Regulation B

Federal RegisterJun 30, 2004

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

[Release No. 34-49879; International Series Release No. 1278; File No. S7-26-04]

RIN 3235-AJ28

Regulation B

AGENCY:

Securities and Exchange Commission.

ACTION:

Proposed rule.

SUMMARY:

The Securities and Exchange Commission (“Commission”) is publishing Regulation B for public comment. Regulation B proposes a number of new exemptions for banks from the definition of the term “broker” under Section 3(a)(4) of the Securities Exchange Act of 1934 (“Exchange Act”), as amended by the Gramm-Leach-Bliley Act (“GLBA”). The proposal would broaden a number of exemptions already available to banks, savings associations, and savings banks that effect transactions in securities. It also would define certain terms used in the GLBA. The proposal would exempt credit unions that engage in limited securities activities that are conducted under the terms applicable to certain of the bank exceptions from the definitions of “broker” and “dealer.” The Commission also requests comment on a proposed conforming amendment to an Exchange Act rule that grants a limited exemption from the broker-dealer registration requirement for foreign broker-dealers. The proposal is intended, among other things, to facilitate banks' compliance with the GLBA.

DATES:

Comments should be received on or before August 2, 2004.

ADDRESSES:

Comments may be submitted by any of the following methods:

Electronic Comments

• Use the Commission's Internet comment form (

http://www.sec.gov/rules/proposed.shtml

); or

• Send an e-mail to

rule-comments@sec.gov.

Please include File Number S7-26-04 on the subject line; or

• Use the Federal eRulemaking Portal (

http://www.regulations.gov/

). Follow the instructions for submitting comments.

Paper Comments

• Send paper comments in triplicate to Jonathan G. Katz, Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-0609.

All submissions should refer to File Number S7-26-04. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method. The Commission will post all comments on the Commission's Internet Web site (

http://www.sec.gov/rules/proposed.shtml

). Comments are also available for public inspection and copying in the Commission's Public Reference Room, 450 Fifth Street, NW., Washington, DC 20549. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT:

Catherine McGuire, Chief Counsel; Lourdes Gonzalez, Assistant Chief Counsel—Sales Practices; Richard C. Strasser, Attorney Fellow; Linda Stamp Sundberg, Attorney Fellow; Joseph Corcoran, Special Counsel; Brice Prince, Special Counsel; or Norman Reed, Special Counsel, at (202) 942-0073, Office of the Chief Counsel, Division of Market Regulation, Securities and Exchange Commission, 450 Fifth Street, NW., Washington, DC 20549-1001.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Background

A. Statutory Background—The Gramm-Leach-Bliley Act

B. Regulatory and Procedural Background—The Interim Final Rules, Public Comment, and the Temporary Exemptions

II. Discussion of Proposed Regulation B

III. Discussion of Comments on the “Broker” Rules and Proposed Amendments

A. Networking Exception

1. Comments on Definition of “Nominal One-Time Cash Fee of a Fixed Dollar Amount”

2. Proposed Amendments to Definition of “Nominal One-Time Cash Fee of a Fixed Dollar Amount”

a. Meaning of “Nominal”

b. Meaning of “One-Time”

c. Meaning of “Cash Fee”

d. Meaning of “Fixed Dollar Amount”

3. Comments on Definition of “Referral” and Proposed Amendments

4. Proposed New Definition of “Contingent on Whether the Referral Results in a Transaction”

5. Interpretations of “Contractual or Other Written Arrangement” and “Qualified Pursuant to the Rules of a Self-Regulatory Organization”

B. Trust and Fiduciary Activities Exception

1. Chiefly Compensated

a. Statutory Requirements and Existing Rules

b. Comments on “Chiefly Compensated” Requirement

c. Proposed Changes in Response to Comments

d. Proposed Line-of-Business Exemption

i. Description of Existing Rule

ii. Description of Proposed Line-of-Business Exemption

e. Proposed New Living, Testamentary, and Charitable Trust Account Exemption

f. New Conditional Safe Harbor

g. New Proposed Account-by-Account Exemption

i. Proposed Account-by-Account Exemption

ii. New Safe Harbor for Account-Specific Exemption

h. Other Provisions

i. “Chiefly Compensated” and Related Definitions

ii. Formulas to Allocate Sales Compensation to Individual Accounts

A. 12b-1 Fees

B. Other Fees

iii. Indenture Trustee Exemption

2. Definition of “Trustee Capacity” and Indenture Trustees

3. Interpretations of “Fiduciary Capacity” and “Similar Capacity”

4. Comments on Definition of “Investment Adviser if the Bank Receives a Fee for Its Investment Advice” and Proposed Amendments

5. Comments on “Other Department That Is Regularly Examined by Bank Examiners for Compliance With Fiduciary Principles and Standards”

C. Sweep Accounts Exception

1. Comments on Definition of “No-Load” and Proposed Amendments

2. Interpretation of “Program”

3. Definition of “Money Market Fund”

D. Affiliate Transactions Exception

E. Safekeeping and Custody Activities Exception

1. Background on Safekeeping and Custody Exception

2. Comments on Commission's Interpretation Regarding Accepting Customer Orders

3. Comments on Proposed Amendments to the General Bank Custody Exemption

a. Modifications to General Bank Custody Exemption

1. Bank Compensation

2. Solicitation Restrictions

3. Employee Activities and Compensation

4. Trustee and Fiduciary Activity Accounts

5. Employee Benefit Plans

6. Small Bank Exemption

7. Custody Account Definition

8. Request for Comments

9. Carrying Broker Definition

4. Comments on and Proposed Amendments to the Small Bank Custody Exemption

a. Bank Asset Size Limit

b. Annual Sales Compensation Limit

c. Other Conditions

1. Solicitation

2. Securities Networking

3. Employee Staffing Restrictions

4. Employee Compensation Restriction

5. Investment Company Shares for Tax-Deferred Accounts

d. Trust and Fiduciary Activity Accounts

e. Availability of Exemption to Non-Depository Trust Companies

f. Request for Comments

F. General and Special Purpose Exemptions

1. General Exemption

2. Employee Benefit Plan Exemption

3. Regulation S Transactions with Non-U.S. Persons

4. Redesignation and Revision of Exemptions for Savings Associations and Savings Banks

5. Credit Unions

a. Networking

b. Sweep Accounts

c. Investment, Trustee, and Fiduciary Transactions

d. Scope of Credit Union Exemption

e. Additional Exemptions for Credit Unions

6. Exemption for the Way in Which Banks Effect Transactions in Investment Company Securities

G. Temporary Exemptions

1. Extension of Time and Transition Period

2. Temporary Exemption for Contracts Entered into by Banks from Being Considered Void or Voidable

H. Amendment to Exchange Act Rule 15a-6

IV. Administrative Law Matters

A. General Request for Comments

B. Paperwork Reduction Act Analysis

C. Consideration of Benefits and Costs

D. Consideration of Burden on Competition, and on Promotion of Efficiency, Competition, and Capital Formation

E. Consideration of Impact on the Economy

F. Regulatory Flexibility Analysis

V. Statutory Authority

VI. Text of Proposed Rules and Rule Amendments

I. Introduction and Background

A. Statutory Background—The Gramm-Leach-Bliley Act

The GLBA amended several federal statutes governing the activities and supervision of banks, bank holding companies, and their affiliates.

Among other things, it lowered barriers between the banking and securities industries erected by the Banking Act of 1933 (“Glass-Steagall Act”).

It also altered the way in which the supervisory responsibilities over the banking, securities, and insurance industries are allocated among financial regulators. Among other things, the GLBA repealed the complete separation of investment and commercial banking imposed by the Glass-Steagall Act, which was enacted as a response to the perceived abuses and conflicts of interest in the securities industry during the 1920s. The GLBA also revised the provisions of the Exchange Act that had completely excluded banks from broker-dealer registration requirements.

Pub. L. 106-102, 113 Stat. 1338 (1999).

Pub. L. 73-66, ch. 89, 48 Stat. 162 (1933) (as codified in various sections of 12 U.S.C.).

Congress originally adopted these complete exclusions in 1934, stipulating that under the Glass-Steagall Act, banks were not generally permitted to engage in the securities business. The House Committee on Commerce explained the rationale behind the original complete bank exclusion from the definitions of “broker” and “dealer” and Congress' rationale for its subsequent repeal:

The [Committee on Commerce] strongly believes that functional regulation—regulation of the same functions, or activities, by the same expert regulator, regardless of the nature of the entity engaging in those activities—has become essential to a coherent financial regulatory scheme, as activities and affiliations expand and change with the financial marketplace.

Subtitle A of title II amends the Exchange Act to eliminate the blanket exemptions for banks from the definitions of “broker” and “dealer.” These exceptions, which have been part of the Exchange Act since its inception, were * * * based on the assumption that the Glass-Steagall Act, which had become law just one year before the Exchange Act, had prohibited all but extremely limited specified bank securities activities. Specifically, at the time of its enactment, the Glass-Steagall Act included exceptions that permitted banks to underwrite and deal in obligations of the United States * * * and their subdivisions. Amendments to the Glass-Steagall Act made in 1935 permitted banks to provide limited securities brokerage services as an accommodation to their customers, by permitting banks to engage in stock purchases and sales in an “agency” capacity, at the request of customers.

Section 20 of the Glass-Steagall Act forbids affiliation of any Federal Reserve member bank with any business entity “principally engaged” in investment banking activities. For more than fifty years following the enactment of the Glass-Steagall Act, bank holding companies could not underwrite securities.

As noted above, however, the limitations on bank securities activities have eroded as a result of administrative actions by the Federal banking regulators. The rationale for the exemptions in the Federal securities laws that apply to banks is, thus, no longer sound, given the extensive and increasing securities activities in which banks are engaging.

H.R. 106-74, pt. 3, at 113 (1999).

Charters for U.S. banks, unlike those for most for-profit corporations, restrict bank activities to the “business of banking.”

For many years, U.S. banking regulators took a narrow view of what constituted the “business of banking,” which did not include securities activities.

Beginning in the 1980s, commercial businesses began directly to access the capital markets and banks faced more competitors in extending credit to commercial customers.

Prior to passage of the GLBA, many of the regulatory barriers preventing full-scale integration of commercial bank and securities firms were relaxed. For example, in 1982, the Federal Deposit Insurance Corporation (“FDIC”) determined that state banks that were not members of the Federal Reserve system were not subject to the Glass-Steagall Act's affiliation restrictions.

In 1987, the Board of Governors of the Federal Reserve System (“Federal Reserve”), through a series of administrative actions, began to lower the barrier between banks and securities firms by allowing bank holding companies to derive a percentage of their revenue from underwriting and dealing in securities that were, prior to the Federal Reserve's actions, impermissible for banks to underwrite and deal in.

Over time, the

Federal Reserve increased the percentages of revenue that banks could derive from underwriting and dealing in such securities, repealed most of the conflict of interest firewalls between banks and securities firms, and approved the creation of the first U.S. universal bank—Citigroup.

During the past two decades, the Office of the Comptroller of the Currency (“OCC”), the Office of Thrift Supervision (“OTS”), and the FDIC also expanded the types of bank securities activities that, in the view of these agencies, were within the permissible “business of banking.”

The “business of banking” provision refers to section 24 (seventh) of the National Bank Act. 12 U.S.C. 24 (seventh). Banks are chartered and regulated under a dual banking system—federal and state bank charters are available as are federal and state thrift charters. Unlike broker-dealers, banks may choose whether to be chartered at the state or federal level. Persons that register as broker-dealers, however, must be licensed at both the federal and state levels.

As one observer has noted: “In 1975, U.S. banks were largely barred from entering the securities or insurance businesses. The Glass-Steagall Act prohibited banks from underwriting or dealing in securities, except for certain narrowly defined categories of ‘bank-eligible’ securities such as U.S. government bonds and general obligation bonds issued by state and local governments.” Arthur E. Wilmarth,

The Transformation of the U.S. Financial Services Industry, 1975-2000: Competition, Consolidation, and Increased Risks

, 2002 U. Ill. L. Rev. 215 at 225-6 (2002) [hereinafter “Wilmarth Article”].

The development of asset-backed securities, high-yield securities, and commercial paper has enhanced the ability of banks' traditional commercial borrowers to access capital markets directly and forego bank financing. In addition, non-bank competitors have entered the commercial and consumer lending markets, further putting pressure on banks' profits. At the same time, investors in search of higher yields have shifted assets from banks to money market funds and other securities. To replace the loss of revenue from traditional lending, large banks have shifted their focus to fee-based activities, including securities activities. As one industry observer has noted:

[C]onsolidation is dividing the banking industry into two distinct sets of institutions. The ten largest banks now hold almost half of the banking industry's assets, and the fifty largest institutions control three-quarters of such assets. These large institutions have shifted away from the traditional, relationship-based business of lending to long-term customers. Instead, big banks are pursuing a transaction-based strategy that emphasizes investment banking, derivatives, syndicated loans, securitized consumer loans, and other activities tied to the capital markets.

Wilmarth Article,

supra

note 5, at 251.

In 1982, the FDIC adopted a policy statement on the applicability of the Glass-Steagall Act to securities activities of insured state non-member banks.

See

47 FR 38984, (Sept. 3, 1982). In 1984, the FDIC adopted a rule regulating the securities activities of affiliates and subsidiaries of insured state non-member banks under the FDI Act. 49 FR 46709 (Nov. 28, 1984) (regulations codified at 12 CFR 337.4) (1986). Representatives of mutual fund companies and investment bankers unsuccessfully challenged the FDIC's Policy Statement (

Investment Company Institute

United States

, D.D.C. Civil Action No. 82-2532, filed September 8, 1982, dismissed without prejudice) and later its regulations (

Investment Company Institute

, v.

FDIC

, 815 F.2d 1540 (D.C.1987) (regulations were upheld)).

In 1987, the Federal Reserve began to permit Section 20 subsidiaries to underwrite or deal in commercial paper and other bank-ineligible securities provided that those activities accounted for less than five percent of the bank's annual gross revenues.

See

Citicorp Order, Approving

Applications to Engage in Limited Underwriting and Dealing in Certain Securities. 73 Fed. Res. Bull. 473 (1987) and Chase Manhattan Corp., Order Approving Application to Underwrite and Deal in Commercial Paper to a Limited Extent. 73 Fed. Res. Bull. 369 (1987).

In 1989, the Federal Reserve provided additional guidance on Section 20 subsidiaries, raising the revenue limit on underwriting and dealing in bank-ineligible securities from five percent to ten percent of the subsidiary's total revenues. Order Approving Modifications to Section 20 Orders, 75 Fed. Res. Bull. 751 (1989). Subsequently, the Federal Reserve raised the revenue limits from non-eligible securities to twenty-five percent, eliminated most of the firewalls between banks and securities firms, and added private placement services and riskless principal transactions to the list of approved non-banking activities.

See

Regulation Y, 12 CFR 225.

Conditional approval of applications by Travelers Group Inc., (Sept. 23, 1998). 84 Fed. Res. Bull. 985 (1998).

http://www.federalreserve.gov/boarddocs/press/bhc/1998/19980923

See

Julie L. Williams and Mark P. Jacobsen, The Business of Banking: Looking to the Future, 50 Bus. Law. 783 at 814 (May 1995) and Julie L. Williams and James F.E. Gillespie,

The Business of Banking: Looking to the Future—Part II

, 52 Bus. Law. 1279 (Aug. 1997) (“While the nature of the national bank charter is the grant of a banking franchise, it explicitly does not limit national banks to banking activities.”).

By enacting the GLBA, Congress repealed most of the remaining vestiges of the ownership restrictions that prevented banks, securities, and insurance firms from combining, thereby allowing them to adopt the universal banking model through the creation of financial conglomerates known as “financial holding companies.”

Congress recognized, however, that combined ownership would likely create conflicts that would need to be addressed through other safeguards.

For a general discussion,

see, e.g.

, Wilmarth Article,

supra

note 5 at 219-220.

In eliminating the ownership separations, Congress understood the need to adopt other safeguards to mitigate the conflicts of interest that combined ownership could create. One of the bill's authors highlighted functional regulation as a key requirement of the GLBA:

The second major feature of the bill is that we promote and strengthen functional regulation. Under the bill, the general rule is that if you are a bank and you are in the securities business, you are regulated by the Securities and Exchange Commission. If you are a bank and you are in the insurance business, you are regulated by the state insurance commissioner in the area where you are engaged in the insurance business. If you are a bank and you are engaged in banking, you are regulated by bank regulators. By opting for functional regulation, we preserve consumer protection, we lower costs.

Statement of Senator Phil Gramm, 145 Cong. Rec. S13783-01.

The Commission has consistently supported Congress' efforts to eliminate the few remaining legal barriers among the various types of financial service providers.

Because eliminating the legal distinctions or separations between commercial and investment banking increased the opportunity for conflicts of interest in the purchase and sale of securities, however, the Commission supported a system of functional regulation to ensure that investors receive the same high level of consumer protection no matter where they effect their securities transactions.

The Commission testified that complete functional regulation would mean that a bank—just like any other securities business—would have to obtain a broker-dealer license and adhere to consumer protections adopted under the federal securities laws to engage as a broker in securities transactions with investors or shift those activities to a registered broker-dealer that is obligated to provide those protections.

For a list of Commission testimony and related correspondence,

see

Exchange Act Release No. 44291 (May 11, 2001), 66 FR 27760 (May 18, 2001) at n. 8.

Id.

The General Accounting Office recognized that investors have received unequal levels of investor protection (including disclosures) and disparate access to remedies depending on the market professional selling them securities.

See

U.S. General Accounting Office, Report to Congressional Requesters:

Bank Mutual Fund Sales Practices and Regulatory Issues

GAO/GGD-95-210, at p. 52 (Sept. 1995); U.S. General Accounting Office, Report to Congressional Requesters:

Banks' Securities Activities—Oversight Differs Depending on Activity and Regulator

, GAO/GGD-95-214, at p. 25 (Sept. 1995).

Testimony of SEC Chairman Arthur Levitt Before the Committee on Commerce Concerning H.R. 10, “The Financial Services Act of 1999” (May 5, 1999).

In enacting the GLBA, Congress adopted functional regulation for bank securities activities, with limited exceptions from Commission oversight. In particular, the GLBA eliminated the complete bank exceptions from the definitions of “broker” and “dealer” in the Exchange Act and replaced them with narrower transaction-based bank exceptions. Although it granted a number of exceptions for banks' securities activities, Congress expressed concerns that banks were engaging in securities activities for investors who are not protected by the federal securities laws.

See

H.R. Rep. No. 106-74, pt. 3, at 114 (1999). In adopting the GLBA, Congress also intended to level the playing field between banks and broker-dealers. As the House Committee on Commerce noted in the legislative history to the GLBA, the complete exception for banks from broker-dealer registration created a competitive disparity by permitting banks to engage in securities activities without being subject to the same regulatory requirements as registered broker-dealers.

See id.

In drafting the bank exceptions from broker-dealer registration, the Committee stated that, “registration may not be required because the conditions imposed on the excepted activities are tailored to protect investors and to ensure competitive fairness among different types of financial services providers.”

Id.

at 162.

With respect to the definition of “broker,” the Exchange Act, as amended by the GLBA, provides that a bank is not considered a broker to the extent it meets the requirements of eleven specific exceptions.

Each of these exceptions permits a bank to act as an agent with respect to specified securities products or in transactions that meet specific statutory conditions.

Exchange Act Section 3(a)(4) [15 U.S.C. 78c(a)(4)].

In particular, Section 3(a)(4) of the Exchange Act provides conditional exceptions from the definition of broker for banks that engage in third-party brokerage arrangements;

trust and fiduciary activities;

permissible securities transactions;

certain stock purchase plans;

sweep accounts;

affiliate transactions;

private securities offerings;

safekeeping and custody activities;

identified banking

products;

municipal securities;

and

de minimis

transactions.

As part of the Exchange Act, these provisions are subject to Commission interpretation.

A bank that effects transactions in securities as agent outside the scope of these exceptions is required to register as a broker in accordance with Section 15(a) of the Exchange Act.

Exchange Act Section 3(a)(4)(B)(i). This exception permits banks to enter into third-party brokerage, or “networking” arrangements with brokers under nine specific conditions.

Exchange Act Section 3(a)(4)(B)(ii). This exception permits banks to effect transactions as trustees or fiduciaries for securities customers under two specific conditions.

Exchange Act Section 3(a)(4)(B)(iii). This exception permits banks to buy and sell commercial paper, bankers' acceptances, commercial bills, exempted securities, certain Canadian government obligations, and Brady bonds.

Exchange Act Section 3(a)(4)(B)(iv). This exception permits banks, as part of their transfer agency activities, to effect transactions for certain issuer plans.

Exchange Act Section 3(a)(4)(B)(v). This exception permits banks to sweep funds into no-load money market funds.

Exchange Act Section 3(a)(4)(B)(vi). This exception permits banks to effect transactions for affiliates, other than broker-dealers.

Exchange Act Section 3(a)(4)(B)(vii). This exception permits certain banks to effect transactions in privately placed securities.

Exchange Act Section 3(a)(4)(B)(viii). This exception permits banks to engage in certain enumerated safekeeping or custody activities, including stock lending as custodian.

Exchange Act Section 3(a)(4)(B)(ix). This exception permits banks to buy and sell certain “identified banking products,” as defined in Section 206 of the GLBA [codified at 15 U.S.C. 78c(a)(4)(B)(ix)].

Exchange Act Section 3(a)(4)(B)(x). This exception permits banks to effect transactions in municipal securities.

Exchange Act Section 3(a)(4)(B)(xi). This exception permits banks to effect up to 500 transactions in securities in any calendar year in addition to transactions referred to in the other exceptions.

In contrast, the Glass-Steagall Act is interpreted by the federal banking agencies.

Exchange Act Section 15(a) generally prohibits broker-dealers that are not registered with the Commission from effecting any transactions in, or inducing or attempting to induce the purchase or sale of, any security.

B. Regulatory and Procedural Background—The Interim Final Rules, Public Comment, and the Temporary Exemptions

In 2001, the Commission adopted interim final rules (“the Interim Rules”) largely in response to interpretive questions and industry concerns about the way in which the Commission would interpret the GLBA.

The Interim Rules were designed to provide banks with guidance regarding the GLBA by defining certain key terms used in the new statutory exceptions. The Interim Rules also provided banks with additional targeted exemptions from the definitions of “broker” and “dealer” for certain types of ongoing securities transactions or activities. The Commission adopted the Interim Rules in interim final form to provide the banking industry with immediate guidance and exemptive relief while also soliciting public comment. In response, the Commission received over 200 letters commenting on the Interim Rules.

Exchange Act Release No. 44291,

supra

note 13.

Nearly all of these letters came from the banking industry or its representatives. The federal banking agencies (the Federal Reserve, OCC, and FDIC) (collectively referred to as the “Banking Agencies”) also submitted comments.

See

letter and appendix dated June 29, 2001 from Alan Greenspan, Chairman, Federal Reserve, John D. Hawke, Comptroller of the Currency, and Donna Tanoue, Chairman, FDIC (“Banking Agencies letter”).

Included in the comment letters were 111 comment letters in a form letter format. Many of the banking organizations that submitted these form comment letters sent multiple copies of a common form letter, including 54 letters from one banking organization. The following banks and persons submitted 116 form letters (“Bank Form Letters”): Amarillo National Bank (54 letters); American Bank Holding Co.; American Church Trust Co.; Austin Trust Co.; Bank Midwest; Bank of West (two letters); Bonham State Bank; Jeff Scribner, Senior Vice President, Financial Services Division Manager, Citizens National Bank; Steven M. Dow, Vice President and Trust Officer, Community Bank &Trust; Extraco Banks; First Command Bank; First National Bank; First National Bank of Abilene (seven letters); First National Bank; First National Bank of Mineola; First State Bank of Texas; First State Bank & Trust Co. (two letters); Richard Perryman, CPA, Vice President and Trust Officer, Guaranty Bank; Hibernia National Bank (two letters); Hibernia Trust (two letters); Murray Pate, Kanaly Trust Company; Legacy Trust Co.; Longview Bank & Trust; Lubbock National Bank; David Malleck; Charles Hall Jr., CEO, MaximBank; McAllen National Bank (four letters); Linda Park; Kimberly Miller, Senior Vice President and Trust Officer, PNB Financial; Luptis Rosales, VP & Trust Officer of unnamed bank; Secured Trust Bank; Sentinel Trust Co.; Southside Bank (two letters); Carol Preston, Senior Vice President and Trust Officer, Southwest Bank; Texas Bank; Texas Capital Bank; Wayne Spencer, President, Texas Community Bank and Trust; Texas Gulf Bank; Texas State Bank (nine letters); Debbie Truman; Willard B. III Wagner. Three additional form letters were submitted without identifying information.

The Commission temporarily suspended the implementation of the exceptions in light of concerns that banks needed more time to adjust their operations to comply with the Interim Rules.

The Commission staff has used this period during the temporary suspension to continue discussions with banking industry representatives, staff from the Banking Agencies, and other interested parties to refine further the guidance and exemptions provided in the Interim Rules.

See

Exchange Act Release No. 44291,

supra

note 13, 66 FR 27760 (adopting Interim Rules, including Exchange Act Rule 15a-7, which gave banks a temporary exemption from the definitions of “broker” and “dealer” until October 1, 2001, and provided an additional conditional exemption until January 1, 2002); Exchange Act Release No. 44570 (July 18, 2001) (providing banks, savings associations, and savings banks with an additional conditional exemption from the definitions of “broker” and “dealer” under the Exchange Act until May 12, 2002); Exchange Act Release No. 45897 (May 8, 2002) (order extending the exemption from the definition of “broker” until May 12, 2003, and from the definition of “dealer” until November 12, 2002); Exchange Act Release No. 46751 (Oct. 30, 2002) (extending the exemption from the definition of “dealer” until February 10, 2003); Exchange Act Release No. 47366 (Feb. 13, 2003) (extending the exemption from the definition of “dealer” until September 30, 2003); Exchange Act Release No. 47649 (April 8, 2003) (extending the exemption from the definition of “broker” until November 12, 2004).

During this period, to facilitate a prompt and efficient resolution of remaining questions and concerns about the Interim Rules, the Commission bifurcated the rulemaking process to address the “broker” and “dealer” issues separately. For an explanation of this bifurcation,

see

Exchange Act Release No. 46745 (Oct. 30, 2002) 67 FR 67496 (Nov. 5, 2002) (“Dealer Proposing Release”). The dealer provisions, along with the Commission's implementing rules, became effective September 30, 2003.

See

Exchange Act Release No. 47364 (Feb. 13, 2003), 68 FR 8686, 8687 (Feb. 24, 2003) (“Dealer Release”).

II. Discussion of Proposed Regulation B

After reviewing the comments on the Interim Rules and discussing the practical application of those Rules with representatives from the banking industry, banking regulators, and other interested parties, the Commission is proposing to revise and restructure the Interim Rules and to codify them in a new regulation, Regulation B. The proposed new rule series is Exchange Act Rule 710 through Rule 781 (17 CFR 242.710 through 781).

Proposed Regulation B includes rules designed to define and clarify a number of the statutory exceptions from the definition of “broker.” In addition, proposed Regulation B would grant new exemptions from the “broker” definition to banks and certain other financial institutions. These proposed exemptions would supplement the statutory exceptions to preserve bank securities activities where consistent with the statutory purpose of investor protection. For example, proposed Regulation B would provide a broad exemption for certain bank cash management services. This proposed exemption would allow banks to buy and sell money market securities for qualified investors and certain other bank customers who keep funds at banks.

Moreover, in response to banks' concerns about calculating their compensation as fiduciaries on an account-by-account basis, the proposal would provide a “line-of-business” compensation test that would permit banks to bypass the account-by-account test in the trust and fiduciary activities exception. In addition, the proposal would broaden an exemption for small banks and thrifts, which could greatly expand the number of smaller financial institutions that are excluded from broker-dealer registration requirements.

The proposal also would provide a number of specialized exemptions to accommodate banks' current business practices, balanced with conditions that are designed to protect investors. These proposed specialized exemptions include exemptions for banks that effect transactions for certain custody customers or pension plans, and those that effect transactions in Regulation S securities with non-U.S. persons.

The proposed titles and numbering of the rules in proposed Regulation B, including the proposed new rules, appear below, with parenthetical explanations added to the titles:

Regulation B: Securities Activities of Banks and Other Financial Institutions

Subpart A—Networking Exception: Defined Terms

242.710: Defined terms relating to the networking exception from the definition of “broker” (proposed amendment to provisions in Exchange Act Rule 3b-17).

Subpart B—Trust and Fiduciary Activities Exception: Exemptions and Defined Terms

242.720: Exemption from the “chiefly compensated” condition for banks with existing personal trust accounts (proposed new rule).

242.721: Exemption for banks from determining whether they are “chiefly compensated” on a line of business (proposed expansion and redesignation of Exchange Act Rule 3a4-2).

242.722: Exemption for banks from determining whether they are “chiefly compensated” on an account-by-account basis (proposed new rule).

242.723: Exemption from the definition of “broker” for banks effecting transactions as an indenture trustee in a no-load money market fund (proposed expansion and redesignation of Exchange Act Rule 3a4-3).

242.724: Defined terms relating to the trust and fiduciary activities exception from the definition of “broker” (proposed amendment to terms in current Exchange Act Rule 3b-17, which would be repealed).

Subpart C—[Reserved]

Subpart D—Sweep Accounts Exception: Defined Terms

242.740: Defined terms relating to the sweep accounts exception from the definition of “broker” (proposed amendment to terms in current Exchange Act Rule 3b-17).

Subpart E—Affiliate Transactions Exception: Defined Terms

242.750: Defined terms relating to the affiliate transactions exception from the definition of “broker” (proposed amendment to terms in current Exchange Act Rule 3b-17).

Subpart F—Safekeeping and Custody Activities Exception: Exemptions

242.760: Exemption from the definition of “broker” for banks effecting transactions in securities in a custody account (proposed expansion and redesignation of Exchange Act Rule 3a4-5).

242.761: Exemption from the definition of “broker” for small banks effecting securities transactions in a custody account (proposed expansion and redesignation of Exchange Act Rule 3a4-4).

Subpart G—Special Purpose Exemptions

242.770: Exemption from the definition of “broker” for banks effecting transactions in securities in certain employee benefit plans (proposed new rule).

242.771: Exemption from the definitions of “broker” and “dealer” for banks effecting transactions in securities issued pursuant to Regulation S (proposed new rule).

242.772: [Reserved]

34a

If the Commission adopts proposed Regulation B, it will redesignate Exchange Act Rule 15a-11 as Exchange Act Rule 772 without changing the language of the current rule.

242.773: Exemption from the definitions of “broker” and “dealer” for savings associations and savings banks (proposed amendment to and redesignation of Exchange Act Rule 15a-9).

242.774: Exemption from the definitions of “broker” and “dealer” for credit unions (proposed new rule).

242.775: Exemption from the definition of “broker” for the way banks effect excepted or exempted transactions in investment company securities (proposed expansion and redesignation of Exchange Act Rule 3a4-6).

Subpart H—Temporary Exemptions

242.780: Exemption for banks from liability under Section 29 of the Securities Exchange Act of 1934 (proposed amendment to and redesignation of Exchange Act Rule 15a-8).

242.781: Exemption from the definition of “broker” for banks for a limited period of time (proposed amendment to and redesignation of Exchange Act Rule 15a-7).

III. Discussion of Comments on the “Broker” Rules and Proposed Amendments

A. Networking Exception

The third-party brokerage (“networking”) exception in Exchange Act Section 3(a)(4)(B)(i)

allows banks to partner with broker-dealers in offering their customers a wide range of financial services, including securities brokerage. Specifically, the exception provides that a bank will not be considered a broker if, under certain conditions, the bank enters into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to bank customers (“networking arrangement”). If the bank's networking activities meet the conditions of the exception, it may, without itself being registered as a broker-dealer, receive compensation related to brokerage transactions the broker-dealer effects as a result of the networking arrangement. The exception also allows unregistered bank employees

to engage in limited securities-related activities and to receive incentive compensation in the form of a “nominal one-time cash fee of a fixed dollar amount” for referring bank customers to the broker-dealer.

15 U.S.C. 78c(a)(4)(B)(i).

“Unregistered” bank employees are bank employees who are not also employed as registered representatives of a registered broker-dealer that supervises their securities activities.

The statutory conditions under which banks may rely on the networking exception stem from a line of no-action letters in which the Commission staff indicated enforcement action would not be recommended against thrifts that entered into highly circumscribed networking arrangements. H.R. Rep. No. 106-74, pt. 3, at 163 (1999). The first of these letters was issued in response to a request from Chubb Securities Corp.

See

Letter re:

Chubb Securities Corp.

(Nov. 24, 1993) (“Chubb letter”). Because they are not banks, thrifts could not rely on the then-existing general exemption from the definition of “broker” enjoyed by banks, and these letters provided thrifts with a means to compete with banks in making securities brokerage services available to their customers. For the relief the Commission is proposing to extend to thrifts,

see

Section III.F.4

infra.

Although the networking exception in Exchange Act Section 3(a)(4)(B)(i) allows banks to continue many of the networking activities in which they engaged before the GLBA was enacted, it also limits the scope of those activities.

Various aspects of bank networking activities are also subject to limitations and requirements in self-regulatory organization (“SRO”) rules, including NASD Rule 2350 (“Broker/Dealer Conduct on the Premises of Financial Institutions”) and NASD Rule 3040 (“Private Securities Transactions of an Associated Person”).

See also

letter re:

First Piedmont Federal Savings and

Loan Association

(July 22, 1991) (the fee specified was $15 (approximately $18 in 1999 dollars)). This amount also is consistent with the $5 to $15 fee range most banks were understood to pay their employees for securities brokerage referrals when the GLBA was drafted in 1998. FDIC,

Nondeposit Investment Products and Recordkeeping Requirements—Questions and Answers

at 10 (July 16, 1998) (citing results of a 1996 survey on bank retail investment services conducted by American Brokerage Consultants, Inc., which “indicated that most banks pay referral fees in a range between $5 and $15.”).

Estimates of inflation-adjusted dollar amounts in this footnote and elsewhere in this release were calculated with the online inflation calculator available on the U.S. Department of Labor Bureau of Labor Statistics' website, which uses the average Consumer Price Index for a given calendar year, available at

http://data.bls.gov/cgi-bin/cpicalc.pl.

Twenty-five dollars approximates the value of the larger fees some banks have begun to pay their employees for brokerage referrals in the past few years, although it appears that at such levels the fees may be contingent on factors inconsistent with the conditions of the networking exception.

See infra

note 55.

The proposed inflation-adjusted $15 and non-adjusted $25 alternative measures of nominal value should address concerns some commenters raised that administering an hourly, wage-based standard might be burdensome or unworkable. As proposed, the amended definition of “nominal one-time cash fee of a fixed dollar amount” should permit many banks to continue paying referral fees with values comparable to fees they pay under their existing referral incentive programs, but others may be required to reduce the amount paid for referrals of customers meeting certain financial criteria.

We anticipate that the most significant changes that may be required at some banks could involve steps such as discontinuing certain types of brokerage-related conditions on referral fees.

Information on existing incentive programs provided through the ABASA, the Bank Insurance Securities Association (“BISA”), and the Independent Community Bankers Association (“ICBA”) suggests that the proposed amendments would accommodate levels of referral fees consistent with the existing referral incentive programs of most banks that provided information to the Commission staff, to the extent such programs do not create inappropriate sales incentives for unregistered bank employees. A representative of the ICBA told the Commission staff that $8 is the average referral fee paid by community banks. Information from BISA on fees for brokerage referrals paid by ten banks that provided a dollar amount in response to a survey indicates a range from zero to $30: one bank pays $5; one bank pays $7 per qualified referral, which is paid into a branch-wide pool of funds that the branch will receive if it meets certain goals that include investment and insurance production; three banks pay $10; one bank pays a range between zero and $14.84, depending on whether employees meet or exceed a threshold number of qualified referrals; one bank pays $20; one bank pays $10 for a discount brokerage referral and $20 for a full-service brokerage referral; one bank pays either $18.75 or $25, depending on whether an employee has already made referrals that have resulted in twelve meetings with a registered representative; and one bank pays points with a value of $25, $25 in cash, or a cash award of between $25 and $30 for referrals exceeding quarterly target levels. One sample plan from ABASA provides for payments in points having a value of $10 for referrals that result in a kept appointment with a registered representative. Another, apparently used by multiple banks, provides for referral fees of either $25 or $35 in cash, depending on whether a bank utilizing the incentive plan selects a minimum investable assets amount of $10,000 or $25,000 for “qualified” customers—

i.e.

, those to whom the referring bank employee has spoken personally, meet the $10,000 or $25,000 minimum investable assets level, and keep an appointment with a registered representative of the broker-dealer within 60 days.

As discussed above, some commenters criticized the definition of “nominal one-time cash fee of a fixed dollar amount” in the Interim Rules

for listing conditions on referral fees that are inconsistent with the networking exception.

As amended, the definition would not list impermissible referral fee conditions. Instead, such conditions would be addressed by the meaning given to the phrase “fixed dollar amount” in the definition, and the proposed new definition of “contingent on whether the referral results in a transaction,” as described below.

See

17 CFR 240.3b-17(g)(2).

See,

e.g.

, Harris Trust letter and QMellon letter (arguing that the Interim Rules should not identify impermissible conditions on referral fees that are not explicitly identified in the statute).

We request comment on the proposed dollar-amount and hourly compensation standards for measuring nominal value in the proposed amended definition of “nominal one-time cash fee of a fixed dollar amount.” In particular, are the $15-inflation adjusted and $25 amounts the most appropriate levels?

The Commission also solicits comments on the merits of providing another alternative standard for determining whether a referral fee is nominal that would be based on the incentive a bank would pay its employee for the sale or renewal of a certificate of deposit (“CD”). To avoid such a standard leading to referral fees with non-nominal values equivalent to what a bank might pay for the sale of a large, long-term CD, the measure would refer to a CD with a term and value equal to the term and value of the CDs banks most frequently issue. The Commission solicits comments on whether such a standard would provide a useful means for measuring a nominal value in this context. In particular, we request comment on what compensation, if any, banks pay for the sale or renewal of a CD. Does the compensation for the sale or renewal of a CD vary based on economic factors such as the bank's level of interest in gathering deposits? Does the incentive vary depending on whether the transaction is a new purchase or a renewal? Does the incentive vary depending on the value of the CD or based on the term of the CD? For example, would the average incentive that a bank pays for the sale of a one-year, $5,000 CD be nominal? The Commission also solicits comments on other possible objective measures banks could use to gauge whether the referral fees they pay are nominal.

b. Meaning of “One-Time”

Exchange Act Section 3(a)(4)(B)(i)(VI)

permits unregistered bank employees to receive a “one-time” fee for the referral of a customer. Commenters expressed the view that banks should be able to pay fees more often than contemplated by the statute.

This could include, for example, making a payment at the time of a referral and then a second one later if the employee makes a particular number of referrals in a period of time covering the referral for which the employee was already paid. Such an approach would be inconsistent with the plain language of the networking exception, which limits banks to paying unregistered employees only “one-time” referral fees.

15 U.S.C. 78c(a)(4)(B)(i)(VI).

See,

e.g.

, NYCH letter.

We therefore propose to include in the amended definition of “one-time nominal cash fee of a fixed dollar amount” an interpretation of the term “one-time” to clarify that a referral fee may be paid to a bank employee no more than one time per customer referred by that employee. This proposed amendment should help clarify the issue, raised by some commenters, of the circumstances under which compensation paid in the form of bonuses falls within the networking exception's prohibition on the payment of brokerage-related incentive compensation to unregistered bank employees.

The proposed provision would not require a bank to determine whether a customer had ever been referred by any of the bank's unregistered employees to pay the referring employee a referral fee. A bank could not, however, pay additional fees to the same unregistered employee based on additional referrals of the same customer, including additional referrals for different types of brokerage products. In other words, a bank could not pay a particular employee more than one referral fee based on multiple referrals of the same customer, and an unregistered bank employee who referred a customer more than once could receive only one fee related to that customer.

Some commenters argued that only bonus plans used as a conduit to pay

brokerage-related compensation to unregistered employees under the exception are prohibited.

We do not agree. Any bonus or other incentive compensation that is payable based in part, directly or indirectly, on a referral for which the employee has already received a referral fee, would violate the exception's requirement that brokerage-related incentive compensation paid to unregistered employees under the exception be limited to “one-time” referral fees. However, consistent with the meaning we propose to give “cash fee” (described below) in the definition of “nominal one-time cash fee of a fixed dollar amount,” a referral fee could be paid partially in cash at the time of the referral and partially in points to be paid to the employee as a bonus at a later time, if the total value of the cash and points in which the fee is paid has a nominal value under the definition.

See,

e.g.

, July 17, 2001, ABA/ABASA letter; Banking Agencies letter; and PNC letter. The Bank One letter, Mellon letter, and SIA letter also sought clarification regarding the circumstances under which bonuses would not be impermissible incentive compensation under the networking exception.

Other types of bonuses that do not give unregistered bank employees a promotional interest in securities brokerage would not be prohibited by the exception's “one-time” requirement. As we explained in adopting the Interim Rules, while the exception does not permit unregistered bank employees to receive bonuses based on brokerage referrals, it does not prohibit bonuses based on the overall profitability of a bank that are determined and paid regardless of the brokerage-related activities of an employee receiving such a bonus.

This is true even though the financial performance of the bank as a whole would in part depend on the bank's securities networking activities, because such activities are unlikely to represent a significant source of the bank's overall profits and such bonuses are not likely to give unregistered employees a promotional interest in the brokerage services offered by the broker-dealers with which the bank networks.

See

Exchange Act Release No. 44291,

supra

note 13, 66 FR at 27766. The explanation continued with the caveat that a bank could not rely on the networking exception and use bonuses as a means of indirectly paying their unregistered employees brokerage-related incentive compensation based on the performance of a branch, department or line of business of the bank. This is also true for bonuses based on points paid under the proposed interpretation of “cash fee.” Such bonuses also must not be contingent on factors on which the payment of a referral fee, or the value of a referral fee, may not be conditioned.

See

discussions regarding “fixed-dollar amount” and “contingent on whether the referral results in a transaction,”

infra

. Of course, whether an unregistered employee receives a bonus based in part on brokerage referrals could be contingent on factors unrelated to securities brokerage, such as whether the employee opens a certain number of deposit accounts or consistently follows the bank's risk management policies. However, as explained below, the exception's “fixed dollar amount” condition means that the value of any points paid for brokerage referrals that might count toward the bonus would need to have a set, nominal value at the time the referrals were made.

In addition, some commenters stated that a bonus program applicable to all employees of a bank holding company, or based on the profitability of a bank holding company as a whole, should not be limited by the networking exception's restrictions on brokerage-related compensation.

The Commission believes that a bonus based on the profitability of a bank's ultimate parent company should be analyzed in the same way as a bonus based on the bank's profitability. We believe that bonuses based on measures more closely related to securities brokerage, however, would be inconsistent with the statutory limitations on referral fees.

See

e.g.

, letter dated July 12, 2001 from Michael P. Smith, President, New York Bankers Association (“NYBA letter”); Harris Trust letter; Mellon letter; and SIA letter.

We request comment on the interpretation of the term “one-time” in the proposed amended definition of “nominal one-time cash fee of a fixed dollar amount.” We are also soliciting comment on what additional guidance, if any, commenters would find useful with respect to bonus programs.

c. Meaning of “Cash Fee”

In addition to cash payments, the definition of “nominal one-time cash fee of a fixed dollar amount” in the Interim Rules provided for payments in points in a system or program covering a range of bank products and non-securities related services in which points count toward a bonus, so long as the value of the points awarded for referrals involving securities are not greater than the value of the points awarded for activities not involving securities.

While Exchange Act Section 3(a)(4)(B)(i) does not contemplate the payment of referral fees in points instead of cash, the Commission included this provision in recognition of banks' existing practices to give them additional flexibility. While some commenters supported the provision, others expressed concern or raised questions about it. For example, some asserted that it should not be limited to points awarded for securities referrals as part of a broader program or argued that it unfairly limited the value of fees paid in points.

See

17 CFR 240.3b-17(g)(1)(ii).

See

Banking Agencies letter; BSA letter; Harris letter; Mellon letter; NYCH letter; Regions letter; and letter dated July 17, 2001 from Ted T. Cecala, Chairman & CEO, Wilmington Trust Company (“Wilmington Trust letter”). Moreover, in meetings with the Commission staff, bank representatives explained they were uncertain regarding the scope of services a program would need to cover to qualify for the exception.

In response to questions and concerns expressed about this provision, the Commission is proposing to modify it. The amended definition of “nominal one-time cash fee of a fixed dollar amount”

would allow the payment of referral fees or portions of referral fees other than in cash to the extent that: (1) Such payments are in units of value with a readily ascertainable cash equivalent;

(2) the total value of the referral fee meets the nominal value conditions of the proposed amended definition; and (3) the payment is made under an incentive program that covers a broad range of products and that is designed primarily to reward activities unrelated to securities.

As noted above, this interpretation of the networking exception's “cash fee” requirement would permit banks to continue using certain types of point-based incentive programs under which points are accumulated toward a cash bonus or other incentive. These provisions are intended to maintain the flexibility provided in the Interim Rules for banks to continue using such programs, while providing greater certainty as to the conditions under which such programs may be used to reward securities brokerage referrals. Of course, a referral fee paid in part or entirely in points must not only have a nominal value, but it must also meet the other conditions of the networking exception.

See

proposed Exchange Act Rule 710(b)(1).

The “readily ascertainable cash equivalent” condition would limit the value of a referral fee paid in points to an amount that is determined by a bank and known to an employee before the employee makes a brokerage referral. This requirement would not permit the value of a “point” to be based on the number of points an employee earns from brokerage referrals. For example, the size of a points-based bonus could not be based on the number of brokerage referrals an employee makes over a target number of brokerage referrals. Similarly, the value of a points-based bonus could not be increased by the percentage of an employee's total points earned from securities brokerage referrals.

See

proposed Exchange Act Rule 710(b)(3). The condition that the incentive program cover a broad range of products and be designed primarily to reward activities unrelated to securities means the program provides incentives for activities such as selling bank products or services not involving securities or for making referrals for non-securities products such as insurance, and that the program is not focused on brokerage referrals.

We request comment on the proposed interpretation of the exception's “cash fee” requirement. In particular, commenters are invited to discuss whether the limitations in this provision

would be sufficient to assure that unregistered bank employees are not given incentives to promote a broker-dealer's brokerage business by engaging in more than the limited activities permitted under the exception. We are also soliciting comment on what additional guidance, if any, commenters would find useful with respect to such programs.

d. Meaning of “Fixed Dollar Amount”

We also propose to amend the definition of “nominal one-time cash fee of a fixed dollar amount” to specify that a fee of a “fixed dollar amount” means a flat fee.

The proposed definition would state that fees paid for brokerage referrals made by a particular employee must have a set value and may not vary based on factors such as the financial status of a customer the employee refers, the identity of the broker-dealer to which the customer is referred, the number of referrals the employee makes, or whether the customer expresses an interest in a particular type of securities product.

The proposed definition would clarify that rewarding referrals with non-flat fees that vary in amount based on “success” factors would be inconsistent with the “fixed dollar” amount requirement in the statute.

3. Comments on Definition of “Referral” and Proposed Amendments

The Interim Rules define the term “referral” to exclude any activity beyond arranging a first securities-related contact between a registered broker-dealer and a bank customer. We received over a dozen comments on the definition of “referral.”

Commenters characterized the definition as excessively narrow,

and generally took the position that it was more restrictive than required by the Exchange Act, the Banking Agencies, and the Interagency Statement.

Several commenters indicated that they saw no need to restrict referral payments at all.

A few objected to the use of the phrase “first securities-related contact,” or suggested that the phrase be defined.

See

e.g.

, Banking Agencies letter; Bank of America letter; BONY letter; Connecticut Bankers letter; NYCH letter; Regions letter; Roundtable letter; UMB Bank letter; and Wells Fargo letter.

See

Interagency Statement,

supra

note 37.

See

Banking Agencies letter; Connecticut Bankers letter; and UMB Bank letter.

See

e.g.

, NYCH letter and Wells Fargo letter.

In response to these comments and to address concerns commenters expressed about difficulties they might have in meeting the definition in the Interim Rules, we propose to eliminate the first securities-related contact limitation from the definition of “referral.” We also propose to simplify the definition in a manner consistent with pre-GLBA networking arrangements. Under the amended definition, a “referral” would mean the action taken by a bank employee to direct a customer of the bank to a registered broker or dealer for the purchase or sale of securities for the customer's account.

See

proposed Exchange Act Rule 710(c). Representatives of banks have expressed an interest in paying their unregistered employees for broker-related activities other than referrals, such as screening potential brokerage customers. The Commission believes that such activities constitute brokerage activities beyond those intended to be covered by the networking exception. The Commission believes it would be inconsistent with the networking exception for banks to pay fees to unregistered bank employees to perform functions—other than those expressly permitted by the GLBA or an applicable exemption—that are traditionally performed by a registered representative of a broker-dealer. A broker-dealer has a duty to know its customers, which involves obtaining financial information from them through its registered representatives. Moreover, whether investing in securities through a broker-dealer is appropriate for a particular individual must be determined by that broker-dealer's registered representative, not unregistered bank employees that are not subject to suitability obligations.

The proposed amendment also would specify that a bank may pay a fee for a brokerage referral only to the employee who made the referral and not to other employees, such as a branch manager or other supervisor. This interpretation of the statute is consistent with existing networking practices and banking agency guidance. We request comment on these proposed changes and clarifications to the definition of “referral.” Commenters are invited to discuss whether banks need additional guidance on what constitutes a referral.

4. Proposed New Definition of “Contingent on Whether the Referral Results in a Transaction”

The Interim Rules stated that the payment of a “nominal one-time cash fee of a fixed dollar amount” for a referral cannot be related to certain enumerated factors, including the value of any securities transaction or a customer's financial status.

Although some commenters indicated that limitations on the conditions under which referral fees may be paid are unnecessary,

the networking exception is clear that the payment of referral fees in reliance on this exception may not be contingent on whether the referral results in a transaction.

See

17 CFR 240.3b-17(g)(2). Proposed Regulation B uses the word “including” as expanding or illustrative, not as exclusive or limiting. The use of the term “including, but not limited to” in Exchange Act Rules 10b-10 and 15b7-1 is not intended to create a negative implication regarding the use of “including” without the term “but not limited to” in Regulation B or other Exchange Act rules.

See

Bank of America letter and SIA letter.

Exchange Act Section 3(a)(4)(B)(i)(VI).

Thus, to provide guidance on those contingencies on which incentive compensation may not be based under the exception, we propose to define the term “contingent on whether the referral results in a transaction” to mean, with two exceptions, contingent on any factor related to whether the referral results in a transaction, including whether it is likely to result in a transaction, whether it results in a particular type of transaction, or whether it results in multiple transactions.

See

proposed Exchange Act Rule 710(a).

For example, under the proposed definition, a bank could not make referral fees contingent on whether a customer opens a brokerage account because such a contingency would make it more likely that the referral would result in a securities transaction.

Referral fees also may not be contingent on whether the customer invests more than a specified amount in securities or maintains a brokerage account for a specified time.

Opening a brokerage account is the first step in a securities transaction. Typically, opening a brokerage account results in the purchase or sale of securities.

In response to commenters' requests,

however, the proposed definition specifically would permit referral fees to be contingent on two factors. First, the term would permit referral fees to be contingent on whether a customer contacts or keeps an appointment with a broker-dealer as a result of a referral.

Second, referral fees may be contingent on whether a bank customer has assets meeting any minimum requirement that the registered broker-dealer, or the bank, may have established generally for referrals for securities brokerage accounts.

Both of these factors give broker-dealers the flexibility to avoid paying fees for worthless referrals without inappropriately aligning the financial interests of the bank's employee with those of the broker-dealer. A customer could fail to keep an appointment scheduled at the time of a referral but still contact a broker-dealer as a result of the referral. Banks may wish to pay referral fees in those contexts. These contingencies appear to be commonly used in existing networking arrangements. In contrast, contingencies based on whether a referral results in a customer opening or funding a brokerage account, on

whether the customer keeps the account open for a certain period of time, or on whether the referral results in brokerage-related fees above a certain amount or assets invested above a certain amount are the type of success-based factors that are close measures of whether a referral results in a transaction.

See

Bank of America letter and SIA letter.

See

proposed Exchange Act Rule 710(a)(1).

See

proposed Exchange Act Rule 710(a)(2).

We request comment on the proposed definition of “contingent on whether the referral results in a transaction.” In particular, we seek comment on whether there are additional contingencies that banks currently place on referral fees that should be permissible under the proposed definition of “contingent on whether the referral results in a transaction.” In addition, we encourage commenters to discuss other areas where they believe the Commission should grant exemptive relief related to networking arrangements. For example, in addition to the asset, net worth, and income contingencies excluded from the proposed definition, we seek comment on whether banks should be able to condition the payment of referral fees on other criteria relating to other aspects of a customer's financial profile, such as tax bracket. Banks also are invited to discuss whether they would be able to continue their existing networking activities if the current rules were amended as described above. If not, banks should explain what proposed rule provisions would prevent them from doing so. Banks should also explain what changes, if any, they would need to make to their existing networking programs to comply with the amended rules.

5. Interpretations of “Contractual or Other Written Arrangement” and “Qualified Pursuant to the Rules of a Self-Regulatory Organization”

The Commission has received requests to provide further guidance on certain terms used in the Interim Rules in connection with the networking exception that were not defined in the Interim Rules. Therefore, it may be useful to clarify the meaning of some of these terms. First, one commenter proposed that the Commission interpret the networking exception requirements expansively to “apply to any bank subsidiary expressly formed for the purpose of engaging in securities transactions.”

We decline to expand the scope of the networking exception in this manner. The Exchange Act's functional exceptions for banks from the definitions of “broker” and “dealer” apply only to banks, and only under limited circumstances. Non-bank affiliates of banks are not subject to the same level of regulation as banks, and such entities were not exempted from the Exchange Act's broker-dealer registration requirements by the general exemption that the GLBA replaced with limited, functional exceptions for banks. Non-bank subsidiaries or affiliates of a bank may not rely on a bank exception or exemption from broker-dealer registration.

This interpretation is consistent with the plain language of the GLBA. Non-bank entities that refer customers, including bank customers, to broker-dealers would generally have to register as broker-dealers.

See

letter dated July 17, 2001 from Neil Milner, President and CEO, Conference of State Bank Supervisors (“CSBS letter”). Similarly, the Commission staff has received informal requests for guidance on whether the networking exception would permit a bank to avoid being considered a broker based on a networking arrangement entered into by an affiliate or a subsidiary of the bank, and whether a bank could participate in networking activities under arrangements entered into by an affiliated insurance agency.

See

Exchange Act Section 3(a)(6) which defines “bank.”

In general, absent an exception or exemption, a person who regularly refers securities business prospects for compensation to a broker-dealer would be a broker required to be registered with the Commission.

See

Exchange Act Release No. 27017 (July 11, 1989), 54 FR 30013, 30017-18 (July 18, 1989).

Second, the Commission has received informal requests to clarify the term “qualified pursuant to the rules of a self-regulatory organization.” This term means to be qualified to effect a securities transaction as a natural person associated with a registered broker or dealer under Exchange Act Rule 15b7-1, which requires broker-dealers to comply with SRO qualification standards.

See

17 CFR 240.15b7-1.

We request comment on these interpretations, and on whether banks require additional clarification of these terms or explanations of other terms used in the networking exception. We also seek comment on whether these interpretations or any other suggested interpretations related to the networking exception should be included as amendments to the Interim Rules.

The Commission staff also has received informal requests for guidance on whether particular activities are clerical or ministerial, and thus can be performed by unregistered bank employees within the scope of the networking exception. Clerical and ministerial functions are those such as scheduling appointments with a broker-dealer that do not require specific qualifications or licensing when performed by an employee of a broker-dealer. These functions do not require familiarity with the securities industry, or the exercise of judgment concerning securities. Detailing all of the activities that would constitute clerical and ministerial functions is beyond the scope of this release. Nevertheless, the Commission would welcome requests for exemptive or no-action relief or interpretive guidance with respect to specific activities that interested parties believe are clerical or ministerial in the banking context.

B. Trust and Fiduciary Activities Exception

Section 3(a)(4)(B)(ii) of the Exchange Act

permits a bank, under certain conditions, to effect transactions in a trustee or fiduciary capacity without registering as a broker. Under this exception, a bank must effect such transactions in its trust department, or other department that is regularly examined by bank examiners for compliance with fiduciary principles and standards.

The bank also must be “chiefly compensated” for such transactions, consistent with fiduciary principles and standards, on the basis of: (1) An administration or annual fee, (2) a percentage of assets under management, (3) a flat or capped per order processing fee that does not exceed the cost the bank incurs in executing such securities transactions, or, (4) any combination of such fees.

The term “chiefly compensated” is not defined in the GLBA. Therefore, in the Interim Rules, the Commission provided a definition for the term to establish clear standards for complying with the “chiefly compensated” requirement under the GLBA.

15 U.S.C. 78c(a)(4)(B)(ii).

15 U.S.C. 78c(a)(4)(B)(ii)(I). Banks relying on this exception may not publicly solicit brokerage business, other than by advertising that they effect transactions in securities in conjunction with advertising their other trust activities. 15 U.S.C. 78c(a)(4)(B)(ii)(II). The exception also provides that a bank's trust and fiduciary activities that result in a transaction in the United States of any security that is publicly traded must meet the conditions set out in Section 3(a)(4)(C) of the Exchange Act. 15 U.S.C. 78c(a)(4)(C). These conditions require a bank to direct a trade to a registered broker or dealer for execution, to 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 contravention of fiduciary principles established under applicable federal or state law, or to effect the trade in some other manner permitted by the Commission. 15 U.S.C. 78c(a)(4)(C)(i)-(iii). The term “assets under management” is not defined in the Exchange Act or in the proposed rules.

Exchange Act Rule 3b-17(a) defines the term “chiefly compensated” to mean that “the ‘relationship compensation’ received by a bank from a trust or fiduciary account exceeds the ‘sales compensation’ received by the bank from such account during the immediately preceding year. * * *”

Provisions of the Interim Rules relating to the “chiefly compensated” requirement engendered a great deal of public comment and have been a primary focus of the discussions the Commission staff has had with banking industry representatives and bank regulators since the Interim Rules were adopted. As a result of these comments and discussions, the Commission is proposing to modify substantially the “chiefly compensated” provisions in the Interim Rules. In the Commission's view, these proposed improvements should facilitate their compliance with the “chiefly compensated” requirement while permitting banks to continue many of their current practices. This, in turn, should ease their costs of transition to the new statutory scheme without compromising investor protection.

1. Chiefly Compensated

a. Statutory Requirements and Existing Rules

To qualify for the trust and fiduciary activities exception, Exchange Act Section 3(a)(4)(B)(ii) requires a bank to be “chiefly compensated” for transactions effected in its trustee or fiduciary capacity, consistent with fiduciary principles and standards. This condition reflects Congress' goals to implement the functional regulation of securities activities and to permit banks to continue to conduct limited securities activities while acting as, and being paid as, fiduciaries.

The statutory conditions that a bank must meet to qualify for this exception are designed to ensure that bank trustees and fiduciaries conducting securities activities outside of the protections of the securities laws are compensated as traditional trustees and fiduciaries.

By enacting a trust and fiduciary activities exception in the Exchange Act, Congress acknowledged that banks held securities in trust accounts. In the GLBA's legislative history, the conference committee stated that “[t]he Conferees expect that the SEC will not disturb traditional bank trust activities under this provision.” H.R. Conf. Rep. No. 106-434, 164 (1999).

The House Committee on Commerce further stated that it expected the Commission “to interpret this exception, and, in particular the references to “chiefly” and “fiduciary principles and standards” contained in this exception, so as to limit a bank's ability to receive incentive compensation or similar compensation that could foster a salesman's stake in promoting securities transactions.” That Committee also stated that it did not intend for a bank to conduct a full-scale securities brokerage operation in the trust department that would be exempt from Commission regulation and the imposition of appropriate investor protections under the Federal securities laws. H.R. Rep. No. 106-74, pt. 3, at 164 (1999).

The question of when a bank may be acting in a fiduciary

capacity

is separate and distinct from the question of whether a specific account is established for a fiduciary

purpose

. For example, a bank may be acting in a fiduciary

capacity

when it provides investment advice to a common investment fund. Such a fund, however, will be excluded from the definition of investment company under the Investment Company Act of 1940 (“Investment Company Act”) only if it is employed solely as an aid to the administration of accounts maintained for a traditional fiduciary

purpose

See

Section 3(c)(3) of the Investment Company Act.

By its terms, the “chiefly compensated” condition divides a bank's compensation into qualifying (traditional fees received by trustees and fiduciaries) and non-qualifying types (traditional fees received by broker-dealers), and limits the amount of non-qualifying compensation a bank may receive and still rely on the exception. In other words, Section 3(a)(4)(B)(ii) contemplates that a bank relying on the trust and fiduciary activities exception will need to limit its non-qualifying compensation and will need to have a mechanism in place to determine whether it has succeeded in doing so.

While defining the types of compensation to compare is essential to making the test meaningful, the statutory limitations require many banks to categorize and compare their compensation in a manner that is new to them. Current Exchange Act Rule 3b-17 was intended to facilitate that categorization and comparison. The Rule defines “chiefly compensated” to mean that more of a bank's payments for securities transactions must come from qualifying, or “relationship compensation,”

than from non-qualifying, or “sales compensation.”

See

Exchange Act Rule 3b-17(i). The term “relationship compensation,” an amended version of which the Commission is proposing to codify in Exchange Act Rule 724, includes administrative or annual fees (payable on a monthly, quarterly, or other basis), fees based on a percentage of assets under management, a flat or capped per order processing fee limited by the bank's cost in effecting the transaction, or any combination of such fees.

See

Exchange Act Rule 3b-17(j). The “sales compensation” definition, an amended version of which the Commission is proposing to codify in Exchange Act Rule 724, includes compensation that a bank receives for a securities offering that the bank does not receive directly from a customer, beneficiary, or the assets of the trust or fiduciary account. “Sales compensation” also includes Rule 12b-1 fees. “Rule 12b-1 fees” or “12b-1 fees” are fees paid out of fund assets pursuant to a distribution plan adopted under Rule 12b-1 under the Investment Company Act. 17 CFR 270.12b-1. The “sales compensation” definition reflects the fact that bank trust departments, like broker-dealers, receive payments for securities transactions from third parties. Many of the sales practice provisions of the federal securities laws, including a number of NASD rules, are designed to address such conflicts of interest. “Sales compensation” also includes revenue sharing payments that bank trust departments receive from mutual fund companies.

To determine compliance with the “chiefly compensated” condition, current Exchange Act Rule 3b-17 requires banks to compare their “relationship compensation” to their “sales compensation” annually, on an account-by-account basis. Unrelated compensation is not included in the “chiefly compensated” calculation because it is not relevant to whether a bank is acting as a broker.

Any fee a bank receives that is not related to effecting securities transactions is considered “unrelated compensation” and, except as discussed below, is not included in the definition of “relationship compensation.” Unrelated compensation includes fees charged separately for activities, including taking deposits, lending funds (including margin lending), preparing taxes, or providing other services that are not related to managing securities accounts pursuant to the trust and fiduciary activities exception. Unrelated compensation also includes compensation received as permitted under the terms of another bank exception from the definitions of “broker” and “dealer.” This exclusion includes any payment made to the bank or one of its employees pursuant to the networking exception.

See

Exchange Act Section 3(a)(4)(B)(i)(VI).

The Interim Rules also provided two exemptions from the general requirements of the “chiefly compensated” condition. First, current Exchange Act Rule 3a4-2 exempts banks that receive less than ten percent sales compensation from making calculations on an account-by-account basis. Second, Exchange Act Rule 3a4-3 exempts banks from the definition of broker when they act in the narrow role of indenture trustees investing in no-load money market funds. These exemptions are explained in more detail below.

b. Comments on “Chiefly Compensated” Requirement

We received multiple comments addressing the “chiefly compensated” condition.

Many commenters agreed

that the term “chiefly compensated” should not be interpreted to require a higher percentage threshold than the fifty percent standard in the Interim Rules.

Many commenters disagreed with the Commission's interpretation, however, that the “chiefly compensated” calculation should be made on an account-by-account basis.

Commenters opposing an account-by-account calculation argued that the GLBA does not expressly require such a calculation and that determining compliance in this manner would be unduly costly and complicated. Some commenters expressed the view that the “chiefly compensated” condition should instead be interpreted to allow banks to determine compliance on a line-of-business basis because they believe that Congress intended a line-of-business approach.

100

See

e.g.

, ABA/ABASA letters; ACB letter; Bank of America letter; ABA Banking Law Committee letter; Bank One letter; Banking Agencies letter; BONY letter; Broadway letter; CSBS letter; letter dated July 17, 2001 from Jerry W. Powell, General Counsel, Compass Bancshares (“Compass letter”); Connecticut Bankers letter; letter dated July 2, 2001 from Melanie L. Fein, Attorney at Law, on behalf of Federated Investors, Inc. and letter dated June 18, 2001 from Eugene F. Maloney, Executive Vice President and Corporate Counsel, Federated Investors, Inc. (“Federated letters”); letter dated July 10, 2001 from William Nappi, CTCP, Trust Compliance Officer, FirstMerit Corp., N.A. (“FirstMerit letter”); letter dated July 13, 2001 from Michael Watkins, Senior Vice President and Deputy General Counsel, First Union Corporation (“First Union letter”); Fleet letter; Harris Trust letter; IIB letter; Mellon letter; National City letter; Bar of NY letter; NYCH letter; PNC letter; Regions letter; Roundtable letter; letter dated July 17, 2001 from Stewart P. Greene, Chief Counsel, Securities Law, Teacher Insurance and Annuity Association (“TIAA-CREF letter”); Texas Bankers Trust Division letter; UMB Bank letter; Victoria letter; Virginia Bankers letter; Wells Fargo letter; letter on behalf of an unnamed client, dated July 17, 2001 from Satish M. Kini of Wilmer, Cutler & Pickering (“Wilmer, Cutler letter”); and letter dated July 16, 2001 from W. David Hemingway, Chief Financial

Officer, Zions Bank Capital Markets, Zions First National Bank, letter dated July 17, 2001 from Rick D. Burtenshaw, Senior Vice President, Investment Division, Zions National Bank (“Zions Bancorporation letters”).

See

e.g.

, Banking Agencies letter.

See

e.g.

, ABA/ABASA letters; ACB letter; Banking Agencies letter; BONY letter; Compass letter; Connecticut Bankers letter; Mellon letter; NYCH letter; PNC letter; Regions letter; UMB Bank letter; Wells Fargo letter; and Wilmer, Cutler letter.

But see

Statement of the ABASA Before the Committee on Banking and Financial Services, U.S. House of Representatives, on The Financial Services Act of 1999, H.R. 10, February 16, 1999:

[H.R. 10's] fee provisions . . . will force every trust bank to analyze each fiduciary account to ensure that the account satisfies the exemption's fee requirements. . .. Despite the regulatory burdens associated with complying with the fee aspect of the exemption, the overall exemption is, ABASA believes, workable. . . .

The Commission notes that H.R. 10 contained language regarding bank securities activities within a trust and fiduciary exception to the definition of broker that was virtually identical to the version that Congress ultimately adopted.

100

See

e.g.

, ABA/ABASA letters.

Some commenters also raised concerns about the way in which the Commission proposed to categorize certain types of compensation. For example, under the Interim Rules, Rule 12b-1 fees are considered “sales compensation” rather than “relationship compensation.” Some commenters believed that 12b-1 fees should be categorized as “relationship compensation.”

101

In addition, one commenter asserted that banks should be able to treat fees based on a percentage of assets under management, such as separately charged fees for managing real property, as “relationship compensation.”

102

101

See

NYCH letter and PNC Bank letter.

102

See

Texas Bankers Trust Division letter.

One commenter recommended that the Commission “grandfather” trust and fiduciary arrangements that were entered into prior to the establishment of the parameters for categorizing compensation.

103

Others emphasized the need for a cure period or “safe harbor” for banks that inadvertently failed to meet the “chiefly compensated” condition during a particular time period.

104

103

See

NYCH letter.

104

See

ABA/ABASA letters; Banking Agencies letter; Roundtable letter; Bar of NY letter; and Wilmer, Cutler letter. The Commission also received a number of comments regarding the exemptions from the “chiefly compensated” requirement in current Exchange Act Rules 3a4-2 and 3a4-3. These comments are discussed below in connection with proposed amendments to those exemptions.

c. Proposed Changes in Response to Comments

In response to comments on provisions of the Interim Rules dealing with the “chiefly compensated” condition, the Commission is proposing new exemptions and expanding the existing exemptions. To simplify compliance, the Commission also is proposing to expand the definition of “relationship compensation” to expand the types of assets that could qualify for assets under management fees paid directly by the customer, beneficiary, or account.

105

The Commission believes that the proposed amendments to the provisions of the Interim Rules that address the “chiefly compensated” condition should significantly simplify compliance with the condition, alleviate concerns about inadvertent noncompliance, and reduce the costs banks were likely to have incurred in making the “chiefly compensated” calculation under the Interim Rules.

105

Although the term “assets under management” is defined in Section 203A(a)(2) of the Advisers Act, it is not defined in the Exchange Act or in these proposed rules and would include non-securities assets.

See

section III.B.1.h

infra.

For example, the Commission is proposing a “line-of-business” alternative to the account-by-account methodology in response to requests by representatives from the banking industry. Moreover, the Commission is proposing to exempt existing living, testamentary, and charitable trust accounts from the “chiefly compensated” calculation. Finally, the Commission is proposing to establish a multi-tiered “safe harbor” for banks determining compliance on an account-by-account basis that find themselves out of compliance with respect to particular accounts. The proposed safe harbors would provide banks with legal certainty during those periods in which they were not compliant and would provide them opportunities to come into compliance with the “chiefly compensated” condition. These proposed changes to the Interim Rules, as well as Commission guidance on other aspects of the Interim Rules, are discussed below.

106

Despite commenters' suggestions, an annual account-by-account calculation is consistent with implementing functional regulation to protect investors. It also is consistent with the way in which both broker-dealers and banks establish their obligations and duties to their customers which, in turn, defines the capacity in which they will act. It is also consistent with accounting requirements and other fundamental determinations that trustees must make under state trust law. Moreover, bank trust departments primarily charge fees at the same level at which securities transaction fees are assessed—the account level.

d. Proposed Line-of-Business Exemption

i. Description of Existing Rule

Exchange Act Rule 3a4-2 permits a bank to rely on the trust and fiduciary activities exception from broker registration under the GLBA if the bank's total “sales compensation” during the previous year was less than ten percent of its total “relationship compensation” for that period, provided the bank meets other conditions in the exception.

107

The rule was intended to provide banks with an alternative to the account-by-account calculation of the “chiefly compensated” requirement.

107

A bank relying on the Exchange Act Rule 3a4-2 exemption must comply with all other terms of the trust and fiduciary activities exception and must maintain procedures reasonably designed to ensure compliance with the “chiefly compensated” requirement with respect to a trust or fiduciary account. Exchange Act Rule 3a4-2 currently requires those procedures to provide that an account will be reviewed when it is opened, when the compensation arrangement for the account is changed, and when sales compensation received from the account is reviewed by the bank for purposes of determining an employee's compensation. Exchange Act Section 3(a)(4)(C) requires that a bank must also execute any securities orders through a broker-dealer (or in a cross trade or other means that the Commission may prescribe).

Commenters generally agreed that an alternative to the account-by-account “chiefly compensated” calculation was desirable.

108

Some argued, however, that the alternative that the Commission adopted in Exchange Act Rule 3a4-2 was unduly restrictive and in practice would not provide meaningful relief from the account-by-account calculation. In particular, several commenters stated that the procedural conditions in the exemption essentially require an account-by-account calculation, thereby defeating the purpose of the exemption.

109

108

See

e.g.

, Banking Agencies letter and BSA letter.

109

See

e.g.

, Banking Agencies letter; BONY letter; Bank One letter; Federated letters; Fleet letter; ICBA letter; Mellon letter; PNC letter; Regions letter; and UMB Bank letter. Commenters expressed concern about the costs and burdens associated with these requirements.

See

e.g.

, Mellon letter. One commenter suggested eliminating one of the

procedural conditions so that banks could adopt an across-the-board fee increase without triggering an account-by-account compliance review.

See

Federated letters.

ii. Description of Proposed Line-of-Business Exemption

In response to comments, we propose to adopt a “line-of-business” approach in proposed Exchange Act Rule 721.

110

The proposal would define a “line of business” as an identifiable department, unit, or division of a bank organized and operated on an ongoing basis for business reasons with similar types of accounts and for which the bank acts in a similar type of fiduciary capacity as listed in Exchange Act Section 3(a)(4)(D).

111

Under the proposal, a bank could use an alternative calculation for “chiefly compensated” during one year if it could demonstrate that during the preceding year its ratio of “sales compensation” to “relationship compensation” was no more than one to nine either on a line-of-business or bank-wide basis (

i.e.

, “one to nine ratio”).

112

110

See

proposed Exchange Act Rule 721(c). We do not expect banks to be in compliance with the “chiefly compensated” condition during the delayed compliance period for the Interim Rules. Moreover, given that the exemption we are proposing under Exchange Act Rule 721 depends on compliance during the preceding year, this condition would not apply during the first year that the broker exceptions apply to banks. Of course, banks would be expected to demonstrate compliance at the end of the first year after the delayed compliance period. Then, by demonstrating year-end compliance, a bank would have legal certainty for the following year under the terms of the proposed exemption.

111

See

proposed Exchange Act Rule 724(e).

112

We are proposing a one to nine ratio, which is similar to the test in the Interim Rules, because we understand that many banks would fit within this proposed exemption using this threshold.

See

Exchange Act Release No. 44291,

supra

note 13. A one to nine ratio allows banks to receive slightly more than ten percent in sales compensation and not run afoul of the proposed exemption. The proposal would require that the comparison be made based on compensation from accounts within the scope of Exchange Act Section 3(a)(4)(D). For this exception and all of the proposed related exemptions, year continues to be defined as a calendar year or other fiscal year consistently used by a bank for recordkeeping and reporting purposes.

A bank could use this proposed alternative on a line-of-business basis provided that the “sales compensation” and “relationship compensation” from all trust and fiduciary activity accounts within a particular line of business (or all such accounts within a particular line of business established before a single date certain) is used to determine whether the bank meets this condition.

For example, the bank could limit the accounts in a personal trust line of business that would be used in the line-of-business compensation comparison to all of the accounts established before a single date certain. The enhanced flexibility in this part of the proposal would permit a bank to phase in the use of account-by-account exemptions for qualifying fiduciary activities as long as the bank establishes a specific cut-off date for older accounts within a line of business. This flexibility also should allow them to use this proposal consistent with their changing business practices.

Banks relying on the proposed line-of-business alternative would be required to meet the other conditions in the trust and fiduciary activities exception and would be required to maintain procedures reasonably designed to ensure that, before opening or establishing an account, the bank reviews the account to ensure that the bank is likely to receive more “relationship compensation” than “sales compensation” with respect to that account.

113

In addition, in contrast to the requirement in current Exchange Act Rule 3a4-2 that the bank review an existing account whenever the compensation arrangement for the account changes, the proposal would only require the bank to maintain procedures reasonably designed to ensure that, after opening or establishing an account, at such time as the bank individually negotiates with the accountholder or beneficiary of that account to increase the proportion of “sales compensation” as compared to “relationship compensation,” the bank reviews the account to ensure that the bank is likely to receive more “relationship compensation” than “sales compensation” with respect to that account.

114

In other words, only when the bank is revising the fees of a particular account with the accountholder or beneficiary in a way that would increase the proportion of “sales compensation,” would it also have to review the account to ensure that it is likely to receive more “relationship compensation” than “sales compensation.”

115

113

See

proposed Exchange Act Rule 721(a)(3).

114

See

proposed Exchange Act Rule 721(a)(4). This proposed requirement would not be triggered, for example, when the fees received by the bank change due to changes in assets or asset allocation, or if the bank makes across-the-board changes in fees to address inflation.

115

We also propose to eliminate the requirement in current Exchange Act Rule 3a4-2 that a bank review an account when sales compensation is reviewed for purposes of determining an employee's compensation.

See

Exchange Act Rule 3a4-2(a)(2)(iii).

The proposed line-of-business alternative is intended to give banks legal certainty for each year based on their demonstrated compliance for the previous year.

We request comment on the line-of-business alternative in proposed Exchange Act Rule 721. Generally, would the proposed line-of-business alternative make it easier for banks to comply with the “chiefly compensated” condition? If so, please provide quantitative information regarding the cost savings banks that choose the line-of-business alternative could expect versus the account-by-account calculation. In this regard, we request comment on how banks are generally compensated with respect to their existing trust and fiduciary activity accounts. The one to nine ratio is essentially the same comparison used in the Interim Rules, but expressed as a ratio rather than as a percentage to align the comparison in the proposed rules more closely with the “chiefly compensated” condition in the statute. We request comment on whether the use of a ratio makes the comparison more clear, or whether the comparison should be expressed as a percentage. We also request comment on whether a one to nine ratio (or, if expressed as a percentage, 11 percent) is the most appropriate comparison, if a one to ten ratio would be sufficient to accommodate banks' current business, or if another ratio would be more practicable. Commenters should include specific information on each particular bank's “sales compensation” compared to its “relationship compensation.”

In addition, we request comment on what impact the expanded definition of “relationship compensation,” which would now include separately charged assets under management fees for managing other assets (such as real property, oil and gas, etc.), would have on banks' ability to meet the proposed line-of-business alternative.

116

See

proposed Exchange Act Rule 724(h) and section III.B.1.h

infra.

Further, we solicit comment on the procedural requirement that a bank review an account when the proportion of “sales compensation” is increased, and the impact of this condition on waiving “relationship compensation” for a particular account.

117

Is there an alternative that would allow for fee waivers without allowing the bank to be continually compensated by a significant number of accounts entirely through “sales compensation”?

117

See

proposed Exchange Act Rule 721(a)(4).

We also request comment on what impact the requirement that the bank use the compensation from all trust and fiduciary activity accounts within a particular line of business would have on the bank's ability to use the other exemptions proposed in this release,

such as the exemptions in proposed Exchange Act Rules 720 and 776. In particular, we solicit comment on whether living, testamentary, and charitable trust accounts are grouped with other non-exempt accounts in a line of business. We also request comment on whether banks place employee benefit plan accounts and other accounts not subject to a special purpose exemption within a particular line of business. Banks that believe they will need additional flexibility for their personal trust and retirement business should provide a detailed explanation of the type of relief they believe would be useful and discuss the sources of their compensation in connection with that business. In addition, we request comment on whether the definition of line of business is practicable. Is this definition subject to manipulation by banks that may have difficulty meeting the line-of-business test in a particular year, and if so, how should it be modified to prevent this?

We also request comment on whether it is appropriate that banks be permitted to use the proposed line-of-business alternative for some lines of businesses, and use an account-by-account calculation or other proposed exemptions for its other lines of business if available. In addition, we request comment on whether it is appropriate for banks to choose whether to use this proposed exemption for particular accounts based on a cut-off date that the bank determines.

Bank representatives informed Commission staff that it would be simpler and more cost effective if banks were permitted to compare “sales compensation” to a bank's total trust and fiduciary activities compensation rather than to “relationship compensation.” Presumably, total trust and fiduciary activities compensation would include “relationship compensation,” “sales compensation,” and any compensation that a bank receives for the sale of other products and services. We are soliciting comment on the feasibility and desirability of amending the “one to nine ratio” in the line-of-business calculation to require banks to compare their “sales compensation” to their total compensation from qualifying fiduciary activities, as opposed to the current comparison of “sales compensation” to “relationship compensation.” What ratio would be appropriate if the basis were expanded?

In particular, we solicit comment on what compensation items, in addition to “sales compensation” and “relationship compensation,” would be included in a bank's total compensation for qualifying fiduciary activities and the quantitative impact of including these compensation items on the line-of-business proposal. In addition, what impact, if any, would such a change in the calculation have on the number of banks that could meet the trust and fiduciary activities exception? Moreover, what would be the cost savings to banks in complying with the “chiefly compensated” condition if we were to permit banks to compare “sales compensation” to total compensation rather than to “relationship compensation?” We would like to know the types of compensation that banks would include in total compensation from qualifying fiduciary activities. To evaluate the recommendation that we permit banks to compare “sales compensation” to total compensation for trust and fiduciary activities, we are soliciting quantitative information from banks that would illustrate how such a bank would fare under each of the tests.

118

What other changes, if any, do commenters believe should be made to the “chiefly compensated” calculation?

118

To the extent that such information would be deemed proprietary, banks could request confidential treatment for that information.

Finally, we are seeking comment on the way in which banks are likely to use the proposed calculation alternatives to determine whether additional flexibility is needed in this particular exemption and how best to provide it. For example, do banks have lines of business containing both accounts covered by the special purpose exemptions (

e.g.

, for Regulation S or employee benefit plan accounts) and accounts that are not? If so, which lines of business contain both types of accounts?

e. Proposed New Living, Testamentary, and Charitable Trust Account Exemption

Commenters indicated that banks need flexibility with respect to established personal trust accounts that have terms that cannot readily be changed without consequences to both the bank and the trust beneficiaries. These commenters explained that fees received in connection with these accounts were negotiated in the past and may be difficult to change to meet the “chiefly compensated” condition based on, for example, the age or type of the trust.

119

Banks may administer trusts that were created by settlors who have died or who may have become incompetent. In addition, we understand that state law may make it impracticable to change the compensation structure of existing trusts.

119

See, e.g.

, Banking Agencies Letter and NYCH letter.

In response to these concerns, we are proposing new Exchange Act Rule 720. This proposed rule would exempt a bank from meeting the “chiefly compensated” condition to the extent that it effects transactions for a living, testamentary, or charitable trust account opened, or established before July 30, 2004, in a trustee or fiduciary capacity if the bank does not individually negotiate with the accountholder or beneficiary of the account to increase the proportion of “sales compensation” as compared to “relationship compensation” after July 30, 2004.

120

For purposes of this proposed rule, a testamentary trust may be deemed to be established as of the date of the will that directed that the trust be established. Banks making an account-by-account calculation that rely on a particular exemption must comply with all of the requirements in that exemption, but have the option of choosing the exemption or exemptions they need to match their business.

120

This date was chosen for administrative simplicity.

We invite comment on the proposed exemption for existing personal trust accounts. Banks are particularly invited to explain the ways in which they are compensated for administering existing personal trust accounts.

f. New Conditional Safe Harbor

We also propose to adopt a one-year conditional safe harbor for a bank that exceeds the one to nine ratio that it would need to meet to rely on the line-of-business alternative in proposed Exchange Act Rule 721.

121

Under this safe harbor, a bank that exceeds the one to nine ratio in any given year may continue to rely on the proposed line-of-business alternative for the following year if it meets three requirements.

122

First, it must meet the other requirements of the rule and the other requirements of the trust and fiduciary activities exception. Second, the bank's ratio of “sales compensation” to “relationship compensation” the bank received from its qualifying fiduciary business must have been no more than one to seven.

123

Third, it may not have relied on this safe harbor during any of the five preceding years.

121

See

proposed Exchange Act Rule 721(b).

122

See supra

note 112 for a discussion of the term “year.”

123

The one to seven ratio is intended to provide legal certainty to banks that are working in good faith to comply with the terms of the proposed exemption.

Used in conjunction with the line-of-business alternative, discussed above,

this proposed new safe harbor should provide banks with time to adjust their “sales compensation,” when necessary, to ensure that it does not exceed the exemption's limit. For example, a bank that finds its “sales compensation” is likely to exceed the one to nine compensation ratio could begin to adjust its compensation immediately. The legal assurance that it would have time to make this adjustment without consequence should permit banks to refine their compensation sufficiently to assure that they will remain in compliance.

This new safe harbor should supplement the rule's general exemption in addressing banks' concerns that if they inadvertently exceed the exemption's “sales compensation” percentage in one year, they would immediately need to conduct an account-by-account analysis to determine whether they are in compliance with the “chiefly compensated” condition. We understand that banks relying on proposed Exchange Act Rule 721 may not have compliance procedures in place to do account-by-account monitoring. Banks could rely on the proposed new safe harbor for one year while taking steps to ensure that they will meet the terms of the general exemption before the end of that year.

124

These steps could include employing brokers to execute transactions for trust and fiduciary activity accounts, or charging those accounts only a flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers. A bank could also rebate 12b-1 fees to the account. Alternatively, the bank could restructure the compensation from some or all of its trust and fiduciary activity accounts to change the proportion of “relationship compensation” by reducing the price it charges for executing transactions, executing transactions at cost so the reimbursement would be characterized as “relationship compensation,” or raising the bank's annual fee and offering unlimited securities transactions at no additional cost to the account.

A bank could implement any, or several, of these alternatives at any time during the year. For example, a bank might identify a problem in November of a calendar year that it finds is caused by a large account with high “sales compensation” that would likely cause the bank to fail its compensation comparison. The bank could waive securities transaction fees, or refund fees already charged to the account. The bank could also restructure the compensation in the account by not charging for additional securities transactions, or by converting to an annual fee that includes unlimited transactions.

We invite comment on the proposed one-year safe harbor in proposed Exchange Act Rule 721, including whether an additional year is a sufficient amount of time and whether one to seven is the appropriate ratio.

g. New Proposed Account-by-Account Exemption

Proposed Exchange Act Rule 722 would provide banks with a new exemption designed to give additional flexibility and legal certainty to banks that determine their compliance with the “chiefly compensated” requirement on an account-by-account basis.

i. Proposed Account-by-Account Exemption

Proposed Exchange Act Rule 722 is intended to provide banks that determine compliance with the “chiefly compensated” condition through an account-by-account calculation with legal certainty for one year based on their demonstrated compliance for the previous year. Under proposed paragraph (a) of Rule 722, a bank would be exempt from the “chiefly compensated” condition with respect to a particular account during any year if it meets four conditions. First, the bank would be required to meet the other conditions of the trust and fiduciary activities exception. Second, the bank must have met the “chiefly compensated” condition with respect to that particular account during the preceding year.

125

Third, a bank would be required to maintain procedures reasonably designed to ensure that, before opening or establishing an account, the bank reviews the account to ensure that the bank is likely to receive more “relationship compensation” than “sales compensation” with respect to that account. Fourth, a bank would be required to maintain procedures reasonably designed to ensure that, after opening or establishing an account, at such time as the bank individually negotiates with the accountholder or beneficiary of that account to increase the proportion of “sales compensation” as compared to “relationship compensation,” the bank reviews the account to ensure that the bank is likely to receive more “relationship compensation” than “sales compensation” with respect to that account.

125

This condition would not apply during the first year that the broker exceptions apply to banks. During that first year, banks will be expected to demonstrate compliance at the end of the year. By demonstrating compliance during the first year that the broker exceptions are implemented for banks, a bank will have legal certainty for the following year under the terms of the exemption.

We request comment on the proposed exemption. Banks are particularly invited to discuss the extent to which the proposed exemption would provide them with legal certainty. In addition, we are seeking comment from those who believe that the account-by-account calculation should be eliminated. In particular, we invite comment on how banks would satisfy the “chiefly compensated” requirement of the trust and fiduciary exception in the absence of an account-by-account calculation requirement.

ii. New Safe Harbor for Account-Specific Exemption

Commenters expressed concern that banks that determine their compliance with the “chiefly compensated” condition on an account-by-account basis would need flexibility if they discovered that their “sales compensation” for a particular account had exceeded their “relationship compensation” in a particular year.

126

To mitigate banks' compliance concerns, we are proposing a one-year conditional safe harbor for a bank that does not meet the “chiefly compensated” requirement with respect to a particular account.

127

This new safe harbor would provide a bank the time to bring its compensation arrangements for that account into compliance with the “chiefly compensated” condition.

126

Some commenters indicated that occasionally, prudent financial management of an individual customer account, such as a position concentration, could result in a particular account exceeding the chiefly compensated requirement in a particular year. For example, a bank could need to lessen a customer's concentration in a particular investment.

See, e.g.

, Banking Agencies Letter.

In addition, the Banking Agencies, bank trade associations and a law firm stated that banks would be at risk of unintentionally violating the securities laws because a bank can fall out of compliance with the exception for the preceding year based on one account without any type of cure period.

See

Roundtable letter and Wilmer, Cutler letter.

We note that there are many ways that a concentrated portfolio may be diversified without incurring high transaction payments to the bank.

127

See

proposed Exchange Act Rule 722(b) and (c). This alternative safe-harbor is not necessary until after the first year that the bank broker exceptions apply.

Under the proposed safe harbor, a bank with one or more accounts that exceed the “chiefly compensated” requirement could continue to rely on the trust and fiduciary activities exemption in the next year for these “sales compensation” accounts so long as these accounts represent ten percent or less of the total number of accounts for which the bank acts in a trustee or fiduciary capacity.

128

A bank relying on this exemption would need to meet two requirements. First, it must meet the other requirements of the rule, as well as the other requirements of the trust and fiduciary activities exception. Second, the bank may not have relied

on this safe harbor with respect to the particular “sales compensation” account during any of the five preceding years.

128

The ten percent limitation is intended to provide legal certainty to banks that are working in good faith to comply with the terms of the proposed exemption.

This safe harbor is intended to provide banks with time to restructure the compensation arrangement with respect to a particular account or accounts. It would not require banks to expand or otherwise modify their overall compliance procedures. Rather, it would permit them to target particular accounts and adjust their compensation accordingly.

We would expect banks to use the safe harbor period to ensure that their new compensation arrangement with respect to the “sales compensation” account will allow them to meet the “chiefly compensated” condition in the future for that account. While this should theoretically mean that an account that exceeds the “chiefly compensated” threshold would not exceed that threshold again, the character of an account can change over time. Therefore, the safe harbor would be available for a bank to use for the same account once every five years.

Banks that choose to calculate their compliance with the “chiefly compensated” condition on an account-by-account basis will need to have systems in place to monitor their own compliance. We would expect banks' systems to ensure that few accounts actually exceed the “chiefly compensated” threshold. While the proposed safe harbor would permit up to ten percent of a bank's trust and fiduciary activities accounts to exceed the compensation threshold in a given year, we would expect banks to monitor their compliance closely enough that their percentage of non-complying accounts remains small. We request comment on the ten percent limit. Banks that believe the limit should be higher are encouraged to discuss what limit would be consistent with the compliance systems they plan to put in place.

In addition to the general one-year safe harbor, we are proposing to give additional flexibility to banks when a small number of accounts do not meet the “chiefly compensated” condition more frequently than once in a five-year period. Under this proposal, a bank can continue to be exempt even though the lesser of 500 accounts or 1 percent of the total number of its qualifying fiduciary activity accounts continued not to meet the “chiefly compensated” condition, provided the bank has documented the reason that each such account continued not to meet the condition and linked that reason to the bank's exercise of fiduciary responsibility.

129

See proposed Exchange Act Rule 722(c)(4). For example, during a particular year, an accountholder may have unexpectedly inherited a large number of shares of stock that a trust instrument required to be deposited into an account for which the bank was acting in a trust or fiduciary capacity. This proposed threshold is intended to provide banks that are working in good faith to comply with the provisions of the proposed exemption with an additional safety valve.

Commenters are invited to discuss the utility of the proposed safe harbors and whether they would provide banks with sufficient legal certainty. We also request comment on whether the general limit on using the exemption once every five years for a particular account together with the additional flexibility for a few accounts that exceeded the “chiefly compensated” condition more than once in a five-year period would provide banks with sufficient flexibility while remaining consistent with the statutory purpose. We also solicit comment on the additional safe harbor for a small number of accounts that fail the “chiefly compensated” test more than once in a five-year period and on whether the lesser of 500 or one percent of the total number of a bank's qualifying accounts is the appropriate threshold. Banks likely to need additional flexibility are invited to include a discussion of their planned compliance systems.

h. Other Provisions

i. “Chiefly Compensated” and Related Definitions

In addition to expanding the exemptions to facilitate banks' compliance and eliminate unnecessary burdens, we are proposing several technical changes to the definitions and proposing to expand the definition of “relationship compensation.” Otherwise, we are not proposing to change substantially the definition of “chiefly compensated” or related definitions. The technical changes to these rules are intended to simplify and clarify the definitions. Moreover, we believe the proposed exemptions discussed above should address many of the practical problems commenters noted in discussing these definitions.

130

For example, we address commenters' concerns about defining Rule 12b-1 fees as “sales compensation” by proposing amendments to simplify the exemption in Exchange Act Rule 3a4-2 to allow banks to compare “sales compensation” to “relationship compensation” derived from its trust and qualifying fiduciary activity accounts on a line-of-business basis and proposing a separate exemption in proposed Exchange Act Rule 770. We also note that an investment company may restructure its fee arrangement to pay shareholder servicing fees that are not being paid for sales or distribution outside of a Rule 12b-1 plan. This type of fee arrangement is unrelated compensation under the Interim Rules rather than “sales compensation.” We also propose to replace the term “trust or fiduciary account” with the term “an account for which the bank acts in a trustee or fiduciary capacity.” Because this language more closely matches the statutory language in the trust and fiduciary activities exception, it should reduce confusion.

We also note that the definition of “sales compensation” includes revenue sharing payments. As we discussed in proposing targeted disclosure requirements for broker-dealers selling mutual funds, revenue sharing arrangements not only pose potential conflicts of interest for the recipient, but also may have the indirect effect of reducing investors' returns by increasing the distribution-related costs incurred by funds.

See

Exchange Act Release No. 49148 (Jan. 29, 2004), 69 FR 6437 (Feb. 10, 2004). Revenue sharing arrangements may give broker-dealers heightened incentives to market the shares of particular mutual funds, or particular classes of fund shares. These incentives may be reflected in the use of “preferred lists” that explicitly favor the distribution of certain funds, or they may be reflected in other ways, including incentives or instructions to employees of a bank or broker-dealer. The magnitude of revenue sharing payments—estimated in 2001 at $2 billion annually—suggests that those arrangements influence the mutual fund choices presented to investors.

See

“How high can costs go?,”

Institutional Investor,

May 2001 at 56.

The expansion of the definition of “relationship compensation” that we are proposing would add types of assets that could qualify for assets under management fees paid directly by the customer, beneficiary, or account. This amended definition would include, for example, separately charged assets under management fees for managing real property, and would affect the ratio in the line-of-business exemption in proposed Exchange Act Rule 721 discussed above.

131

While the original definition of “relationship compensation” required the bank to be engaged in securities management activities for these fees to be included in the definition, we propose this change to address banks’ accounting and systems concerns that it would be difficult to treat assets under management fees differently for managing different types of assets.

131

Banks determining compliance on an account-by-account basis would not need to consider accounts that did not contain securities, such as an account that only contained real estate, since broker-dealer registration is not necessary for these accounts.

One commenter urged the Commission to amend the definition of “flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers;” in current Exchange Act Rule 3b-17(b) to allow banks to include the cost of shared resources as opposed to the “exclusively dedicated” standard in the Interim Rules.

132

In response, we propose to amend the definition to

include the direct marginal cost of any resources of the bank that are used for transaction execution, comparison, or settlement for trust and fiduciary activity accounts if the bank makes a precise and verifiable allocation of these resources according to their use. We believe this proposed change is consistent with the statutory requirement of cost recovery. We also propose to amend the definition to clarify that the account, rather than the bank, pays the fee. We request comment on the proposed amendments to the definition of “flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers;” in proposed Exchange Act Rule 724(b).

132

See

ABA/ABASA letters.

We request comment on these proposed amendments to the definitions. Commenters are invited to discuss whether the “sales compensation” definition should include additional sales-related arrangements that may create conflicts of interest, such as sales or distribution-related payments to affiliates or employees of banks. We also invite banks to provide us with any specific information on their compensation arrangements that might help us to further simplify the “chiefly compensated” calculation while implementing the statutory provisions.

ii. Formulas to Allocate Sales Compensation to Individual Accounts

A. 12b-1 Fees

Rule 12b-1 under the Investment Company Act permits investment companies to use their assets to finance sales-related expenses.

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Unlike fees for assets under management by the bank, which do not differ depending on the investment that the bank selects, Rule 12b-1 fees paid to banks and other distributors often vary from investment company to investment company. Rule 12b-1 fees create incentives to distribute particular investment company securities and create conflicts between the bank and investors. Such conflicts of interest drive much of broker-dealer regulation. Accordingly, Rule 12b-1 fees are included in the “sales compensation” definition.

134

133

See

Investment Company Act Release No. 11414, 45 FR 73898 (Nov. 7, 1980).

134

See

Exchange Act Release No. 44291,

supra

note 13, 66 FR at 27775.

Commenters pointed out that because Rule 12b-1 fees are paid based on the amount of assets in an omnibus account, it would be difficult to allocate such fees on an account-by-account basis.

135

We therefore propose to add a formula to the definition of “sales compensation” in proposed Exchange Act Rule 724 to allow banks to estimate the amount an individual account pays annually in Rule 12b-1 fees that are paid on an entity basis. The proposed formula would allow a bank to calculate the Rule 12b-1 fees for each account using one of two methods. First, a bank could calculate the 12b-1 fees based on the number of each class of an investment company's shares held in each account on the last business day of the preceding year, multiplied by the net asset value per share on that day and by the annual Rule 12b-1 fee rate applicable to that class of securities. Alternatively, a bank could use another allocation method if it fairly and consistently measures the amount of “sales compensation” attributable to each account during the preceding year.

136

135

See

NYCH letter and PNC Bank letter. We note, however, that in connection with E*Trade's Rule 12b-1 fee rebate program, E*Trade explains its fifty percent rebate formula as follows: “For example, if the average daily value of your eligible mutual fund holdings for the year is $200,000 and we receive 12b-1 fees at the annual rate of 0.25% (25 basis points) from the funds you selected, you would receive an annual rebate of $250 (0.0025 x $200,000÷2).”

See

(

https://us.etrade.com/e/t/home?SC=LBH4249

136

We chose the year-end formula to allow banks performing the “chiefly compensated” calculation on an account-by-account basis to make a reasonable estimate, consistent with the chiefly timeframe, of the amount of 12b-1 fees paid by an account during the preceding year. The proposed formula also is intended to provide banks with the additional flexibility to measure the changing value of an account during the year to determine the amount of 12b-1 fees paid by that account, provided that the bank uses the same fair method for each account.

We request comment on whether the proposed formula would facilitate banks' allocation of the 12b-1 fees to individual accounts. We also invite commenters to discuss any alternative allocation methods they believe would more accurately measure the amount of “sales compensation” attributable to each account. In addition, commenters are invited to suggest other allocation methods that they believe would be simpler, while providing a reasonably accurate allocation of these fees to individual accounts. Commenters should explain how the results from any alternative method would compare to the results from the proposed allocation method.

Other Fees

We also propose to amend the definition of “sales compensation” in proposed Exchange Act Rule 724(i)(4) and (6) to allow a bank to estimate the amount that it receives annually that is attributable to an individual account, but that is not paid directly from the account. This formula would allow a bank to calculate these fees for each account by using one of two methods. First, a bank could divide the number of shares of each class of each type of investment company held in each account on the last business day of the preceding year by the total number of the same type of investment company shares that the bank held in a trustee or fiduciary capacity on the same day, and multiply the resulting number by the total dollar amount of these fees the bank received in connection with that class during the preceding year. Second, a bank could use its own method of allocation if it fairly and consistently measures the amount of “sales compensation” attributable to each account during the preceding year.

137

See

id.

for a discussion of the reasons why we are proposing this formula.

We request comment on the proposed formula. Commenters are invited to discuss whether it will facilitate banks' allocation of these fees to individual accounts. We also invite comment on whether there would be a simpler method that would provide a reasonably accurate allocation of these fees to individual accounts. We also invite comment on how to address the problem of the sale of shares at the end of the year. For example, an account that held a substantial proportion of a bank's total holdings in a given fund for most of a year, but whose shares were sold just before year-end, may be allocated none of the bank's fees earned from that fund. At the same time, an account with relatively small holdings in the same fund that did not sell at the end of the year might be allocated a disproportionately large amount of the bank's fees earned from that fund. In addition, we invite comment on whether this formula should be revised to make it more consistent with other proposals on which the Commission is currently seeking comment regarding revenue sharing payments that occur at the fund complex level, as opposed to the fund level.

138

Commenters are specifically requested to consider whether the formula should compare the value of the account with the value of all assets held by the bank in a fund complex if revenue sharing is paid on a fund complex basis.

138

See infra

note 405.

iii. Indenture Trustee Exemption

Exchange Act Rule 3a4-3 currently provides a limited exemption from broker registration for a bank that serves

as an indenture trustee in a no-load money market fund, provided that it meets certain conditions. Comments we received on this rule criticized its utility in part based on the definition of “indenture trustee,” which is currently codified in Exchange Act Rule 3b-17.

139

For example, two commenters recommended that we expand the “indenture trustee” definition to include trustees appointed pursuant to pooling and servicing agreements, trust agreements, bond resolutions, and mortgages, given that, according to these commenters, documents appointing trustees generally are not limited to indentures.

140

139

17 CFR 240.3b-17(c). Current Exchange Act Rule 3a4-3 permits banks to effect transactions as indenture trustees in no-load money market funds without meeting the “chiefly compensated” condition in the trust and fiduciary activities exception.

140

See

ABA/ABASA letters and Bank One letter.

In lieu of modifying the “indenture trustee” definition (which we are proposing to move to Exchange Act Rule 724), as discussed previously, the Commission is proposing a broad general exemption (proposed Exchange Act Rule 776) that would permit banks to effect transactions for qualified investors and certain other investors in money market funds.

141

As discussed below, we propose to eliminate the definition of “trustee capacity,” which defined the term to include the capacity of a trust indenture trustee. As a result, banks acting in an indenture trustee capacity would not need to look to the definition of “indenture trustee” to determine whether they qualify for the trust and fiduciary activities exception.

141

See

Section III.F.1

supra

for discussion of proposed Exchange Act Rule 776, under which banks not acting in an indenture trustee capacity could effect transactions for customers who are “qualified investors” and customers for whom they act in a trustee or fiduciary capacity or in certain escrow capacities in money market funds, including those that charge a “load.”

We propose to move the definition of “indenture trustee” to proposed Exchange Act Rule 724(c), where the term would be defined for purposes of the exemption in proposed Exchange Act Rule 723, which would provide an exemption from the “chiefly compensated” calculation for banks to effect transactions as an indenture trustee in no-load money market funds. While the exemption would still be available on the same terms as before, we believe that banks acting as indenture trustees may opt for the exemption in proposed Exchange Act Rule 776.

We request comment on proposed Exchange Act Rule 723. Commenters are specifically invited to discuss whether the exemption would be necessary if we adopt proposed Exchange Act Rule 776.

2. Definition of “Trustee Capacity” and Indenture Trustees

We received numerous comments on the definition of “trustee capacity,” which was included in the Interim Rules to clarify that for purposes of the trust and fiduciary activities exception, the term includes indenture trustees and trustees for tax-deferred account described in sections 401(a), 408, and 408A under subchapter D and in section 457 under subchapter E of the Internal Revenue Code of 1986 (26 U.S.C. 1,

et seq.

)

142

Some commenters supported the definition's provision of legal certainty for indenture trustees and trustees for certain tax-deferred accounts.

143

However, some commenters urged the Commission to expand the definition to cover banks acting as custodial trustees for Individual Retirement Accounts (“IRAs”).

144

Commenters also indicated that the definition should cover both indenture trustees operating under appointive documents other than indentures, and indenture trustees serving on issues or transactions outside those delineated in the Interim Rules.

145

Some commenters urged the Commission to withdraw the definition of “trustee capacity” and instead interpret the trust and fiduciary activities exception to cover all types of “trustees.”

146

Several commenters indicated that defining “trustee capacity” as including an indenture trustee or a trustee for certain tax-deferred accounts may create ambiguity by suggesting that other “trustees” may not be able to rely on the trust and fiduciary activities exception.

147

One commenter took issue with the analysis of trustee relationships because, in the commenter's view, it focused on whether a bank exercises investment discretion.

148

This commenter asserted that there are numerous trustee relationships in which a bank may not exercise investment discretion, but would still be subject to fiduciary duties, such as personal trusts, charitable foundation trusts, insurance trusts, rabbi trusts, secular trusts, conservatorships and guardianships.

149

Two commenters stated that the governing trust instrument under state and federal fiduciary law, and not the Commission, should determine the nature of a trust or fiduciary relationship.

150

One commenter maintained that it is unclear how banks could “push out” trust accounts to b

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