of “nominal” for referrals of certain institutional customers and high net-worth customers. For purposes of the regulation, an institutional customer is defined as an entity that has, or is controlled by an entity that has, at least (a) $10 million in investments; (b) $20 million in revenues; or (c) $15 million in revenues if the bank employee refers the customer to the broker-dealer for investment banking services.
A high net-worth customer is a natural person who, either individually or with his or her spouse, has at least $5 million in net worth, excluding the primary residence and associated liabilities of the person and, if applicable, his or her spouse.
Bank bonus plans that are based on the overall profitability or revenue of a bank, operating unit of a bank – for example, a branch – or geographic region are permitted, as are multi-factor bonus plans that include multiple and significant factors or variables that are not related to securities transactions at the broker-dealer. The multi-factor bonus plan requirement would appear to be satisfied under a bonus plan including multiple metrics involving bank deposits, credit, cash management, personal and institutional trust, as well as brokerage products offered by an affiliated firm.
VI. SWEEP ACCOUNTS AND MONEY MARKET FUND TRANSACTIONS
Banks are authorized to sweep deposits into no-load money market funds without registering as a broker under Regulation R. A conditional exemption is also available for transactions in money market funds that are not no-load and for transactions that are not sweeps. In order to qualify for the conditional exemption involving funds that are not no-load, banks must provide the customer with the prospectus showing the fund’s fees and may not characterize the fund as no-load. As a result, banks may offer money market mutual funds to all clients, including their trust clients, without registering their employees as registered representatives.