Federal and state banks, including those that are affiliated with issuers of structured products, remain important participants in the distribution of structured notes and structured CDs. However, banks’ distribution and brokerage activities are limited due to changes in federal law during the last several years. This article describes the provisions of Regulation R that govern these activities, as well as their impact on selected dealer agreements and similar agreements that govern these sales.
What Is Regulation R?
The SEC adopted Regulation R in 2007 in order to address some of the uncertainty surrounding bank broker-dealer activities after the 1999 passage of the Gramm-Leach-Bliley Act (the “GLB Act”). The GLB Act amended the definitions of “broker” and “dealer” under the Exchange Act by removing the global bank exception from those definitions. In the place of that exception, the GLB Act provided a list of specific, permissible bank broker-dealer activities, including networking arrangements, trust activities, custody activities and sweep accounts. If a bank’s securities activities fall within the definitions of broker or dealer, but not within one or more of the enumerated categories of permissible bank broker-dealer activities, the bank is required to transfer (i.e., “push-out”) the activity to an affiliated broker-dealer.
Regulation R primarily addresses four of the statutory exceptions that preclude a bank from being deemed to be a “broker” under the Exchange Act, including two that are of principal importance to banks that participate in the structured product market: (1) networking arrangements and (2) trust and fiduciary activities.
Section 3(a)(4)(B)(i) of the Exchange Act provides an exception from the definition of “broker” that permits a bank to contract with broker-dealers under certain conditions in order to offer bank customers securities brokerage products and services without the bank having to register as a broker-dealer (the “Networking Exception”). For example, a bank may provide office space in its branches for its affiliated broker-dealer under a networking arrangement. Regulation R defines certain of the key terms included in the Networking Exception.
- “Nominal one-time cash fee of a fixed dollar amount”
Under the Networking Exception, there are no limitations on the types of compensation that a broker-dealer may pay a bank under a networking arrangement. However, non-licensed bank employees may only receive a “nominal one-time cash fee of a fixed dollar amount” for referring a bank customer to a broker-dealer. Under Regulation R, the phrase “nominal one-time cash fee of a fixed dollar amount” is defined as a cash payment for a referral in an amount that does not exceed either:
- twice the average of the minimum and maximum hourly wage established by the bank for the current or prior year for the job family that includes the relevant employee, or 1/1000th of the average of the minimum and maximum annual base salary established by the bank for the current or prior year for that job family;
- twice the employee’s actual base hourly wage or 1/100th of the employee’s actual annual base salary; or
- $25 dollars, periodically adjusted for inflation.
- “Contingent on whether the referral results in a transaction”
Under the Networking Exception, a referral fee paid to an unregistered bank employee for referring a customer to a broker-dealer cannot be “contingent on whether the referral results in a transaction.” Regulation R provides that a fee would be considered “contingent on whether the referral results in a transaction” if payment of the fee depends on whether (1) the referral results in a purchase or sale of a security, (2) an account is opened with a broker-dealer, (3) the referral results in a transaction involving a particular type of security, or (3) the referral results in multiple securities transactions. A referral fee may, however, be contingent on whether a customer (a) contacts or keeps an appointment with a broker-dealer as a result of the referral or (b) meets any objective, base-line qualification criteria established by the bank or broker-dealer for customer referrals, such as minimum assets, net worth, income or marginal federal or state income tax rate, or any requirement for citizenship or residency that the bank or broker-dealer may have established generally for referrals for securities brokerage accounts.
- “Incentive compensation”
Under the Networking Exception, unregistered bank employees that refer customers to a broker-dealer cannot receive “incentive compensation” for the referral. Regulation R defines “incentive compensation” as compensation that is intended to encourage a bank employee to refer customers to a broker-dealer or give a bank employee an interest in the success of a securities transaction of a broker-dealer. Regulation R excludes from the definition of incentive compensation amounts paid by a bank under a bonus or similar plan that is paid on a discretionary basis dependent on multiple factors or variables, so long as (1) those factors or variables include multiple significant factors or variables that are not related to securities transactions of a broker-dealer, (2) a referral made by the employee is not a factor or variable in determining the employee’s compensation under the plan, and (3) the employee’s compensation under the plan is not determined by reference to referrals made by any other person.
In addition, Regulation R provides that the definition of incentive compensation does not prevent a bank from compensating an officer, director or employee of the bank on the basis of any measure of the overall profitability or revenue of (1) the bank, either on a stand-alone or consolidated basis, (2) any of the bank’s affiliates (other than a broker-dealer) or any operating unit of the bank or an affiliate, if the affiliate or operating unit does not over time predominately engage in the business of making referrals to a broker-dealer, or (3) a broker-dealer, if the measure of overall profitability or revenue is only one of multiple factors or variables used to determine the compensation of the officer, director or employee.
Trust and Fiduciary Activities
Section 3(a)(4)(B)(ii) of the Exchange Act contains an exception from the definition of “broker” that permits a bank, under certain conditions, to effect securities transactions in a trustee or fiduciary capacity without registering as a broker-dealer (the “Trust Exception”). Under the Trust Exception, banks frequently make purchases of structured notes and structured CDs on behalf of their accountholders.
Under Regulation R, a bank must meet four general requirements in order to qualify for the Trust Exception. First, the bank must effect the transactions in either its trust department or in another department regularly examined by bank examiners for compliance with fiduciary principles and standards. Second, the bank must be “chiefly compensated” for the transactions in a manner that is consistent with fiduciary principles and standards, based on (1) an administration or annual fee, (2) a percentage of the assets under management, (3) a flat or capped per order processing fee that does not exceed the bank’s cost in executing the securities transactions, or (4) any combination of these fees. Third, the bank must not publicly solicit brokerage business other than by advertising that it effects transactions in securities as part of its trust business. Fourth, the bank must comply with the “claw-back” provisions of Section 3(a)(4)(C). In other words, a bank must (a) direct the trade to a registered broker-dealer for execution, (b) effect the trade through a cross trade or substantially similar trade either within the bank or between the bank and an affiliated fiduciary that is not in violation of fiduciary principles established under applicable law, or (c) effect the trade in another manner permitted by the SEC.
The “chiefly compensated” requirement under the Trust Exception means that a bank must be compensated as a traditional trustee or fiduciary and not as a broker-dealer. Regulation R requires that the percentage of the bank’s compensation as a traditional trustee or fiduciary compared to its total compensation (i.e., “relationship-total compensation percentage”) for each trust and fiduciary account must exceed 50%. A bank can calculate this percentage on either an account-by-account basis or a bank-wide basis, provided that it meets certain conditions under the selected approach. Regulation R also allows a bank to exclude certain types of accounts for purposes of determining its compliance under either approach.
Impact on Selected Dealer Agreements
Banks may participate in offerings of structured notes and structured CDs. However, they are regulated differently from the registered broker-dealers that are typically parties to selected dealer and similar agreements. Accordingly, a variety of differences typically exist in the agreements that underwriters may execute with them.
- The agreement may provide that the bank’s purchases are limited to purchases by the bank for trust or fiduciary accounts.
- The agreement will not grant to the bank the typical selling concession.
- The bank may be requested to give a specific representation as to its compliance with the relevant provisions of the GLB Act and Regulation R. For example, a sample representation could provide: [Distributor] represents and warrants that in connection with any offer, purchase or sale of the [Securities]: (i) it shall comply with all applicable requirements under the Graham-Leach-Bliley Act (the “GLB Act”), Regulation R under the [Exchange Act], Sections 3(a)(4) and 3(a)(5) of the [Exchange Act]; (ii) it has adopted and implemented comprehensive oversight, examination and supervision policies and procedures reasonably designed to ensure compliance with all applicable requirements under such provisions; and (iii) it shall comply with all applicable trust or fiduciary obligations and other regulations applicable to trust or fiduciary accounts.