Many broker-dealers engaged in the structured products industry are affiliates of large U.S. banks, which have a significant customer footprint. When yields are low on conventional banking products, such as fixed-rate certificates of deposit or savings accounts, broker-dealers and bank customer relations specialists alike are especially mindful that structured products may be useful investments for some bank customers.
If broker-dealer services are offered on a bank’s premises, or if bank employees refer bank customers to the brokerdealers, the participants must be aware of, and comply with, FINRA Rule 3160 and SEC Rule 7011 of Regulation R, which govern these arrangements. In this article, we summarize some of the key provisions of these rules.
Scope of Regulation
Rule 3160 regulates “networking arrangements,” in which a FINRA member conducts broker-dealer services on or off the premises of a financial institution. For example, a broker-dealer may utilize a portion of the space at a bank branch to offer its services. Alternatively, there may be a referral arrangement in place under which bank employees will refer customers to the broker-dealer, typically in exchange for a referral fee.
Identification of the FINRA Member
If a FINRA member conducts broker-dealer services on the premises of a financial institution, such as a bank branch, it must:
- clearly identify itself as the party providing the broker-dealer services;
- distinguish its broker-dealer services from the services of the financial institution;
- conduct its broker-dealer services in an area that clearly displays the FINRA member’s name; and
- to the extent practicable, operate its broker-dealer services in a location that is physically separate from the routine retail deposit-taking activities of the financial institution.
These requirements are all designed to help ensure that a customer will not confuse the products and services offered to him or her by the broker-dealer with those of an FDIC-insured bank.
Written Agreement Between the Parties and Rule 701
Networking arrangements between a FINRA member and a financial institution, whether or not they are affiliated entities, must be governed by a written agreement. This agreement will set forth the responsibilities of the parties and their compensation arrangements; it must include all broker-dealer obligations required by Rule 701 of SEC Regulation R. The Regulation R obligations are imposed upon the FINRA member under Rule 3160, whether or not set forth in the written agreement.
Among other requirements of Rule 701, a referral fee cannot be paid by the broker-dealer to a bank employee unless the referred customer is a “high net worth customer” or an “institutional customer,” as these terms are defined in Rule 701. Similarly, the broker-dealer must perform an appropriate suitability analysis as to the proposed transaction before paying the referral fee (or determine that the relevant customer has the ability to evaluate the relevant investment risk on its own, and is in fact exercising its independent judgment). Needless to say, for structured products, particularly those that are complex, the suitability analysis is likely to be more rigorous than that which may be undertaken for a more conventional financial product.
The written agreement must provide that the FINRA member’s supervisory personnel, and any representatives of the SEC or FINRA, will be permitted access to the financial institution’s premises where the member conducts broker-dealer services in order to inspect the books and records and other relevant information maintained by the member with respect to its broker-dealer services.
Rule 3160 requires the FINRA member to promptly notify the financial institution if any associated person of the FINRA member who is employed by the financial institution is terminated for cause by the member. This requirement will often be set forth in the networking agreement.
Required Customer Disclosures and Communications
Upon or prior to opening a customer account by the applicable FINRA member, the broker-dealer must disclose in writing to each customer that its broker-dealer services are being provided by the FINRA member and not by the financial institution, and that the “securities products” purchased or sold in a transaction are:
- not insured by the FDIC;
- not deposits or other obligations of the financial institution and are not guaranteed by the financial institution; and
- subject to investment risks, including possible loss of the principal invested.
These disclosures must also be made orally by the FINRA member for any customer account opened on the premises of a financial institution.
When the FINRA member provides confirmations and account statements, these must clearly indicate that the brokerdealer services are being provided by the FINRA member. In addition, “retail communications,” including material published, or designed for use in media broadcasts, ATM welcome screens, billboards, signs, posters and brochures, that announce the location of a financial institution where broker-dealer services are provided by the member or that are distributed by the member on the premises of a financial institution must also include these disclosures.
As a result of these provisions, many structured note prospectuses include a prominent caption with these three key points where it is anticipated that the product may be offered on the premises of a financial institution that is party to a networking agreement.
These “legends” are not required for certain specified short-form presentations.
Limitations on Referral Fees
Rule 701 operates as a safe harbor for banks to be excluded from the Exchange Act’s definition of “broker,” even if a bank employee receives a referral fee for referring a high net worth customer or institutional customer to a FINRA member subject to a networking arrangement. Rule 701 does not specifically address networking relationships that do not involve a referral fee; however, the use of referral fees is typically an important incentive for bank employees to direct a branch customer to the relevant broker-dealer.
For purposes of Rule 701, a high net worth customer is one that has at least $5 million in net worth (excluding its primary residence and associated liabilities). An institutional customer is an entity that has: (a) at least $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 or dealer for investment banking services.
To receive that referral fee, the bank must have a reasonable basis on which to conclude that the customer is a high net worth customer. The relevant customer also must be notified that the bank employee is participating in an incentive compensation program for referring the customer, and the payment of this fee may be contingent on whether the referral results in a transaction with the broker-dealer.
Additional Requirements Applicable to Bank Employees
To qualify under Rule 701, the relevant bank employee:
- must not be registered or approved, or otherwise be required to be registered or approved, under the qualification standards established by an SRO, such as FINRA;
- must be predominantly engaged in banking activities other than making referrals to a broker or dealer;
- must not be subject to most of the statutory disqualifications provided by Section 3(a)(39) of the Exchange Act; and
- must encounter the relevant customer in the ordinary course of the employee’s assigned duties for the bank.
Good Faith Compliance
Rule 701 includes a cure provision that may apply if the bank has not made the required determination as to one or more customers, if the bank has reasonable policies and procedures in place to comply with Rule 701.