Date: November 7, 2007 To: From: Re: Interested Persons Davis Polk & Wardwell SEC and Federal Reserve Board Jointly Adopt Final Broker Push Out Rules Background On September 24, 2007, the U.S. Securities and Exchange Commission ( SEC ) and the Board of Governors of the Federal Reserve System ( Federal Reserve Board ) jointly issued final rules ( Regulation R ) that implement exceptions for banks from the definition of a broker under Section 3(a)(4) of the Securities Exchange Act of 1934 ( Exchange Act ). 1 The effect of these exceptions is to permit banks to engage in certain activities that would otherwise require them to register as broker-dealers with the SEC under the Exchange Act. Regulation R addresses four major types of activities: third-party networking arrangements; trust and fiduciary activities; sweep activities; and safekeeping and custody activities. Regulation R also includes several additional exemptions for banks brokerage activities, including exemptions for: certain agency transactions involving securities offered and sold outside the United States in accordance with Regulation S under the Securities Act of 1933 ( Regulation S ); securities lending transactions; transactions in certain investment company securities; 1 Definitions of Terms and Exemptions Relating to the Broker Exceptions for Banks, Release No. 34-56501 (Sept. 24, 2007) (the Regulation R Adopting Release ). Regulation R uses the same definition of bank as that in Section 3(a)(6) of the Exchange Act, which includes U.S. branches and agencies of foreign banks. This memorandum is a summary for general information only. It is not a full analysis of the matters presented and should not be relied upon as legal advice.
certain transactions involving a company s securities for its employee benefit plans and participants; and contracts entered into by banks from being considered void or voidable. On the same day, the SEC issued final rules in a companion release concerning bank exemptions from the definition of a dealer under Section 3(a)(5) of the Exchange Act. 2 These final rules contain a new exemption for riskless principal transactions under Regulation S, a conditional exemption for banks engaged in securities lending transactions, conforming amendments to Exchange Act Rule 15a-6 and the withdrawal of Exchange Act Rules 3b-9, 15a-8 and 15a-9. Regulation R is the result of a lengthy effort to implement the functional regulation of bank brokerage activities as contemplated by the Gramm-Leach- Bliley Act of 1999 ( GLB Act ). Among other things, the GLB Act amended the Exchange Act by adding provisions, colloquially known as the push-out provisions, that replaced the historic blanket exemption for banks from brokerdealer registration requirements with specific exemptions for designated broker and dealer activities. The dealer push-out provisions were implemented by final SEC rulemaking in 2003, but implementation of the broker provisions of the GLB Act have been stayed by SEC orders, pending the issuance of final rules, with the effect that banks have been wholly exempt from broker-dealer registration with respect to their brokerage activities. The SEC attempted to issue final broker rules (proposed Regulation B) on two prior occasions, but was unsuccessful largely due to opposition by federal banking regulators and the banking industry. Regulation R, initially proposed in December 2006, responded to many of the concerns raised by the prior proposals. 3 As adopted, Regulation R is substantially consistent with the December 2006 proposed rules, but contains some further refinements and additions, including changes to the definitions for institutional customer and high net worth customer for the purposes of the networking exemption, and adding an exemption permitting banks to effect certain company stock transactions for employee stock plans and participants. The Regulation R Adopting Release also requests comment on banks transactions involving repurchase agreements. Although most provisions of Regulation R will be effective on December 3, 2007, banks will continue to enjoy a blanket exemption from the definition of a broker until the first day of their 2 Exemptions for Banks Under Section 3(a)(5) of the Securities Exchange Act of 1934 and Related Rules, Release No. 34-56502 (Sept. 24, 2007) (the SEC-only Release ). 3 Definitions of Terms and Exemptions Relating to the Broker Exceptions for Banks, Release No. 34-54946 (Dec. 18, 2006) (the Proposing Release ). 2
first fiscal year commencing after September 30, 2008. The final rules relating to the definition of a dealer became effective on November 2, 2007. Discussion A. Exceptions from the Definition of a Broker and Related Exemptions 1. Networking Arrangements The GLB Act s broker push-out provisions permit banks to enter into arrangements with registered broker-dealers (referred to as networking arrangements ) who offer brokerage services if certain conditions are met. One such condition is that unregistered bank employees may not receive incentive compensation for brokerage transactions, except such employees may receive a nominal one-time cash referral fee of a fixed dollar amount that is not contingent on whether the referral results in a transaction. 4 The statute does not, however, define the key terms incentive compensation, nominal or contingent. Regulation R provides definitions for these and other terms used in the statute, and contains an exemption from the statutory definition of a broker for bank employee referrals involving institutional customers or high net worth customers. a. Definitions Regarding Referral Fees Incentive compensation is defined as compensation that is intended to encourage a bank employee to refer customers to a broker-dealer or to give a bank employee an interest in the success of a securities transaction at a brokerdealer. 5 Certain types of bonuses or similar plans which are not likely to give bank employees a promotional interest in a broker-dealer s services are excluded from the definition of incentive compensation. 6 Such plans are not deemed to be incentive compensation if they are [p]aid on a discretionary basis; and based on multiple factors or variables... 7 The latter must include criteria that are unrelated to securities transactions at a broker-dealer and may not include bank employee referrals to a broker-dealer or any such referrals made by another person. Regulation R clarifies, however, that banks may pay employee bonuses 4 Banks, however, may establish other objective criteria for referral fees. Regulation R lists the following as acceptable criteria upon which referral fees may be based: minimum assets, net worth, income, marginal federal or state income tax rate, or citizenship or residency requirements. Rule 700(a)(2). Referral fees may also be conditioned on whether the customer contacts a broker-dealer or maintains an appointment because of the referral. Rule 700(a)(1). 5 Rule 700(b). 6 Id.; see also Regulation R Adopting Release at 32. 7 Rule 700(b)(1). 3
based upon the overall profitability or revenue of the bank, non-broker-dealer affiliates and operating units of the bank or a broker-dealer, subject to certain conditions. 8 Regulation R offers four alternative referral fee structures that qualify as nominal. In offering alternatives, the regulators sought to create flexibility for banks operating in different business contexts while preserving the overall policy that the compensation should be small in relation to the employee s overall compensation and therefore unlikely to create undue incentives for bank employees to pre-sell securities to bank customers. 9 The first two alternatives measure the nominal value of the fee in relationship to wages earned within the employee s job family (examples of distinct job families include tellers, loan officers and branch managers). 10 The third alternative is based on the employee s actual base hourly wage or annual base salary. 11 The fourth alternative is that the fee not exceed twenty-five U.S. dollars ($25), adjusted for inflation. 12 In all cases, referral fees may only be paid to bank employees who were personally involved in referring the customer to the broker-dealer. 13 A supervisory employee, for example, may receive a referral fee only if the supervisory employee personally participates in the referral. 14 b. Exemption for More than a Nominal Referral Fee Regulation R provides a conditional exemption which allows a bank employee to receive otherwise prohibited contingent and greater than nominal referral fees if the customer referred to the broker-dealer is either an institutional customer or a high net worth customer. Institutional customer is defined as a non-natural person that has, or is controlled by a non-natural person who has, at least: $10 million in investments; $20 million in revenues; or 8 Rule 700(b)(2). 9 Proposing Release at 12; see also Regulation R Adopting Release at 19-20. 10 Regulation R Adopting Release at 23; Rule 700(c)(1). 11 Rule 700(c)(2). 12 Rule 700(c)(3). 13 Rule 700(c). 14 Regulation R Adopting Release at 24. 4
$15 million in revenues if the bank employee refers the customer to the broker or dealer for investment banking services. 15 High net worth customer is defined as [a]ny natural person who, either individually or jointly 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; and any revocable, inter vivos or living trust the settlor of which is a natural person who, either individually or jointly with his or her spouse, meets the net worth standard.... 16 To qualify for the exemption, banks must comply with certain conditions, including: the bank must have a reasonable basis to believe that the customer qualifies as either an institutional customer or a high net worth customer; the bank employee must have encountered the customer in the course of his or her ordinary bank duties and may only receive limited types of referral fees; the bank must make certain disclosures to the customer regarding the referral before or at the time of the referral; the broker-dealer must conclude that the bank employee is not required to be registered or approved in accordance with the rules of any self-regulatory organization and is not subject to statutory disqualification; and the agreement between the bank and the broker-dealer must contain certain provisions, including providing for the brokerdealer to perform a suitability analysis with regard to contingent fees and a suitability or sophistication analysis for other referrals. 17 The networking exemption also provides that if a bank acts in good faith and has reasonable policies and procedures, the bank will not be subject to registration as a broker-dealer for failing to comply with the provisions of the 15 Rule 701(d)(2). The term investment banking services is defined in Rule 701(d)(3). 16 Rule 701(d)(1) provides further guidance on the treatment of certain assets for purposes of determining whether the rule s numerical criteria are satisfied. 17 Rule 701. 5
exemption so long as the bank takes prompt corrective action and attempts to reclaim any non-compliant referral fee. 18 2. Trust and Fiduciary Activities The broker push-out provisions in the Exchange Act allow a bank to effect securities transactions without becoming a broker if the bank acts as a trustee or fiduciary and effects transactions in a trust department or other department of the bank that is regularly examined for compliance with fiduciary principles and standards, subject to certain conditions. 19 To qualify for the statutory exception, however, the bank must be chiefly compensated in one of three enumerated ways (or a combination thereof), generally referred to as relationship compensation, described below. a. Chiefly Compensated Banks may determine whether the relevant transactions qualify under the chiefly compensated test via an account-by-account calculation method or on a bank-wide basis. A bank may elect to exclude certain accounts from the chiefly compensated test, including those held at non-shell foreign branches (when using the bank-wide approach), subject to certain conditions. 20 For banks electing to use the account-by-account method, a bank will be regarded as chiefly compensated by one of the three allowed methods if the relationship-total compensation percentage for each trust or fiduciary account of the bank is greater than fifty percent. 21 The relationship-total compensation percentage is a two-year rolling average of a bank s compensation for an account derived from relationship compensation divided by the total compensation from 18 Rule 701(a)(2)(iv). 19 In addition, banks must comply with Exchange Act Section 3(a)(4)(C) by directing trades to a registered broker-dealer for execution, effecting trades through cross trades or substantially similar trades, or effecting trades in some other manner that the SEC permits, and must comply with certain advertising restrictions found in Rule 721(c). 20 Rule 723. The ability to exclude such accounts was a significant point for many banking organizations. Other accounts that a bank may elect to exclude from the calculation are accounts open for less than three months, accounts acquired as part of a business combination or asset acquisition (for a period of twelve months), and a de minimis number of accounts (the total number of accounts excluded must not exceed 1% of the total number of trust or fiduciary accounts held or 500 accounts, whichever is less). In addition, a bank will not be deemed a broker because an account does not meet the account-by-account chiefly compensated test if, within three months following the year in which the account did not meet the test, the account is transferred to a registered broker-dealer or other unaffiliated entity not required to be registered. 21 Rule 721(a)(1). A trust or fiduciary account is an account where the bank acts in a trustee or fiduciary capacity as defined by Section 3(a)(4)(D) of the Exchange Act. Rule 721(a)(6). 6
that account. 22 Relationship compensation consists of administration or annual fees, certain flat or capped per order processing fees and fees based on a percentage of assets under management. 23 Rule 721(a)(4) offers non-exclusive examples of certain of these fees, including: (i) fees pursuant to a 12b-1 plan; (ii) fees for custody services; (iii) fees in connection with securities lending or borrowing transactions; and (iv) fees based on financial performance of the assets in an account. 24 Alternatively, banks may calculate whether they are chiefly compensated by permitted means on a bank-wide basis. 25 In order to come under this exemption, a bank must comply with the conditions in the trust and fiduciary exception (other than those relating to the compensation test) and the two-year rolling average of the bank s aggregate relationship-total compensation percentage for the bank s trust and fiduciary business must be at least seventy percent. 26 The aggregate relationship-total compensation percentage is the mean of (i) the bank s relationship compensation attributed to the bank s trust and fiduciary business as a whole divided by the total compensation attributable to the bank s trust and fiduciary business as a whole during that year, and (ii) the same calculation for the immediately preceding year. 27 b. Advertising Restrictions In taking advantage of either the account-by-account trust and fiduciary activities exception or the bank-wide exemption, a bank must also abide by certain advertising restrictions. 28 When a bank advertises that it effects securities brokerage transactions for trust or fiduciary accounts, the advertisement must be part of a broader advertisement of the bank s trust or fiduciary services, and 22 Rule 721(a)(2). 23 Rule 721(a)(4). 24 Id. 25 Regulation R Adopting Release at 67. 26 Rule 722(a). A bank must also comply with the trade execution requirements under Section 3(a)(4)(C) of the Exchange Act to calculate its relationship compensation on a bank-wide basis. Regulation R Adopting Release at 68. 27 Compliance with both the account-by-account and bank-wide calculation methodologies may be determined on a calendar or fiscal year-end basis. Regulation R Adopting Release at 71. In addition, both tests allow a bank to exclude compensation received in connection with another exception or exemption from its relationship-total compensation calculation. Rule 721(b); Rule 722(d). 28 Rule 721(c); Rule 722(a)(1). The term advertisement has the same meaning as given in Rule 760(g)(2). Rule 721(c)(2). 7
brokerage services may not be more prominently advertised than other aspects of the bank s trust and fiduciary services. 29 3. Safekeeping and Custody The GLB Act s push-out provisions permit banks to engage in certain customary safekeeping and custody activities. 30 Specifically, a bank is not deemed a broker under the Exchange Act when, as a part of its customary banking activities, it provides safekeeping or custody services, facilitates transfers of funds or securities for clearance and settlement purposes in a custodian or clearing agent capacity, effects stock loans in connection with such activities or invests related cash collateral, holds securities pledged by customers or provides custodial or other related administrative services to individual retirement, pension or similar accounts. 31 Regulation R adds two additional exemptions from the definition of a broker : broker activities as an accommodation to customers, and broker activities in relation to certain employee benefit plan, individual retirement and similar accounts. 32 29 Rule 721(c)(1). 30 For many years, non-u.s. banks have provided securities custody and related services to U.S. investors without registering as broker-dealers. However, non-u.s. banks operating from offices outside the United States are not banks within the meaning of the Exchange Act, and therefore do not benefit from the blanket exemption from bank broker activity that has been in effect, or from Regulation R. Nonetheless, many non-u.s. banks have taken the view that they were not subject to registration because their activities did not amount to effecting transactions in securities. The fact that the GLB Act and Regulation R have specific exemptions for custody and safekeeping by banks, and that Regulation R specifically exempts certain accommodation order taking activities by bank custodians, has, arguably, created some ambiguity about the ability of non-u.s. banks to continue to rely upon this position. The Institute of International Bankers, a trade association of non-u.s. banks, has engaged in a dialogue with the SEC staff concerning possible no-action or other guidance or relief for some activities of global custodians, although the ultimate resolution of that dialogue is uncertain. Were the SEC to decline to grant such relief, it could raise numerous practical issues for both non-u.s. banks and investors, including the cost to U.S. investors of maintaining portfolios of foreign securities. Questions of competitive equality and freedom of cross-border services could also be implicated. This would be an anomalous result, since the SEC has announced that it is considering liberalizing the ability of non-u.s. broker-dealers and securities exchanges to provide services to U.S. investors without full SEC registration on the basis of mutual recognition by the SEC of the non-u.s. regulatory regime to which such broker-dealers and exchanges are subject. 31 Exchange Act, 3(a)(4)(viii). This exception applies as long as a bank does not act as a carrying broker, except with regard to government securities (as defined in Section 3(a)(42)). 32 Rule 760. 8
a. Accommodation Trades Regulation R permits a bank to accept orders to effect securities transactions as an accommodation for accounts for which the bank acts as custodian (other than an employee benefit plan, individual retirement or similar accounts). A bank s fee for an accommodation transaction may not vary based on whether the bank accepted the order or the quantity or price of the securities. 33 In addition, accommodation transactions are subject to certain further limitations, including limits on employee compensation, advertisements and sales literature. 34 b. Employee Benefit Plans A bank may effect securities transactions in the ordinary course for an employee benefit plan account or similar account for which the bank acts as a custodian as a part of its customary banking activities. 35 Banks must, however, comply with certain employee compensation, advertising and sales literature requirements. 36 Regulation R also clarifies that banks are exempt under the above Regulation R custody and safekeeping exceptions only if the bank is not acting in a trust or fiduciary capacity and the bank complies with the trade execution and carrying broker requirements of the Exchange Act. 37 4. Sweep Accounts and Money Market Funds Under Section 3(a)(4)(v) of the Exchange Act, a bank may effect transactions as a part of a program for the investment or reinvestment of deposit funds into a money market fund. Regulation R provides definitions for money market fund, no-load and other terms, 38 and a conditional exemption for banks effecting transactions in money market funds. 39 33 Rule 760(b)(3). 34 Rule 760(b), (c). 35 Rule 760(a). 36 Id.; see also Rule 760(e) regarding non-fiduciary and non-custodial administrators and recordkeepers. 37 Rule 760(d). 38 Rule 740. 39 Rule 741. 9
B. Other Exemptions 1. Regulation S Ordinarily, persons in the United States may not conduct brokerage transactions without an applicable exception or exemption or registering as a broker-dealer, even if the selling activity occurs outside of the United States. Regulation R allows a bank to effect certain sales and resales of securities issued pursuant to Regulation S. A bank will be exempt from broker-dealer registration under Regulation R if it effects a sale in accordance with the requirements of Rule 903 of Regulation S of an eligible security to a non-u.s. person (as defined in Regulation S) who is not in the United States. 40 In addition, Regulation R exempts banks for the purpose of a resale of an eligible security by or on behalf of a non-u.s. person or a registered broker-dealer if, in compliance with Regulation S, the bank has a reasonable belief that the securities were initially sold outside of the United States to a non-u.s. person who is not in the United States or, when sold by or on behalf of a non-u.s. person only, a registered broker-dealer. 41 An eligible security is a security that is not sold from the bank s or an affiliate s inventory and is not underwritten by the bank or an affiliate on a firm-commitment basis, unless the bank acquires the security from an unaffiliated distributor that did not purchase the security from the bank or its affiliate. 42 There is some ambiguity created by the drafting of the Regulation R provisions. As noted above, Regulation R requires that, to qualify for the exemption, the security must be sold to a person who is not in the United States. The Regulation R Adopting Release indicates a specific intent not to rely merely upon the requirement that the transaction comply with Rule 903 of Regulation S (i.e., that the offer or sale qualify as an offshore transaction ), but to independently emphasize the requirement that the purchaser not be in the United States. 43 It is unclear whether Regulation R is meant to incorporate the same constructs as Regulation S concerning when a purchaser or offeree is effectively considered to be in the United States. For example, the definitions of offshore transactions and directed selling efforts in Regulation S specifically exclude (and therefore permit) contacts with, and offers and sales to, certain persons who are excluded from the Regulation S definition of U.S. person, such 40 Rule 771(a)(1). 41 Rule 771(a)(2), (3). 42 Rule 771(b)(2). Securities issued by the bank or an affiliate, such as structured notes or shares in a pooled investment vehicle, may be deemed eligible securities. Regulation R Adopting Release at 127. 43 See Regulation R Adopting Release at n.299. 10
as certain international organizations and dealers and other professional fiduciaries holding discretionary or similar accounts of non-u.s. persons. 44 Further SEC guidance may be required in order to clarify the precise contours of the Regulation R exemption for Regulation S transactions. 2. Securities Lending Regulation R also adopts the securities lending exemption formerly found in Exchange Act Rule 15a-11. Under this exemption, a bank may, as agent and in circumstances where the bank does not have custody of the securities or has custody for less than the entire period of the transaction, engage in securities lending transactions, and services related thereto, for a person the bank reasonably believes to be a qualified investor, as defined in Section 3(a)(54)(A) of the Exchange Act, or any employee benefit plan that owns and invests on a discretionary basis, not less than $25,000,000 in investments. This exemption is in addition to the exemption under the statutory safekeeping and custody exception that permits banks to effect securities lending transactions when they have custody of the securities. 45 3. Request for Comment on Repurchase Transactions One commenter suggested that the SEC and the Federal Reserve Board adopt an exemption for banks from the definition of a broker and a dealer for repurchase and reverse repurchase transactions based on their functional equivalency to securities lending. The regulators declined to adopt such an exemption in Regulation R at this time, but have requested comment and specific information on repurchase and reverse repurchase transactions and issues raised by a possible exemption. 4. Other Exemptions Other noteworthy Regulation R exemptions include an exemption for effecting transactions in investment company securities and an exemption for certain transactions involving a company s securities for its employee benefit plans and participants. Rule 775 provides that banks which otherwise meet the requirements of the GLB Act s broker push-out provisions need not comply with the requirements in Exchange Act Section 3(a)(4)(C)(i) (which requires that in certain cases transactions need to be directed to a registered broker-dealer for execution or effected by means of a cross trade meeting specified requirements) for transactions in investment company securities, including transactions involving variable annuities, variable life insurance policies and mutual funds, (vi). 44 See Rules 902(c)(3)(ii) and 902(h)(3) of Regulation S, referencing Rules 902(k)(2)(i), 45 Regulation R Adopting Release at 128-29. 11
provided such securities are not traded on a national securities exchange nor through the facilities of a national securities association or an interdealer quotation system and subject to certain further conditions. Under Rule 776, a bank may also be exempt from compliance with Exchange Act Section 3(a)(4)(C)(i) for certain transactions in the securities of a company for its employee benefit plan and participants, on the condition that no commission is charged, the transactions are effected solely for the benefit of an employee benefit plan and such securities are obtained directly from and are transferred to the employee benefit plan or the company. In addition, Regulation R provides banks a safe harbor from Exchange Act Section 29 liability resulting from a violation of the Exchange Act s broker-dealer registration requirements under Section 15(a) until March 31, 2009 and also thereafter, if the bank acted in good faith, had reasonable policies and procedures in place and the counterparty suffered no significant harm or financial loss. 46 C. Regulatory Guidance and Oversight In accordance with the GLB Act, the Federal Reserve Board and other banking regulators will, in consultation with the SEC, issue recordkeeping rules designed to assist banks to comply, and demonstrate compliance, with the statutory exceptions from the definition of a broker and Regulation R. In addition, the Regulation R Adopting Release states that the federal banking agencies will issue guidance that will describe various policies, procedures and systems banks should implement to ensure that they are not engaging in certain brokerage activities. The SEC and the Federal Reserve Board will consider jointly any requests for future guidance, interpretations and no-action relief regarding the statutory exceptions and Regulation R and will consult one another, as well as other appropriate federal banking agencies, regarding formal enforcement actions. D. Exemptions from the Definition of a Dealer and Related Rules The final rules relating to the definition of a dealer under the Exchange Act contain a new exemption for riskless principal transactions under Regulation S, a conditional exemption for banks engaged in securities lending transactions, conforming amendments to Exchange Act Rule 15a-6 and the withdrawal of Exchange Act Rules 3b-9, 15a-8 and 15a-9. Under recently adopted Exchange Act Rule 3a5-2, banks, when effecting a riskless principal transaction, are exempt from the definition of a dealer if the bank purchases an eligible security in compliance with Rule 903 of Regulation 46 Rule 780. 12
S and sells the security to a person who is not in the United States or effects a resale under the conditions set out in Rules 3a5-2(a)(2), (3). 47 The securities lending exemption for a bank from the definition of a dealer allows a bank to engage in securities lending transactions, and services related thereto, for a person the bank reasonably believes to be a qualified investor 48 as defined in Section 3(a)(54)(A) of the Exchange Act, or any employee benefit plan that owns and invests on a discretionary basis, not less than $25,000,000 in investments. 49 The final rules make a non-substantive amendment to Rule 15a-6(a)(4)(i) of the Exchange Act to incorporate the definitions of a broker and a dealer, as modified by the GLB Act and related rules. Thus, the adopted change to Rule 15a-6(a)(4)(i) allows foreign broker-dealers to engage in securities transactions with a bank acting pursuant to an exception or exemption from the definition of broker or dealer under the relevant sections and rules of the Exchange Act. 50 * * * If you have questions regarding this client memorandum, please call your regular Davis Polk contact. Copyright 2007 by Davis Polk & Wardwell 47 See the discussion of the related broker Regulation S exemption, supra. 48 As defined in Section 3(a)(54)(A) of the Exchange Act. 49 Rule 3a5-3. The definitions of securities lending transaction and securities lending services are substantially the same as those given in Regulation R. 50 SEC-only Release at 11. 13