Definitions of Terms and Exemptions Relating to the “Broker” Exceptions for Banks

Federal RegisterOct 3, 2007

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FEDERAL RESERVE SYSTEM

12 CFR Part 218

[Regulation R; Docket No. R-1274]

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 247

[Release No. 34-56501; File No. S7-22-06]

RIN 3235-AJ74

Definitions of Terms and Exemptions Relating to the “Broker” Exceptions for Banks

AGENCIES:

Board of Governors of the Federal Reserve System (“Board”) and Securities and Exchange Commission (“SEC” or “Commission”) (collectively, the Agencies).

ACTION:

Final rule.

SUMMARY:

The Board and the Commission jointly are adopting a single set of final rules that implement certain of the exceptions 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 rules define terms used in these statutory exceptions and include certain related exemptions. In developing these rules, the Agencies have consulted with, and sought the concurrence of, the Office of the Comptroller of the Currency (“OCC”), the Federal Deposit Insurance Corporation (“FDIC”) and the Office of Thrift Supervision (“OTS”), and have taken into consideration all comments received on the proposed rules issued in December 2006. The rules are intended, among other things, to facilitate banks' compliance with the Exchange Act and the GLBA.

DATES:

Effective dates:

The addition of parts 12 CFR 218 and 17 CFR 247 is effective September 28, 2007. Regulations at 12 CFR 218.781 and 17 CFR 247.781 (collectively “Rule 781”) are effective on September 28, 2007. Regulations at 12 CFR 218.100 through 218.780 and 17 CFR 247.100 through 247.780 are effective December 3, 2007. Amendments affecting Part 240 of Title 17 are effective December 3, 2007.

Compliance date:

Banks are exempt from complying with the rules and the “broker” exceptions in Section 3(a)(4)(B) of the Exchange Act until the first day of their first fiscal year that commences after September 30, 2008.

FOR FURTHER INFORMATION CONTACT:

BOARD:

Kieran J. Fallon, Assistant General Counsel, (202) 452-5270, Andrea Tokheim, Counsel, (202) 452-2300, or Brian Knestout, Attorney, (202) 452-2249, Legal Division, Board of Governors of the Federal Reserve System, 20th Street and Constitution Avenue, NW., Washington, DC 20551. Users of Telecommunication Device for Deaf (TDD) only, call (202) 263-4869.

SEC:

Catherine McGuire, Chief Counsel, Linda Stamp Sundberg, Senior Special Counsel, Joshua Kans, Senior Special Counsel, John J. Fahey, Branch Chief, or Elizabeth MacDonald, Special Counsel, at (202) 551-5550, Office of the Chief Counsel, Division of Market Regulation, Securities and Exchange Commission, 100 F Street, NE., Washington, DC 20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction

A. Background

B. Overview of Comments

C. Final Rules and Related Matters

II. Networking Arrangements

A. Overview of Proposed Rules and Comments

B. Rule 700: Definition of Terms Used in Networking Exception

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

2. Definition of “Referral”

3. Definition of “Contingent on Whether the Referral Results in a Transaction”

4. Definition of “Incentive Compensation”

a. Exception for Discretionary, Multi-Factor Bonus Plans

b. Safe Harbor for Plans Based on Overall Profitability or Revenue

C. Rule 701: Exemption for Referrals Involving Institutional Customers and High Net Worth Customers

1. Definitions of “Institutional Customer” and “High Net Worth Customer”

2. Determining that a Customer Meets the Relevant Thresholds

3. Conditions Relating to Disclosures

4. Suitability or Sophistication Analysis by Broker-Dealer

5. Conditions Relating to Bank Employees

6. Good Faith Compliance and Corrections by Banks

7. Referral Fees Permitted Under the Exemption

8. Permissible Bonus Compensation Not Restricted

III. Trust and Fiduciary Activities

A. Trust and Fiduciary Exception and Proposed Rules

B. Joint Final Rules

1. “Chiefly Compensated” Test and Bank-Wide Exemption Based on Two-Year Rolling Averages

2. “Relationship Compensation”

3. Excluded Compensation

4. Trust or Fiduciary Accounts

5. Exemptions for Special Accounts, Foreign Branches, Transferred Accounts, and a De Minimis Number of Accounts

6. Advertising Restrictions

IV. Sweep Accounts and Transactions in Money Market Funds

A. Rule 740: Definition of Terms Used in Sweep Exception

B. Exemption Regarding Money Market Fund Transactions

V. Safekeeping and Custody

A. Background

B. Rule 760: Custody Exemption

1. Order-Taking for Employee Benefit Plan Accounts and Individual Retirement or Similar Accounts

a. Employee Compensation Restrictions

b. Advertisements and Sales Literature

c. Other Conditions

2. Order-Taking as an Accommodation for Other Types of Accounts

a. Accommodation Basis

b. Employee Compensation Restrictions

c. Limitations on Bank Fees

d. Advertising and Sales Literature Restrictions

e. Investment Advice or Recommendations

3. Other Conditions Applicable to Order-Taking for All Custody Accounts

a. Directed Trustees

b. Broker Execution Requirement

c. Carrying Broker Provisions

4. Custodians, Subcustodians, and Administrators/Recordkeepers

a. “Account for Which a Bank Acts as a Custodian”

b. Administrators/Recordkeepers and Subcustodians

5. Evasions

VI. Other Exemptions

A. Exemption for Regulation S Transactions With Non-U.S. Persons and Broker-Dealers

B. Exemption for Non-Custodial Securities Lending Transactions

C. Exemption for Banks Effecting Certain Excepted or Exempted Transactions in Investment Company Securities and Variable Insurance Products

D. Exemption for Certain Transactions involving a Company's Securities for Its Employee Benefit Plans and Participants

E. Temporary and Permanent Exemption for Contracts Entered Into by Banks From Being Considered Void or Voidable

F. Extension of Time and Transition Period

VII. Finding That the Exemptions Are Appropriate and in the Public Interest and Consistent With the Protection of Investors

VIII. Withdrawal of Proposed Regulation B and Removal of Exchange Act Rules 3a4-2-3a4-6, and 3b-17

IX. Administrative Law Matters

A. Paperwork Reduction Act Analysis

B. Consideration of Benefits and Costs

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

D. Consideration of Impact on the Economy

E. Regulatory Flexibility Analysis

F. Plain Language

X. Statutory Authority

XI. Text of Rules and Rule Amendment

I. Introduction

A. Background

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 most of the separation of investment and commercial banking imposed by the Glass-Steagall Act. The GLBA also revised the provisions of the Exchange Act that had completely excluded banks from broker-dealer registration requirements.

Pub. L. No. 106-102, 113 Stat. 1338 (1999).

Pub. L. No. 73-66, ch. 89, 48 Stat. 162 (1933) (as codified in various Sections of 12 U.S.C.).

In enacting the GLBA, Congress adopted functional regulation for bank securities activities, with certain exceptions from Commission oversight for specified securities activities. With respect to the definition of “broker,” the GLBA amended the Exchange Act to provide eleven specific exceptions for banks.

Each of these exceptions permits a bank to act as a broker or agent in securities transactions that meet specific statutory conditions.

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

In particular, Section 3(a)(4)(B) of the Exchange Act as amended by the GLBA provides conditional exceptions from the definition of broker for banks that engage in certain securities activities in connection with 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 a de minimis number of other securities transactions.

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

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.

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 October 2006, the Financial Services Regulatory Relief Act of 2006 (“Regulatory Relief Act”) became effective.

Among other things, the Regulatory Relief Act requires that the SEC and the Board jointly adopt a single set of rules to implement the bank broker exceptions in Section 3(a)(4) of the Exchange Act.

In addition, it required that the Agencies issue a single set of proposed rules to implement these exceptions not later than 180 days after enactment of the Regulatory Relief Act (April 11, 2007).

Public Law No. 109-351, 120 Stat. 1966 (2006).

See

Exchange Act Section 3(a)(4)(F), as added by Section 101 of the Regulatory Relief Act.

In December 2006, the Agencies jointly issued, and requested public comment on, a single set of proposed rules to implement the broker exceptions for banks relating to third-party networking arrangements, trust and fiduciary activities, sweep activities, and safekeeping and custody activities.

The proposed rules included certain exemptions related to these activities, as well as exemptions related to foreign securities transactions, securities lending transactions conducted in an agency capacity, the execution of transactions involving mutual fund shares, and the potential liability of banks under Section 29 of the Exchange Act. In developing the proposed rules, the Agencies considered, among other things, the language and legislative history of the “broker” exceptions for banks adopted in the GLBA, the rules previously issued or proposed by the Commission relating to these exceptions, and the comments received in connection with those prior rulemakings.

See

71 FR 77522, December 26, 2006.

The Agencies requested comment on all aspects of the proposed rules. In addition, the Agencies requested comment on whether it would be useful or appropriate for the Agencies to adopt rules implementing the other bank “broker” exceptions in Section 3(a)(4)(B) of the Exchange Act that were not addressed in the proposal.

B. Overview of Comments

The Agencies received comments from 58 organizations and individuals on the proposed rules. Commenters included 22 trade associations, 20 banking organizations, 7 other organizations in the financial services industry, 3 community and nonprofit groups, two credit unions, one state government, one self-regulatory organization, one association of state securities administrators, and one individual. Many commenters supported the proposed rules as a general matter. For example, commenters asserted that the proposed rules would provide banks considerable flexibility in providing securities services to their customers, would avoid disrupting bank activities and customer relationships, or were a significant improvement over earlier proposals.

In addition, many commenters supported the general approaches (including related exemptions) taken by the proposed rules to implement the networking, trust and fiduciary, sweep, and safekeeping and custody exceptions. Several commenters, however, contended that the proposed rules did not adequately protect investors, and particularly retail investors.

Some of these commenters argued that that the Agencies should withdraw the proposed rules and issue new rules based on those issued in 2001

or 2004.

See, e.g.

, Citigroup Letter, Independent Community Bankers Ass'n (“ICBA”) Letter, American Bankers Ass'n (“ABA”) Letter, JPMorgan Chase & Co. (“JP Morgan”) Letter, Financial Services Roundtable (“Roundtable”) Letter.

See, e.g.

, Massachusetts Securities Division Letter, Pace Investors Rights Project (“Pace Project”) Letter, Boyd Financial Letter.

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

Exchange Act Release No. 49879 (June 17, 2004), 69 FR 39682 (June 30, 2004).

See, e.g.

, North American Securities Administrators Association (“NASAA”) Letter.

Most commenters also recommended that the Agencies modify specific provisions of the proposed rules to, among other things, reduce administrative burden, better protect bank customers or investors, or clarify the scope or effect of the rules. The comments received on the proposed rules are discussed in greater detail in the following sections of this

SUPPLEMENTARY INFORMATION

C. Final Rules and Related Matters

After carefully considering the comments, the Agencies have adopted

final rules to implement the broker exceptions for banks relating to third-party networking arrangements, trust and fiduciary activities, sweep activities, and custody and safekeeping activities.

The Board and SEC have consulted extensively with, and sought the concurrence of, the OCC, FDIC and OTS in developing these final rules.

Commenters generally did not request that the Agencies adopt rules to implement the other broker exceptions for banks at this time or stated that no additional guidance was needed at this time with respect to these exceptions.

See

ABA Letter.

Like the proposal, the final rules include certain exemptions related to these activities, as well as exemptions related to foreign securities transactions, securities lending transactions conducted in an agency capacity, the execution of transactions other than through a broker-dealer, the potential liability of banks under Section 29 of the Exchange Act, and the date on which the GLB Act's “broker” exceptions for banks will go into effect.

As discussed in the following sections, the Agencies have modified the rules in numerous respects in light of the comments received. These changes include, among other things, modifications to the examples of “relationship compensation” in Rule 721 to clarify the scope of the term for purposes of the rules relating to trust and fiduciary activities; the custody exemption in Rule 760 to permit banks acting as a directed trustee to accept orders under the exemption; and Rule 781 to extend the compliance date for a bank until the first day of its first fiscal year commencing after September 30, 2008. The Agencies also have adopted new exemptions relating to trust or fiduciary accounts held in a foreign branch of a bank,

and to permit a bank to effect, under certain conditions and without using a broker-dealer, transactions in a fiduciary or custodial capacity for an employee benefit plan in the stock of the plan's sponsor.

See

Rule 723(c).

See

Rule 776.

The final rules are designed to accommodate the business practices of banks and protect investors. If more than one broker exception or exemption is available to a bank under the statute or rules for a securities transaction, the bank may choose the exception or exemption on which it relies to effect the transaction without registering as a broker-dealer. For example, if the bank effects a transaction in a security sold in an offshore transaction for a custody account that is permissible under either the Regulation S exemption in Rule 771 or the custody exemption in Rule 760, the bank may choose which exemption to rely on and comply with in effecting the transaction. Similarly, if a bank effects no more than 500 securities transactions as agent for its customers in a calendar year, the bank may rely on the de minimis exception in Section 3(a)(4)(B)(xi) of the Exchange Act in lieu of any other available exception or exemption for such transactions. The bank, of course, must comply with all of the requirements contained in the exception or exemption on which it relies.

An employee of a bank that operates in accordance with the exceptions in Section 3(a)(4)(B) of the Exchange Act and, where applicable, the rules is not required to register as a “broker” to the extent that the employee's activities are covered by the relevant exception or rule.

Section 401 of the Regulatory Relief Act amended the definition of “bank” in Section 3(a)(6) of the Exchange Act to include any Federal savings association or other savings association the deposits of which are insured by the FDIC. Accordingly, as used in the final rules, the term “bank” includes any savings association that qualifies as a “bank” under Section 3(a)(6) of the Exchange Act, as amended.

Several commenters asked the Agencies, or the Commission independently, to adopt rules that would extend to federal or state-chartered credit unions some or all of the “broker” exceptions or exemptions provided banks under Section 3(a)(4)(B) of the Exchange Act or the final rules.

See, e.g.

, Credit Union Nat'l Ass'n Letter, Nat'l Ass'n of Credit Union Service Organizations Letter, Nat'l Ass'n of Fed. Credit Unions Letter, Navy Fed. Credit Union Letter, and XCU Corp. Letter. While the GLBA's “bank” exceptions do not by their terms apply to credit unions, these requests are under consideration by the Commission, which is the agency with authority to address these matters. The Commission notes the existence of SEC staff positions with regard to networking relationships between a credit union and a broker-dealer and is not addressing this issue at this time.

See, e.g.

, Chubb Securities Corp., 1993 SEC No-Act. LEXIS 1204 (Nov. 24, 1993).

Identical sets of the final rules are being adopted by the Board and SEC and will be published by the Board in Title 12 of the Code of Federal Regulations and by the SEC in Title 17 of the Code of Federal Regulations.

Pursuant to the Regulatory Relief Act, this single set of final rules supersedes any and all other proposed or final rules issued by the Commission on or after the date of enactment of the GLBA with regard to the definition of “broker” under Section 3(a)(4) of the Exchange Act.

The final rules adopted by the Board and the SEC within their respective titles of the Code of Federal Regulation (12 CFR part 218 for the Board and 17 CFR part 247 for the SEC) are identically numbered from § ___.100 to § ___.781. For ease of reference, the single set of final rules adopted by each Agency are referred to in this release as Rule ___, excluding title and part designations. A similar format is used to refer to the single set of proposed rules issued by the Agencies.

Pub. L. No. 109-351, § 101(a)(3), 120 Stat. 1966, 1968 (2006).

Any additions or changes to these rules that may be appropriate to implement Section 3(a)(4)(B) of the Exchange Act will be adopted jointly by the SEC and Board in accordance with the consultation provisions in Section 101(b) of the Regulatory Relief Act. In addition, if any rules (including exemptions) are proposed or adopted in the future related to the other bank “broker” exceptions in Section 3(a)(4)(B) of the Exchange Act that are not addressed in the final rules now being adopted by the SEC and the Board, they would be proposed and adopted jointly by the SEC and Board.

A few commenters requested that the Commission delegate authority to act on future exemptive requests from banks to the Director of its Division of Market Regulation.

See

America Community Bankers Ass'n (“ACB”) Letter, Roma Bank Letter. Because particular banks may have individual situations that may be appropriate for additional relief, the Commission delegated authority to the Director of the Division of Market Regulation to consider, on a case-by-case basis, individual requests for exemptive relief from banks. To facilitate the processing of these requests, the Commission delegated this exemptive authority within its Rules of Organization and Program Management in Rule 30-3(a)(70) (17 CFR 200.30-3(a)(70)). The Commission continues to expect the staff to submit novel and complex requests for exemptions to the Commission.

As required by the GLBA, the Board, OCC, FDIC, and OTS (collectively, the Banking Agencies) will develop, and request public comment on, recordkeeping rules for banks that operate under the “broker” exceptions in Section 3(a)(4) of the Exchange Act.

These rules, which will be developed in consultation with the SEC, will establish recordkeeping requirements to enable banks to demonstrate compliance with the terms of the statutory exceptions and the final rules and will be designed to facilitate compliance with the statutory exceptions and the rules.

See

12 U.S.C. 1828(t)(1).

Several commenters urged the Agencies also to cooperate in providing interpretations or guidance (such as staff no-action letters) concerning the final rules or the broker exceptions for banks in Section 3(a)(4)(B) of the Exchange Act or in taking enforcement action to enforce compliance with these rules or exceptions.

In addition, a number of commenters urged the Agencies to work

with the Financial Industry Regulatory Authority (“FINRA”)

to modify promptly its Rule 3040 as it applies to persons that are employees of both a bank and a broker-dealer (so-called “dual employees”).

See, e.g.

, ABA Letter, Clearing House Ass'n Letter, Citigroup Letter, The PNC Financial Services Group, Inc. (“PNC”) Letter. One commenter, however, expressed concern that coordination among the Agencies might result in slower responses to requests for guidance. See American Bar Ass'n Section of Business Law Letter (“Business Law Section Letter”).

On July 26, 2007, the Commission approved a proposed rule change filed by NASD to amend NASD's Certificate of Incorporation to reflect its name change to Financial Industry Regulatory Authority Inc., or FINRA, in connection with the consolidation of member firm regulatory functions of NASD and NYSE Regulation, Inc. See Securities Exchange Act Release No. 56146 (July 26, 2007). FINRA's Rules currently consist of the rules adopted by the NASD and effective on the date of the consolidation (which include NASD Rule 3040), as well as certain rules of the NYSE that FINRA has incorporated into its own rules.

See, e.g.

, ABA Letter, Clearing House Ass'n Letter, Harris Bank Letter, HSBC Bank, N.A. (“HSBC Bank”) Letter, HSBC Securities (USA) Inc. (“HSBC Securities”) Letter, Roundtable Letter. These commenters asserted that it was important for the requested modifications to FINRA's Rule 3040 to be made prior to the date on which banks would first have to comply with the new “broker” exceptions in the GLBA.

In light of the joint nature of the final rules and the Agencies' joint rule-writing authority for the bank broker exceptions in Section 3(a)(4)(B),

the Agencies will jointly issue any interpretations and responses to requests for no-action letters or other interpretive guidance concerning the scope or terms of the exceptions and rules, and will consult and, to the extent appropriate, coordinate with each other and the appropriate federal banking agency for a bank concerning any formal enforcement actions proposed to be taken against a bank for violations of the exceptions or rules.

Rapaport

U.S. Department of Treasury

, 59 F. 3d 212, 216-217 (D.C. Cir. 1995),

cert. denied

116 S.Ct. 775 (1996).

The Agencies already consult with and coordinate with each other and the other federal banking agencies in a variety of areas, and the Agencies and the other federal banking agencies are in the process of supplementing their existing policies and procedures to facilitate coordination with respect to the broker exceptions and rules. Banks or others that seek an interpretation of, or a no-action letter or other staff guidance concerning, the rules or the exceptions should submit their request to both Agencies. The Agencies also expect to continue their dialogue with FINRA concerning potential modifications to that authority's Rule 3040.

II. Networking Arrangements

The third-party brokerage exception (“networking exception”) in Section 3(a)(4)(B)(i) of the Exchange Act permits a bank to avoid being considered a broker if, under certain conditions, it enters into a contractual or other written arrangement with a registered broker-dealer under which the broker-dealer offers brokerage services to bank customers.

The networking exception does not address the type or amount of compensation that a bank may receive from its broker-dealer partner under a networking arrangement. However, the networking exception provides that a bank may not pay its unregistered employees

incentive compensation for brokerage transactions. Nevertheless, the statutory exception does permit a bank employee to receive a “nominal one-time cash fee of a fixed dollar amount” for referring bank customers to the broker-dealer if payment of the referral fee is not “contingent on whether the referral results in a transaction.”

Congress included this general prohibition on, and limited exception to, incentive compensation to reduce concerns regarding the securities sales practice of unregistered bank employees.

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

An unregistered bank employee is an employee that is not registered or approved, or otherwise required to be registered or approved, in accordance with the qualification standards established by the rules of any self-regulatory organization.

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

A. Overview of Proposed Rules and Comments

Proposed Rule 700 defined certain key terms related to referral fees and incentive compensation used in the networking exception. For example, the proposed rule provided that a referral fee would be considered “nominal” if it met any of four standards included in the rule. The proposed rule also defined when a referral fee would be “contingent on whether a referral results in a transaction,” what constitutes “incentive compensation,” and what types of bank bonus plans would not be considered incentive compensation under the networking exception. Proposed Rule 701 included an exemption that permitted bank employees, subject to certain conditions, to receive higher-than-nominal, contingent referral fees for referring institutional customers and high net worth customers to a broker-dealer.

Many commenters supported the general approach of Proposed Rules 700 and 701, including the range of alternatives provided for determining if a referral fee is nominal and the adoption of an exemption for referrals involving high net worth or institutional customers.

Some commenters, however. suggested that the proposed rules would harm investors by giving bank employees undue incentives to direct unsophisticated customers into potentially unsuitable investment products.

See, e.g.

ABA Letter, Roundtable Letter, Citigroup Letter, Union Bank of California (“Union Bank”) Letter.

See, e.g.

, Pace Project Letter.

B. Rule 700: Definition of Terms Used in Networking Exception

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

Proposed Rule 700 defined the term “nominal one-time cash fee of a fixed dollar amount” to mean a cash payment for a referral in an amount that meets any one of four alternative standards: the first based on twice the average hourly base wage established by the bank for the employee's job family; the second based on 1/1000th of the average annual base salary established by the bank for the employee's job family; the third based on twice the employee's actual base hourly wage; and the fourth based on a specified dollar amount ($25), indexed for inflation.

Proposed Rule 700(c).

Many commenters generally supported the flexibility that this range of alternatives would afford in determining whether a referral fee is “nominal.”

Some commenters expressed concern that the proposed rule placed greater limits on permissible payments under networking arrangements than exist currently under applicable federal banking agency guidance or questioned the need for a definition of “nominal” to be established by rule at all.

A few commenters contended that the specific dollar amount in the proposed rule ($25) was too low.

A number of commenters, however, believed that the alternatives would result in the payment of fees that are higher than nominal and would create incentives for bank employees to make securities referrals even when not appropriate for the customer. These commenters questioned, for example, whether twice an employee's hourly wage was truly nominal and whether the Agencies had sufficient basis for selecting that measure of “nominal.”

See, e.g.

, Roundtable Letter, ACB Letter.

See, e.g.

, Bank Insurance & Securities Ass'n (“BISA”) Letter, Wisconsin Bankers Ass'n (“WBA”) Letter.

See, e.g.

, Clearing House Ass'n Letter and ICBA Letter.

See, e.g.

, Boyd Financial Letter, NASAA Letter, Pace Project Letter, and University of Cincinnati Corp. Law Ctr. Letter.

After carefully reviewing the comments, the Agencies have determined to adopt the “nominal” definition substantially as proposed. Including a definition of “nominal” in the rule will provide banks with certainty as to the Agencies” interpretation of that standard and should facilitate compliance. The Agencies believe that each of the alternatives for defining “nominal” is consistent with the statutory networking exception, which provides that a bank employee may receive compensation for each referral if the compensation for that referral is “nominal” and meets the other requirements of the statute. Under each of the alternatives established, the amount of compensation a bank employee may receive for each referral will be small in relation to the employee's overall compensation and therefore unlikely to create undue incentives for the bank employee to engage in activities, such as “pre-selling” specific securities to the customer involved in violation of the networking exception,

which would raise sales practice concerns. As discussed below, the multiple alternatives are designed to provide flexibility for banks of all sizes and locations to use different business models and to take into account economic differences around the country and among their employees in assessing how best to structure their program(s) for paying “nominal” cash referral fees under the networking exception. The alternatives also were designed to allow for roughly equivalent treatment of bank employees at different base or hourly compensation levels within a bank.

See

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

Rule 700(c) provides that a referral fee paid to any bank employee will be considered “nominal” if it does not exceed $25.

This dollar amount will be adjusted for inflation on April 1, 2012, and every five years thereafter, to reflect any changes in the value of the Employment Cost Index For Wages and Salaries, Private Industry Workers (or any successor index thereto), as published by the Bureau of Labor Statistics, from December 31, 2006.

The Agencies selected this index because it is a widely used and broad indicator of increases in the wages of private industry workers, which includes bank employees. Available data indicate that the $25 amount is consistent with the level of referral fees generally paid to tellers and other bank employees engaged in making referrals of retail customers under existing Banking Agency guidance, which also includes a “nominal” standard.

Rule 700(c)(3).

Each adjustment would be rounded to the nearest multiple of $1. Rule 700(f).

See

ABA Securities Ass'n., 2003/2004 National Survey of Bank Retail Investment Services, Vol. I, at 60 (survey data demonstrate that 20 percent of banks pay retail referral fees of $20 or more); Banking Agencies' Interagency Statement on Retail Sales of Nondeposit Investment Products (Feb. 15, 1994).

As under the proposal, a referral fee also will be considered “nominal” under Rule 700(c) if the payment does not exceed (1) twice the employee's actual base hourly wage; (2) twice the average of the minimum and maximum hourly wage established by the bank for the current or prior year for the job family that includes the employee; or (3) 1/1000th of the average of the minimum and maximum annual base salary established by the bank for the current or prior year for the job family that includes the employee.

Rule 700(c)(1) and (2).

In developing these alternatives to the fixed $25 fee, the Agencies considered data on the average hourly wages of bank tellers, which are the class of bank employees most typically engaged in making referrals of retail customers. These data indicate that the national mean hourly wage in 2005 for tellers was $10.59.

Accordingly, the $25 amount is slightly more than twice the national mean hourly wage for tellers in 2005, and slightly more than 1/1000th of the annualized salary of an employee that makes $12.50 per hour (or $25 every two hours) based on a 40 hour work week.

Thus, the alternatives based on twice the employee's hourly base wage or 1/1000th of the employee's base annual salary, at current pay rates, are designed to allow bank employees to receive referral fees that are roughly equivalent to those that may be received by bank tellers under the flat dollar option.

Occupational Employment and Wages, May 2005, (Tellers), U.S. Department of Labor, Bureau of Statistics.

Specifically, twice the hourly wage for an employee who earns an annual base salary of $25,000 (1,000 × $25) would be $24.04, based on a 40 hour per week (or 1080 hours per year) work schedule.

The options based on the employee's job family use these same measurements but allow comparisons to the average of the minimum and maximum hourly base wage or base salary of the employee's job family. These options are designed to reduce administrative burden while also ensuring that referral fees remain nominal in amount. To provide comparability between the alternative based on an employee's actual compensation and those based on the compensation established for the employee's job family, the Agencies have modified the final rule to provide that a referral fee also will be considered nominal if it does not exceed 1/1000th of the employee's actual base annual salary.

Under the final rules, a bank may use a different “nominal” methodology in its different business lines or operating units and may alter the methodology it uses within a given year.

Rule 700(c)(2).

One commenter suggested that the term “job family” was ambiguous and could allow banks to include all employees in a single job family, which would result in payments to employees with salaries at the lower end of the job family that may be well in excess of twice their hourly wage.

Rule 700 defines a “job family” as a group of jobs or positions involving similar responsibilities, or requiring similar skills, education or training, that a bank, or a separate unit, branch or department of a bank, has established and uses in the ordinary course of its business to distinguish among its employees for purposes of hiring, promotion, and compensation.

The requirements that a job family include jobs or positions with similar responsibilities, or that require similar skills, education and training, and be used by the bank in the ordinary course of its business for hiring, promotion and compensation purposes are designed to prevent a bank from establishing special job family classifications to evade the “nominal” standard. A bank may not deviate from its ordinary classification of jobs for purposes of determining whether a referral fee is nominal under this standard, and the Banking Agencies will monitor the job family classifications used by banks for “nominal” determination as part of the risk-focused examination process. Depending on a bank's internal employee classification system, examples of a job family may include tellers, loan officers, or branch managers. The Agencies note, moreover, that other provisions of the networking exception also provide significant protection to customers. For example, the networking exception provides that unregistered bank employees may perform only clerical or ministerial functions in connection with brokerage transactions.

Accordingly, bank employees referring a customer to a broker-dealer under the exception may not provide investment advice concerning securities or make specific

securities recommendations to the customer.

See

Pace Project Letter.

Proposed Rule 700(d).

See

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

A bank employee, however, may describe in general terms the types of investment vehicles available from the bank and the broker-dealer under the arrangement.

See id

A few commenters suggested that, by defining “nominal” by reference to hourly wages and annual base salary, the rule treats unfairly employees who receive a considerable portion of their compensation through bonuses tied to sales of non-securities products.

Because the five alternatives included in the final rule are based on a set dollar amount or the hourly wage or annual base salary established by a bank for the employee or the employee's job family, the alternatives help ensure that a referral fee will be nominal in relation to the employee's compensation in the year it is paid. Bonuses, however, typically are discretionary, vary significantly from year-to-year and, as noted by commenters, may constitute a significant portion of the compensation of certain types of bank employees in particular years. Permitting referral fees to be based in part on the size of a bonus paid in a previous year (or projected to be paid in the current year) could allow bank employees to receive a referral fee that is not nominal in relation to the employee's compensation, or the average compensation paid to employees within the relevant job family, in the year in which the fee is paid and, thus, could increase the potential for sales practice concerns.

See

e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, Harris Bank Letter, Roundtable Letter, PNC Letter, U.S. Trust Company, N.A. (“U.S. Trust”) Letter, and WBA Letter.

Commenters also asserted that more than one employee should be able to receive a fee for a single referral and also requested clarification as to whether officers and directors of a bank may receive referral fees under the exception.

The Agencies believe that the networking exception permits a bank employee who personally participated in a referral to receive a referral fee for the referral.

Accordingly, the Agencies have modified Rule 700(c) to clarify this position. Thus, for example, a supervisory employee may receive a separate, nominal one-time cash fee for a referral made by another individual supervised by the employee only if the supervisory employee personally participated in the referral. A supervisory employee may not, however, receive a referral fee merely for supervising the employee making the referral or administering the referral process. An officer or director of a bank who makes or personally participates in making a referral may receive a nominal fee for the referral as a bank employee.

See

e.g.

, Consumer Bankers Ass'n (“CBA”) Letter, BISA Letter.

See

Section 3(a)(4)(B)(i)(VI) of the Exchange Act (permitting “the bank employee [to] receive compensation for the referral of any customer” in accordance with the exception).

The proposed rule permitted a nominal referral fee to be paid only in cash. Many commenters requested that banks be given the flexibility to pay referral fees in non-cash forms.

The terms of the networking exception, however, provide for a “nominal, one-time cash fee of a fixed dollar amount”

and, accordingly, the final rule continues to require that referral fees paid under the exception be paid in cash. A bank, therefore, may not pay referral fees in non-cash forms, such as vacation packages, stock grants, annual leave, or consumer goods. The final rules do not, however, prevent a bank from paying an employee on a quarterly or more frequent periodic basis the total amount of nominal, fixed cash fees the employee earned during the period. For example, if a bank employee is entitled to receive a $25 referral fee for each securities referral and the employee makes three qualifying referrals in a given quarter, the bank may pay the employee $75 at the end of the quarter instead of three individual payments of $25. A bank also may use a “points” system to keep track of the number of qualifying securities referrals made by the employee during a quarterly or more frequent period and the total amount of nominal, fixed cash fees that the employee is entitled to receive at the end of the period. In all cases, however, points must translate into cash payments on a uniform basis and the cash amount that an employee will receive for a qualifying securities referral (

e.g.

, twice the employee's actual base hourly wage) must be fixed before the referral is made and may not be contingent or vary based on whether an employee makes a specified number or type of securities referrals during a quarterly or more frequent period.

See

e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, and JP Morgan Letter.

See

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

The exception and the final rules also do not prohibit a bank from providing its employees non-cash items, such as pizza or coffee mugs, in connection with programs to familiarize bank employees with new types of investment vehicles offered by the bank or the broker-dealer through the arrangement, provided that the programs or items given to employees do not reward or compensate an employee for making a referral to a broker-dealer. Thus, for example, a “pizza party” that is made available only to those employees that have made one or more referrals to a broker-dealer would not be permissible.

2. Definition of “Referral”

The statutory networking exception permits bank employees to receive a nominal one-time cash fee of a fixed dollar amount for the “referral” of a customer to a broker-dealer. Rule 700(e) defines a referral as an action taken by one or more bank employees to direct a customer of the bank to a broker-dealer for the purchase or sale of securities for the customer's account.

For purposes of the networking exception and Rules 700 and 701, the term “customer” includes both existing and potential customers of the bank.

Rule 700(e).

As proposed, a bank employee may receive a referral fee under the networking exception and Rule 700 for each referral made to a broker-dealer, including separate referrals of the same individual or entity. In addition, nothing in the statutory networking exception or the final rules limits or restricts the ability of a bank employee to refer customers to other departments or divisions of the bank itself, including, for example, the bank's trust, fiduciary or custodial department. Likewise, the networking exception and the rules do not apply to referrals of retail, institutional or high net worth customers to a broker-dealer or other third party solely for transactions not involving securities, such as loans, futures contracts (other than a security future), foreign currency, or over-the-counter commodities, or solely for transactions in securities (such as U.S. Government obligations) that would not require the other party to register under section 15 of the Exchange Act.

A bank that acts as a government securities broker (as defined in Section 3(a)(43) of the Exchange Act) is not exempt from and must comply with the notification and other applicable requirements of section 15C of the Exchange Act.

3. Definition of “Contingent on Whether the Referral Results in a Transaction”

Under the statutory networking exception, a nominal fee paid to an unregistered bank employee for referring a customer to a broker-dealer may not be contingent on whether the referral results in a transaction. This limitation is designed to allow banks to reward bank employees for introducing customers to a broker-dealer without giving unregistered bank employees a direct financial interest in any resulting securities transaction at the broker-dealer.

The final rule, like the proposed rule, provides that a referral fee will be considered “contingent on whether the referral results in a transaction” if payment of the fee is dependent on

whether the referral results in a purchase or sale of a security; whether an account is opened with a broker-dealer; whether the referral results in a transaction involving a particular type of security; or whether the referral results in multiple securities transactions.

The final rule expressly provides that a referral fee may be contingent on whether a customer (1) contacts or keeps an appointment with a broker-dealer as a result of the referral; or (2) meets any objective, base-line qualification criteria established by the bank or broker-dealer for customer referrals, including such criteria as minimum assets, net worth, income, or marginal federal or state income tax rate, or any requirement for citizenship or residency that the broker-dealer, or the bank, may have established generally for referrals for securities brokerage accounts.

A bank or broker-dealer may establish and use different objective, base-line qualification criteria (including citizenship or residency requirements) for different classes of customers or for different business lines, divisions or units of the bank or broker-dealer.

Rule 700(a).

Commenters generally supported these permissible contingencies. Some commenters contended that the rule also should allow payment of a nominal referral fee to be contingent on other events, such as the opening of an account at the broker-dealer or on the opening of an account that may be used to conduct only securities transactions that the bank itself could effect without registering as a broker under the exceptions for banks in Sections 3(a)(4)(B) of the Exchange Act.

Opening a securities account at the broker-dealer, however, is a necessary first step to executing securities transactions and one that a customer is unlikely to take unless the customer anticipates engaging in securities transactions with the broker-dealer. In light of this close link between opening an account and executing securities transactions, the Agencies have not modified the rule as requested and the final rule continues to provide that payment of a referral fee may not be contingent on whether the customer opens an account (other than the types of accounts described in Part B.2

supra.

) at the broker-dealer. Other contingencies not specified in the rule may be permissible if they are not based on whether the referral results in a securities transaction at the broker-dealer.

See

e.g.

, BISA Letter, Clearing House Ass'n Letter, and U.S. Trust Letter.

In addition, the “broker” exceptions in Sections 3(a)(4)(B) of the Exchange Act are available only to banks. Accordingly, a referral to a broker-dealer for a securities transaction within the scope of section 15 of the Exchange Act still involves a “broker” transaction at the broker-dealer even if a bank could conduct the transaction itself without registering as a broker, and a referral fee may not be contingent on the occurrence of such a transaction (or the opening of an account to engage in such transactions).

For similar reasons, a referral to a broker-dealer for such a transaction is a “referral” for purposes of the networking exception and Rule 700.

4. Definition of “Incentive Compensation”

The networking exception prohibits an unregistered employee of a bank that refers a customer to a broker-dealer under the exception from receiving “incentive compensation” for the referral or any securities transaction conducted by the customer at the broker-dealer other than a nominal, non-contingent referral fee. To provide banks and their employees additional guidance in this area, Proposed Rule 700(b) defined “incentive compensation” as compensation that is intended to encourage a bank employee to refer potential customers to a broker-dealer or give a bank employee an interest in the success of a securities transaction at a broker-dealer.

The proposed rule also excluded certain types of bonus compensation from the definition of “incentive compensation.” Proposed Rule 700(b)(1) excluded compensation paid by a bank under a bonus or similar plan if such compensation is paid on a discretionary basis; based on multiple factors or variables; such factors or variables include significant factors or variables that are not related to securities transactions at the broker-dealer; and a referral made by the employee or any other person is not a factor or variable in determining the employee's compensation under the plan.

In addition, Proposed Rule 700(b)(2) provided that the definition of incentive compensation did not prevent a bank from compensating its employees on the basis of any measure of the overall profitability of (1) the bank, either on a stand-alone or consolidated basis; (2) any of the bank's affiliates (other than a broker-dealer) or operating units; or (3) a broker-dealer if such profitability is only one of multiple factors or variables used to determine the compensation of the officer, director, or employee and those factors or variables include significant factors or variables that are not related to the profitability of the broker-dealer. The Agencies specifically requested comment on whether existing bank bonus programs would fit, or could easily be adjusted to fit, within these proposed exclusions.

Many commenters indicated that the proposed bonus provisions worked well and would not interfere with bank bonus plans generally. One commenter, however, opposed the proposed bonus provisions arguing that permitting bonuses to be based even in part on revenues generated by activity conducted at a broker-dealer would encourage bank employees to make referrals regardless of the appropriateness of the referral in order to increase their compensation under the bonus plan.

In addition, a number of commenters requested that the Agencies either confirm that bonus programs structured in particular ways identified by the commenter would not fall within the definition of “incentive compensation” or modify the terms of the exclusions to encompass plans with these features. For example, several commenters asked the Agencies to confirm that the rules would not prohibit a bank from basing an employee's bonus on the assets, revenues or profits brought to the bank and its partner broker-dealer by that employee. Other commenters asked that the Agencies provide that all “traditional” bank bonus programs are protected under the rule.

See

NASAA Letter.

A number of commenters also raised specific issues with one or more aspects of the exception in Rule 700(b)(1) for discretionary, multi-factor bonus plans or the safe harbor in Rule 700(b)(2) for plans based on overall profitability. For example, some commenters requested clarification of the “discretionary” requirement in paragraph (b)(1) and asserted that a bonus plan should be considered “discretionary” if employees do not have an enforceable right to compensation under the plan until it is paid.

One commenter also argued that Proposed Rule 700(b)(1) should not prohibit the number of referrals made by an employee from playing a role in the employee's compensation under a bonus plan.

See

e.g.

, U.S. Trust Letter and Union Bank Letter.

See

TD Banknorth, N.A. (“TD Banknorth”) Letter.

Several commenters also asserted that the safe harbor in paragraph (b)(2) should be clarified or expanded to cover

bonus programs based on any measure of the financial performance, and not just the “overall profitability,” of a bank, affiliate, operating unit or broker-dealer.

Commenters indicated that bank bonus programs may be based on a wide variety of measures or metrics related to the operations or performance of the bank, an affiliate or operating unit.

Some commenters also requested that the safe harbor be revised to clarify that a bonus program may be based on the overall profitability of an operating unit of an affiliate of a bank (other than a broker-dealer), or be expanded to allow bonus programs to be based on the financial performance of a branch, division, or geographical or operational unit of a broker-dealer.

See

e.g.

, ABA Letter, Clearing House Ass'n Letter.

See

e.g.

, Clearing House Ass'n Letter, Harris Bank Letter, U.S. Trust Letter.

See

e.g.

, ABA Letter, Clearing House Ass'n Letter, HSBC Bank Letter, PNC Letter, and Union Bank Letter.

The purpose of the exception and exclusion in paragraph (b) is to recognize that certain types of bonus plans are not likely to give unregistered bank employees a promotional interest in the brokerage services offered by the broker-dealers with which the bank networks and to avoid affecting bonus plans of banks generally. As described below, the Agencies have made several revisions to the exception and exclusion to help clarify the types of bonus plans that fall outside of the scope of “incentive compensation” and to ensure that excepted or excluded plans are not likely to give bank employees an impermissible promotional interest in the broker-dealer's activities. These exceptions and exclusions are crafted to accommodate existing types of bank bonus programs in general. Nevertheless, a plan's longevity or the number of banks that utilize similar plans are not factors in determining whether a plan constitutes “incentive compensation” under this definition. Accordingly, banks that have networking arrangements with a broker-dealer should review their existing bonus programs in light of the standards set forth in the rule to evaluate whether they may constitute impermissible incentive compensation.

a. Exception for Discretionary, Multi-Factor Bonus Plans

Under Rule 700(b)(1) of the final rules, compensation paid by a bank under a bonus or similar plan is specifically excepted from “incentive compensation” if it is paid on a discretionary basis and based on multiple factors or variables, provided that (1) those factors or variables include multiple, significant factors or variables that are not related to securities transactions at the broker-dealer; (2) a referral made by the employee is not a factor or variable in determining the employee's compensation under the plan; and (3) the employee's compensation under the plan is not determined by reference to referrals made by any other person.

The Agencies have modified the rule to make clear that, to be excluded under Rule 700(b)(1), a multi-factor plan must include

multiple

, significant factors or variables that are not related to securities transactions at the broker-dealer.

The proposed rule already required that there be “significant factors or variables” and the addition of “multiple” highlights the plural nature of these terms.

Rule 700(b)(1). The requirement that an employee's compensation not be based on a “referral” made by the employee or another person means that the employee's compensation under the bonus or similar plan may not vary based on the fact that the employee or other person made a referral to a broker-dealer or the number of securities referrals made by the employee or other person to a broker-dealer.

A similar change has been made to the corresponding language in Rule 700(b)(2).

Each factor or variable unrelated to securities transactions at the broker-dealer will be considered “significant” for purpose of Rule 700(b) if it plays a material role in determining an employee's compensation under the bonus or similar plan,

i.e.

, the amount of the employee's bonus could be reduced or increased by a material amount based on the non-securities factor or variable. This clarification will give banks greater certainty and will allow them to more readily identify the types of factors or variables not related to securities transactions that must be included within a discretionary, multi-factor bonus plan under paragraph (b)(1) of the Rule. Thus, under paragraph (b)(1), a bank's bonus program may take account of the full range of banking, securities or other business of one or more customers brought to the bank and its partner broker-dealer by an employee so long as the bonus is paid on a discretionary basis, the banking and other factors or variables not related to securities transactions at the broker-dealer are significant factors or variables under the bonus program, and a referral or number of referrals made by the employee or others is not a factor or variable under the program. In this way, the rule is designed to accommodate discretionary bank bonus programs that are based on general measures of the business or performance of a bank or a particular customer, branch or other unit of the bank, that are

not

based on referrals made by one or more bank employees and that include some inputs based on securities transactions at a broker-dealer as well as multiple significant factors or variables that are unrelated to securities transactions at the broker-dealer.

A bank may not establish or maintain one or more “sham” non-securities factors or variables in its bonus or similar plan for the purpose of evading the restrictions in Rule 700(b) and the Banking Agencies will continue to review the bonus and similar plans of banks participating in networking arrangements as part of the risk-focused supervisory process. In considering if a bonus program at a bank contains sufficient banking or other factors unrelated to securities transactions at a broker-dealer, the agencies will consider, among other things, whether such factors or variables relate to banking or other non-broker-dealer business(es) actually being conducted by the bank or its employees, the resources devoted by the bank to such business(es), and whether such business(es) materially contributes to the payments made under the plan over time. It is not expected that the actual payments made under a bank's bonus or similar plan would, over time, be based predominantly on securities transactions conducted at a broker-dealer. If such a situation were to occur, the bank would be expected to make appropriate modifications to its bonus or similar plan going forward.

A bonus or similar plan will be considered “discretionary” under the final rule if the amount an employee may receive under the plan is not fixed in advance and the employee does not have an enforceable right to payments under the plan until the amount of any payments are established and declared by the bank. A plan may, however, include targets or metrics that must be met in order for any bonus to be paid, provided the plan is otherwise a “discretionary” plan.

The Agencies have not modified the rule to allow a bonus plan to be based on the fact of a referral or the number of referrals made by one or more bank employees. The Agencies believe that doing so would allow a direct linkage between a referral and an employee's bonus compensation and be contrary to the purposes of the exception.

b. Safe Harbor for Plans Based on Overall Profitability or Revenue

The safe harbor provisions of Rule 700(b)(2) are designed to allow banks to avoid having to analyze whether a particular bonus program meets the

requirements of the exception in paragraph (b)(1) in circumstances where the general structure of the program clearly reduces the potential for sales practice concerns in connection with a referral to a broker-dealer. The Agencies have made several changes to the safe harbor to address the issues raised by commenters and to ensure that the safe harbor achieves its purpose. In particular, the Agencies have modified paragraph (b)(2) of the rule to cover any bonus or similar plan that is based on the overall profitability or revenue of:

(i) The bank, either on a stand-alone or consolidated basis;

(ii) Any affiliate of the bank (other than a broker-dealer), or any operating unit of the bank or an affiliate (other than a broker-dealer), if the affiliate or operating unit does not over time predominately engage in the business of making referrals to a broker-dealer; or

(iii) A broker-dealer if:

(A) Such measure of overall profitability or revenue is only one of multiple factors or variables used to determine the compensation of the officer, director or employee;

(B) The factors or variables used to determine the compensation of the officer, director or employee include multiple significant factors or variables that are not related to the profitability or revenue of the broker-dealer;

(C) A referral made by the employee is not a factor or variable in determining the employee's compensation under the plan; and

(D) The employee's compensation under the plan is not determined by reference to referrals made by any other person.

When a bonus program is based on the overall profitability of a bank, an affiliate of a bank (other than a broker-dealer), or an operating unit of the bank or an affiliate (other than a broker-dealer), any relationship between a referral made by an employee and the amount of payments that the employee may receive under the plan are likely to be attenuated. In these circumstances, for example, any potential connection between the revenue received by a bank from its partner broker-dealer as a result of a referral and the payments made to the referring bank employee under the plan likely would be tenuous and largely speculative given the number of other employees, business and actions that contribute to the overall profitability of the bank, affiliate or most operating units. The Agencies believe this attenuation effectively addresses any potential that payments under the plan would give an employee an undue promotional interest in any securities transactions that may occur at the broker-dealer as a result of a referral. A bonus plan based on the overall

revenue

of a bank or qualifying affiliate or operating unit would be similarly attenuated and, for this reason, the Agencies have modified the safe harbor to cover plans based on either the “overall profitability or revenue” of a bank or a qualifying affiliate or operating unit. This would include plans based on an entity's earnings per share or stock price, both of which are directly related to the entity's overall profitability or revenue. Because other, more granular measures of the financial performance of a bank, affiliate or operating unit could create an unduly close connection between the employee's expected payment under the bonus plan and referrals made to the broker-dealer or the securities transactions that result from those referrals, the rules provide for plans structured in more granular ways to be analyzed under the multi-factor, discretionary criteria in Rule 700(b)(1).

The potential connection between a referral made by a bank employee and the payments made to the employee under a bonus plan may be particularly strong if payments under the plan are based on the profitability or revenue of (i) the partner broker-dealer itself or a specific branch or operating unit of the broker-dealer (such as the branch or operating unit responsible for handling customers referred by the bank), or (ii) an operating unit of the bank or a non-broker-dealer affiliate that is predominantly engaged over time in referring customers to the broker-dealer. To address the potential for improper incentives in these situations, the Agencies have modified Rule 700(b)(2)(iii) to allow a bonus program to be based on the overall profitability or revenue of a broker-dealer only if the program meets the conditions specified in (A)-(D) above. These conditions are similar to those that would apply to a discretionary bonus or similar plan under paragraph (b)(1) and are designed to ensure that the profitability or revenue of the broker-dealer is only one of multiple significant factors or variables in determining the employee's compensation and that a referral or number of referrals made by the employee is not a factor or variable under the program.

Like the proposal, the safe harbor in paragraph (b)(2) is not available to bonus plans based on the profitability or revenue of a particular branch, division or operating unit of the partner broker-dealer.

As with a multi-factor bonus plan under paragraph (b)(1) of the Rule, a non-securities factor or variable will be considered “significant” under paragraph (b)(2)(iii) if it plays a material role in determining an employee's compensation under the bonus or similar plan.

In addition, the Agencies have modified paragraph (b)(2)(ii) of the rule to exclude bonus plans based on the profitability or revenue of an operating unit of a bank or non-broker-dealer affiliate that over time predominantly engages in the business of making referrals to a broker-dealer. This exclusion is intended to prevent a bank from basing a bonus plan on the overall profitability or revenue of a bank unit that is focused solely or predominately on making referrals to a broker-dealer. This restriction, however, is not intended to prevent a bonus plan from being based on the overall profitability or revenue of a bank unit, such as a call center, that in fact markets, sells or supports a range of bank products in addition to making referrals to a broker-dealer and which is not, over time, predominantly engaged in the business of making referrals to a broker-dealer.

C. Rule 701: Exemption for Referrals Involving Institutional Customers and High Net Worth Customers

The proposed rules included an exemption that would permit a bank, subject to certain conditions, to pay an employee a contingent referral fee of more than a nominal amount for referring an “institutional customer” or “high net worth customer” to a broker-dealer with which the bank has a contractual or other written networking arrangement.

Among the conditions included in the proposed rule were conditions that—

Proposed Rule 701.

• Established the financial thresholds at which a customer would be considered an “institutional customer” or “high net worth customer”;

• Limited the types of bank employees that may receive a higher-than-nominal referral fee under the exemption and the manner in which these fees may be structured;

See

Proposed Rule 701(a)(1) and (d)(4).

• Required the bank to provide certain disclosures to the customer regarding the referral arrangement;

and

See id.

at 701(a)(2)(i).

• Required that the agreement between the bank and the broker-dealer include certain provisions, including a provision obligating the broker-dealer to perform a suitability analysis of certain securities transactions that may result from the referral or a sophistication analysis of the customer referred.

See id.

at 701(a)(3)(ii).

Many commenters supported providing an exemption for referrals

involving sophisticated individuals and entities.

These commenters, for example, asserted that the exemption was appropriate in light of the required sophistication of the customer involved.

Other commenters, however, argued that providing an exemption to the “nominal” requirement would not be in the interest of investors or the public. These commenters asserted that the exemption as proposed would allow bank employees to have a significant salesman's stake in securities transactions and encourage bank employees to act as finders or salespeople for a broker-dealer.

See, e.g.

, BISA Letter, CBA Letter, Citigroup Letter, ICBA Letter, Roundtable Letter, Securities Industry and Futures Markets Ass'n (“SIFMA”) Letter, State Street Corp. Letter, U.S. Trust Letter, Union Bank Letter.

See

CBA Letter.

See, e.g.

, Massachusetts Securities Division Letter, NASAA Letter.

Many commenters, including a number that supported the exemption, also asked that the Agencies modify the exemption to, among other things, lower or alter the thresholds at which a person would be considered an “institutional customer” or “high net worth customer” under the rule; eliminate the provisions of the rule requiring the broker-dealer to perform a suitability or sophistication analysis in connection with a referral; or eliminate the limitations on the manner in which a higher-than-nominal referral fee may be structured. In addition, many commenters requested that the Agencies modify the rule in several respects to reduce administrative burden and complexity. For example, several commenters asked that the Agencies provide a bank and its partner broker-dealer greater flexibility to assign between themselves the responsibility for fulfilling the disclosure and other obligations included in the rule.

After carefully considering the comments, the Agencies have decided to retain the exemption. The Agencies continue to believe that it is appropriate to provide an exemption from the nominal and contingency limitations in the networking exception for referrals that both involve institutions and individuals that meet certain financial criteria and that occur under other conditions designed for investor protection. When provided appropriate information, such institutions and individuals are more likely to be able to understand and evaluate the relationship between a bank and its employees and the bank's broker-dealer partner and the impact of that relationship on any resulting securities transaction with the broker-dealer. The conditions in the final exemption are designed to help ensure that, among other things, institutional and high net worth customers, as defined in the rule, receive appropriate investor protections and information that enables the customer to understand the financial interest of the bank employee so the customer can make informed choices. Moreover, as the exemption itself provides, a bank operating under the exemption also must comply with the terms and conditions in the statutory networking exception (other than the compensation restrictions in Section 3(a)(4)(B)(i)(VI) of the Exchange Act's networking exception), including the terms and conditions that require the disclosure of the uninsured nature of securities and that limit the role that a bank employee may have in a brokerage transaction.

These conditions provide additional protections to institutional and high net worth customers that may be referred to a broker-dealer under Rule 701.

See

Exchange Act Section 3(a)(4)(B)(i)(V) and (IX).

The Agencies have modified the final rule in several respects to, among other things, provide banks and broker-dealers greater flexibility in complying with the rule's disclosure requirements and to make the exemption more workable in practice. In light of the protections retained in the rule, the Agencies also have modified the thresholds at which a non-natural person will be considered an “institutional customer” for purposes of the rule. These modifications are discussed further below.

Banks that pay their employees only nominal, non-contingent fees in accordance with Rule 700 for referring customers—including institutional or high net worth customers—to a broker-dealer do not need to rely on, or comply with, the exemption provided in Rule 701. As under the proposal, the final rule requires that the written agreement between a bank operating under the exemption and its partner broker-dealer include terms that obligate the broker-dealer to take certain actions. Banks and broker-dealers are expected to comply with the terms of their written networking arrangements. If a bank or broker-dealer does not comply with the terms of the agreement, however, the bank would not become a “broker” under Section 3(a)(4) of the Exchange Act or lose its ability to operate under the proposed exemption.

1. Definitions of “Institutional Customer” and “High Net Worth Customer”

Proposed Rule 701(d)(2) defined an “institutional customer” to mean any corporation, partnership, limited liability company, trust, or other non-natural person that has at least $10 million in investments

$40 million in assets. Under the proposal, a non-natural person also would qualify as an “institutional customer” with respect to a referral if the customer has $25 million in assets

and

the bank employee refers the customer to the broker-dealer for investment banking services. Proposed Rule 701(d)(1) defined a “high net worth customer” to mean any natural person who, either individually or jointly with his or her spouse, has at least $5 million in net worth excluding the primary residence and associated liabilities of the person and, if applicable, his or her spouse. Proposed Rule 701 also included provisions governing the allocation of assets held by a natural person jointly with his or her spouse and provided for the dollar thresholds in the rule to be adjusted for inflation every five years.

A number of commenters argued that the proposed dollar thresholds for both types of customers were too high in light of the nature of the transactions involved and the other requirements of the exemption.

Commenters asserted that customers with lower levels of net worth, assets or investments are sophisticated enough to understand and evaluate the implications of a higher-than-nominal or contingent referral fee. Commenters suggested a wide variety of alternative thresholds, with many recommending that the Agencies use an existing standard established under the federal securities laws for assessing a customer's investment sophistication. For example, commenters recommended that the Agencies use the “accredited investor” definition in the Commission's Regulation D, or the definition of that term proposed for use in connection with investments in certain private investment vehicles, for purposes of defining an institutional or high net worth customer;

treat all corporate and non-natural persons as an institutional customer; consider all persons advised by a bank or a registered investment adviser to be sophisticated; or lower the asset threshold for municipalities or

charitable organizations.

Several commenters also asked that the Agencies allow banks to use a business customer's revenues for purposes of determining if the customer is an institutional customer.

See, e.g.

, HSBC Bank Letter, U.S. Trust Letter, SIFMA Letter, Roundtable Letter.

See

17 CFR 230.501(a)(3), (5) and (6); Securities Act Rel. No. 33-8766, 72 FR 400, Jan. 4, 2007.

See, e.g.

, ABA Letter, Clearing House Ass'n Letter, State Street Corp. Letter.

After carefully reviewing the comments, the Agencies have modified the definition of an “institutional customer” in the final rule to mean any corporation, partnership, limited liability company, trust, or other non-natural person that has, or is controlled by a non-natural person that has, at least: (i) $10 million in investments; or (ii) $20 million in revenues; or (iii) $15 million in revenues if the bank employee refers the customer to the broker-dealer for investment banking services.

When converted to an equivalent asset number, the $20 million and $15 million revenue thresholds in the final rule are somewhat lower than $40 million and $25 million asset thresholds in the proposed rule.

The Agencies believe that these lower thresholds are appropriate for corporate and other non-natural customers in light of the other protections retained in the final rule, including the provisions requiring a suitability or sophistication determination, and the greater internal and external resources that business entities typically have as compared to individuals. The Agencies have modified the thresholds to be based on revenues (rather than assets) to eliminate the potential for borrowings to influence the status of a corporate customer and to promote the equivalent treatment of non-financial companies and financial companies. In addition, the Agencies have amended the rule to provide that a company controlled by an institutional customer will itself be considered an institutional customer. A company controlled by another company should generally have access to the resources and sophistication of the controlling company.

Rule 701(d)(2).

To develop comparable asset and revenue thresholds for an institutional customer, the Agencies used a dataset composed of all publicly traded, U.S.-incorporated, non-financial companies with a market capitalization of greater than $0 and for which asset and sales data were available in the 2005 CompuStat Universe of North American companies published by Standard & Poor's Corporation. For more information on the CompuStat Universe,

see http://www2.standardandpoors.com/spf/pdf/products/Compustat2006.pdf.

A company with $40 million in assets and a company with $25 million in assets would rank at approximately the 27.5th percentile and the 21.9th percentile, respectively, of all companies within this dataset when ranked according to assets. When the companies within this dataset are ranked according to sales, the companies at approximately the 27.5th percentile and the 21.9th percentile have approximately $27.7 million and $15.7 million in sales.

The lower revenue threshold for referrals involving investment banking services is designed to facilitate access to the capital markets by smaller companies. Like the proposal, the final rule defines “investment banking services” to include, without limitation, acting as an underwriter in an offering for an issuer, acting as a financial adviser in a merger, acquisition, tender-offer or similar transaction, providing venture capital, equity lines of credit, private investment-private equity transactions or similar investments, serving as placement agent for an issuer, and engaging in similar activities.

The phrase “other similar services” would include, for example, acting as an underwriter in a secondary offering of securities and acting as a financial adviser in a divestiture. These examples are not exhaustive and are provided solely for illustrative purposes.

See

Rule 701(d)(3).

When used in this rule, the term “include, without limitation” means a non-exhaustive list. This usage is not intended to suggest that the term “including” as used in the Exchange Act and the rules under that Act means an exhaustive list. The use of the term “including, but not limited to” in Exchange Act Rules 10b-10 and 15b7-1 is also not intended to create a negative implication regarding the use of “including” without the term “but not limited to” in other Exchange Act rules.

See

Exchange Act Release No. 49879, 69 FR 39682 (June 30, 2004), at footnote 76.

The final rule continues to define a “high net worth customer” as a natural person who, either individually or with his or her spouse, has at least $5 million in net worth excluding the primary residence and associated liabilities of the person and, if applicable, his or her spouse. In response to comments,

the Agencies have modified this definition to include any revocable, inter vivos or living trust the settlor of which is a natural person who, either individually or jointly with his or her spouse, meets the $5 million in net worth test.

This change is designed to reflect the fact that otherwise sophisticated individuals may hold assets through such trusts for estate planning or other purposes.

See

ABA Letter, PNC Letter, Roundtable Letter.

Rule 701(d)(1)(i)(B).

The Agencies believe that customers that meet the net worth, investment and revenue thresholds included in the final rule should have the ability to understand and evaluate the financial interest of the bank employee making a referral to a broker-dealer under the exemption. In developing these thresholds, the Agencies took into account the limited nature of activities covered by the exemption (

i.e.

, a referral by a bank employee to a broker-dealer). The Agencies have not modified the rule, as requested by some commenters, to treat any person advised by a bank or a registered investment adviser as an institutional or high net worth customer. The existence of such an advisory relationship generally is not, by itself, sufficient to establish the financial sophistication of an individual or corporate entity for purposes of the other similar standards in or developed under the federal securities laws.

See, e.g.

, 15 U.S.C. 80a-2(a)(51), 78c(a)(54); 17 CFR 230.501(a).

For purposes of determining whether a natural person meets the $5 million net worth test, the assets of a person include: (1) Any assets held individually; (2) if the person is acting jointly with his or her spouse, any assets of the person's spouse (whether or not such assets are held jointly); and (3) if the person is not acting jointly with his or her spouse, fifty percent of any assets held jointly with such person's spouse and any assets in which such person shares with such person's spouse a community property or similar shared ownership interest. These rules are designed to ensure that the full amount of jointly owned assets are not considered in cases where one spouse acts independently of the other in contacting a broker-dealer.

The Agencies have re-formatted these allocation provisions in the final rule to make them easier to understand and promote compliance.

One commenter asserted that the Agencies should allow a person to include assets that the person holds jointly with someone other than a spouse, such as a relative or domestic partner, for purposes of calculating whether the person meets the net worth threshold.

See

Roundtable Letter. The Agencies have not modified the rule in this manner to keep the scope of individuals whose assets may be considered in determining whether a natural person has the appropriate level of financial sophistication consistent with the standards used in determining whether a natural person is an accredited investor under the Commission's Regulation D.

See

17 CFR 230.501(a).

As in the proposal, the dollar threshold for both institutional customers and high net worth customers will be adjusted for inflation on April 1, 2012, and every five years thereafter, to reflect changes in the value of the Personal Consumption Expenditures Chain-Type Price Index, as published by the Department of Commerce, from December 21, 2006. The Agencies selected this index because it is a widely used and broad indicator of inflation in the U.S. economy.

2. Determining That a Customer Meets the Relevant Thresholds

The proposal required the bank to determine that the customer being

referred met the standards to be a high net worth or institutional customer either (i) before the referral fee was paid to the bank employee, in the case of a non-natural person, or (ii) prior to or at the time of the referral, in the case of a natural person.

In making these determinations for a natural person, the proposed rule allowed the bank to rely on a signed acknowledgment from the person that he or she met the standards to be a high net worth customer.

The proposed rule also required that the written agreement between the bank and the broker-dealer provide for the broker-dealer to (i) determine that the customer being referred met the standards to be a high net worth customer or institutional customer before the referral fee was paid,

and (ii) promptly inform the bank if the broker-dealer determined that a customer referred under the exemption did

not

meet the applicable standard.

100

Proposed Rule 701(a)(2)(ii).

Proposed Rule 701(a)(2)(ii)(B)(2).

Proposed Rule 701(a)(3)(i).

100

Proposed Rule 701(a)(3)(iii)(A).

Commenters argued that either the bank or the broker-dealer, but not both, should be required to make these customer eligibility determinations and that the bank and the broker-dealer should be permitted to allocate responsibility for these determinations between themselves.

101

In addition, several commenters contended that a bank should be allowed to make the eligibility determinations for both high net worth customers and institutional customers before the referral fee is paid or before a securities transaction is effected at the broker-dealer.

102

A few commenters also asserted that banks and broker-dealers should be permitted to rely on a signed acknowledgement from either an institutional or high net worth customer.

103

101

See, e.g.

, BISA Letter, Clearing House Ass'n Letter, Citigroup Letter, and SIFMA Letter. Some commenters, for example, suggested that requiring bank employees to make these determinations might require the employee to go beyond the limited role a bank employee is permitted to play in a brokerage transaction under the statute.

See, e.g.

, BISA Letter, ABA Letter.

102

See, e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, HSBC Bank Letter, and PNC Letter.

103

See, e.g.

, Citigroup Letter, SIFMA Letter.

The status of the referred customer as a high net worth or institutional customer is a fundamental aspect of the exemption and the final rule continues to provide for both the bank and the broker-dealer to determine that the customer meets the necessary qualification criteria to provide added assurance that these criteria are met.

104

In addition, less information typically is in the public domain concerning the financial resources of an individual than of a corporation or other business entity and, accordingly, there is a greater likelihood that a bank employee—without further investigation—will be able to preliminarily identify corporate or other business customers that are likely to satisfy the rule's eligibility criteria than in the case of individuals. For these reasons, the final rule continues to provide for the bank to determine that a natural person is a high net worth customer before a referral is made and before the employee potentially develops an expectation of a higher-than-nominal fee.

104

See

Rule 701(a)(2)(ii) and (3)(ii)(B). The final rule also continues to provide for the written agreement between the bank and the broker-dealer to require the broker-dealer to inform the bank if the broker-dealer determines that a referred customer does not meet the relevant eligibility thresholds.

See

Rule 701(a)(3)(v)(A).

The Agencies, however, have modified the final rule to make it more flexible while retaining its underlying purpose by providing that a bank or a broker-dealer satisfies its customer eligibility requirements if the bank or broker-dealer “has a reasonable basis to believe that the customer” is an institutional customer or high net worth customer before the time specified in the rule.

105

A bank or broker-dealer would have a “reasonable basis to believe” that a customer is a high net worth customer or institutional customer if, for example, the bank or broker-dealer obtains a signed acknowledgment from the customer (or, in the case of an institutional customer, from an appropriate representative of the customer) that the customer meets the applicable standards to be considered a high net worth customer or an institutional customer, respectively, and the bank employee making the referral or the broker-dealer employee dealing with the referred customer does not have information that would cause the employee to believe that the information provided by the customer (or representative) is false.

105

Rule 701(a)(2)(ii).

3. Conditions Relating to Disclosures

The proposed exemption required that the bank provide a high net worth customer or institutional customer being referred to the bank's broker-dealer partner certain written disclosures about the bank employee's potential interest in the referral prior to or at the time of the referral.

106

Commenters generally believed that providing these types of disclosures to a high net worth or institutional customer would help ensure that the customer received appropriate information concerning the relationship between the bank and the broker-dealer,

107

although a few questioned whether sophisticated customers required any disclosures at all or suggested that more simplified disclosures be permitted.

108

A number of commenters also asserted that the requirement that the bank provide these disclosures “prior to or at the time of the referral” was impractical or burdensome.

109

Commenters instead asserted that the rule should allow the disclosures to be provided before the referral fee is paid or before a securities transaction is effected at the broker-dealer, or allow the bank and the broker-dealer to determine which entity would make the disclosures.

110

106

Proposed Rule 701(a)(2)(i).

107

See, e.g.

, ABA Letter, JP Morgan Letter, Roundtable Letter, BISA Letter.

108

See, e.g.

, Bank of America Corp. (“BofA”) Letter and WBA Letter.

109

For example, some commenters noted that some referrals may occur only by telephone or asserted that it may be unclear to an employee when a referral actually occurs.

110

See, e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, HSBC Bank Letter, and WBA Letter. In addition, some commenters contended that banks should be required to provide similar conflict-of-interest disclosures to customers referred to a broker-dealer under the statutory networking exception.

See, e.g.

, Boyd Financial Letter, Pace Project Letter, University of Cincinnati Corp. Law Center Letter. The statutory networking exception itself sets certain disclosures that the bank or broker-dealer must provide a customer in situations where the bank employee making the referral may receive only a “nominal” referral fee. 15 U.S.C. 78c(a)(4)(i)(IX).

The final rule continues to require that a high net worth or institutional customer referred to a broker-dealer under the exception receive disclosures that clearly and conspicuously disclose (i) the name of the broker-dealer; and (ii) that the bank employee participates in an incentive compensation program under which the bank employee may receive a fee of more than a nominal amount for referring the customer to the broker-dealer and that payment of this fee may be contingent on whether the referral results in a transaction with the broker-dealer.

111

This requirement ensures that high net worth or institutional customers receive notice of the financial interest the referring employee may have in the transaction so they can make informed choices.

111

Rule 701(b).

In light of the comments, the Agencies have modified the provisions of the rule governing how and when these disclosures must be provided to make the rule more workable and less burdensome while also requiring that customers receive the information in time to make informed choices. Specifically, the final rule provides two options for providing the required

disclosures. Under the first option, as under the proposal, the bank must provide the high net worth or institutional customer the disclosures

in writing

prior to or at the time of the referral.

112

The second option allows the bank to provide the disclosure to the customer

orally

prior to or at the time of the referral. However, if the bank provides the customer the required disclosures only orally, then either (i) the bank must provide the disclosure to the customer in writing within 3 business days of the date of the referral; or (ii) the broker-dealer must be obligated, under the terms of its written agreement with the bank, to provide the disclosures in writing to the customer.

113

If the broker-dealer is responsible for providing the written disclosures, then it must provide the disclosures to the customer prior to or at the time the customer begins the process of opening an account at the broker-dealer (if the customer does not already have an account with the broker-dealer) or prior to the time the customer places an order for a securities transaction with the broker-dealer as a result of the referral (if the customer already has an account at the broker-dealer).

114

In this way, the rule provides a mechanism for customers to receive the disclosures in writing when they initially are provided only orally. Whether provided orally or in writing, the required disclosures will be considered to have been made in a clear and conspicuous manner if they are provided in a manner designed to call attention to the nature and significance of the information.

112

Rule 700(a)(2)(i).

113

Rule 701(a)(2)(i) and (a)(3)(i).

114

Rule 701(a)(3)(i). As a general matter, a customer begins the account-opening process when the customer fills out the appropriate forms provided by the broker-dealer to establish an account.

4. Suitability or Sophistication Analysis by Broker-Dealer

The proposed exemption required that the written agreement between the bank and the broker-dealer provide for the broker-dealer to perform a suitability or sophistication analysis of a securities transaction or the customer being referred, respectively. The type and timing of the analysis needed to be conducted by the broker-dealer depended on whether the referral fee was contingent on the completion of a securities transaction at the broker-dealer.

115

The proposed rule also required that the written agreement between the bank and its partner broker-dealer obligate the broker-dealer to inform the bank if it determined that a customer referred under the exemption, or a transaction to be conducted by the customer, did not meet the relevant suitability or sophistication standard.

116

115

Proposed Rule 701(a)(3)(ii).

116

Proposed Rule 701(a)(3)(iii)(C).

Several commenters objected to this suitability/sophistication requirement arguing that the broker-dealer should be required to conduct a suitability/sophistication analysis only when such an analysis would otherwise be required under the rules of the broker-dealer's self-regulatory organization (“SRO”) (

i.e.

, in those cases where the broker-dealer makes a recommendation to the customer concerning securities).

117

Commenters also argued that the suitability/sophistication requirement was unworkable or unnecessary given that the transaction may involve only a referral (without a securities transaction occurring) of a sophisticated customer.

118

In addition, some commenters expressed concern that the proposed standards would increase the potential liability of broker-dealers or delay the ability of a broker-dealer to respond to a customer's instructions.

117

See, e.g.

, ABA Letter, Clearing House Ass'n Letter, Citigroup Letter, and PNC Letter.

See also

FINRA Rule 2310 and FINRA IM-2310-3 (discussing suitability obligations of member broker-dealers). One commenter also asserted that any expansion of a broker-dealer's suitability obligations should be processed and approved through the normal market regulation and SRO process.

See

SIFMA Letter.

118

See, e.g.

, Clearing House Ass'n Letter, SIFMA Letter. Commenters also asserted that a broker-dealer may not be able to perform the proposed “sophistication” analysis if the customer does not open an account or refuses to provide the broker-dealer the information necessary to perform the analysis.

After carefully considering the comments, the Agencies have retained the requirement that the parties' written agreement provide for the broker-dealer to perform a suitability analysis when a referral fee is contingent on a transaction and a suitability or sophistication analysis for other referrals. These requirements provide additional investor protections in those circumstances where the bank employee making the referral may receive a higher-than-nominal referral fee. The suitability and sophistication standards included in the final rule are based on the standards that broker-dealers currently must apply and use under applicable SRO rules and, thus, should be familiar to those broker-dealers that partner with banks operating under the exemption.

119

In addition, the exemption gives a broker-dealer the flexibility to perform a suitability analysis, if one is otherwise required by the rule, in connection with all referrals made under the exemption if the broker-dealer determines that such an approach is appropriate for business, compliance or other reasons.

119

One commenter expressed concern that the suitability/sophistication requirements of the rule may discourage low-cost, execution-only brokers from establishing relationships with banks under the exemption.

See

Business Law Section Letter. The Agencies are mindful of the need to keep appropriate investment options, including low-cost options, available to investors. However, given the cost structure of low-cost brokers, the Agencies expect that few such brokers would participate in referral arrangements under the exemption that provides for higher-than-nominal referral fees. Broker-dealers that do not wish to become obligated to perform the suitability/sophistication analyses required by the rule also may continue to establish and maintain networking arrangements pursuant to the statutory networking exception.

Specifically, for contingent referral fees payable under the exemption, the written agreement between the bank and the broker-dealer must provide for the broker-dealer to conduct a suitability analysis of each securities transaction that triggers any portion of the contingency fee in accordance with the rules of the broker-dealer's applicable SRO as if the broker-dealer had recommended the securities transaction.

120

This analysis must be performed by the broker-dealer before each securities transaction on which the referral fee is contingent is conducted.

120

Rule 701(a)(3)(ii)(A). Because the exemption provides for a broker-dealer to conduct its suitability analysis in accordance with the rules of its applicable SRO, the broker-dealer may follow and take advantage of any applicable SRO rules or interpretations that allow the broker-dealer to make an alternative suitability evaluation. See,

e.g.

, FINRA IM-2310-3 (discussing a member's suitability obligations with respect to certain institutional investors).

For non-contingent referral fees payable under the exemption, the written agreement must provide for the broker-dealer to conduct, before the referral fee is paid, either (1) a sophistication analysis of the customer being referred; or (2) a suitability analysis with respect to all securities transactions requested by the customer contemporaneously with the referral in accordance with the rules of the broker-dealer's applicable SRO as if the broker-dealer had recommended the securities transaction.

121

Under the sophistication analysis option, the broker-dealer must determine that the customer has the capability to evaluate investment risk and make independent decisions, and determine that the customer is exercising independent judgment based on the customer's own independent assessment of the opportunities and risks presented by a potential investment, market factors, and other investment considerations.

122

This sophistication analysis is based on

elements of FINRA IM-2310-3 (Suitability Obligations to Institutional Customers).

121

Rule 701(a)(3)(iii)(B).

122

Rule 701(a)(3)(ii)(B)(

The Agencies have modified the final rule to provide for the broker-dealer to notify the customer, rather than the bank, if the broker-dealer determines that a high net worth or institutional customer, or a securities transaction to be conducted by such a customer, does not meet the applicable sophistication or suitability standard.

123

Providing such notification to the customer should assist the customer in deciding whether or not to conduct the transaction.

123

Rule 701(a)(3)(iv).

5. Conditions Relating to Bank Employees

Paragraph (b)(1) of the Proposed Rule included certain limitations on the types of bank employees that may receive a higher-than-nominal referral fee under the rule. In particular, the Proposed Rule provided that the bank employee: be predominantly engaged in banking activities, other than making referrals to a broker-dealer; encounter the high net worth or institutional customer in the ordinary course of the employee's assigned business for the bank; not be qualified or required to be qualified under the rules of a SRO; and not be subject to statutory disqualification under Section 3(a)(39) of the Exchange Act (other than subparagraph (E) of that Section) (“statutory disqualification”).

124

See

Proposed Rule 701(a)(1).

The proposed exemption also included other provisions related to the SRO and statutory disqualification conditions. First, it required that the written agreement between the bank and the broker-dealer must provide for the bank

and

the broker-dealer to affirmatively determine, before a referral fee is paid to a bank employee under the exemption, that the employee is not subject to statutory disqualification.

125

Second, it required that the bank provide the broker-dealer the name of the employee and such other identifying information that may be necessary for the broker-dealer to determine whether the bank employee is subject to statutory disqualification or associated with a broker-dealer.

126

And third, it required that the parties' written agreement obligate the broker-dealer to promptly inform the bank if it determined the bank employee was subject to statutory disqualification.

127

125

Proposed Rule 701(a)(3)(i)(A).

126

Proposed Rule 701(a)(2)(iii).

127

Proposed Rule 701(a)(3)(iii)(B).

The final rule retains these provisions with the following modifications.

128

In response to comments,

129

the Agencies have modified the SRO condition in paragraph (a)(1)(A) of the Rule to provide that the employee receiving the referral fee must not be “registered or approved, or otherwise required to be registered or approved, in accordance with the qualification standards established by the rules of any self-regulatory organization.” The Agencies have modified the related language in paragraph (a)(2)(iii) of the rule in a similar manner.

128

See

Rule 701(a)(1), (a)(2)(iii), (a)(3)(ii)(A), and (a)(3)(v)(B).

129

See

Business Law Section Letter.

Several commenters argued that the requirement that a bank employee encounter the high net worth or institutional customer “in the ordinary course of the bank employee's assigned duties” was unnecessary and ambiguous.

130

The Agencies have retained the requirement to help ensure that a bank employee making a referral under the rule does so as part of the employee's duties as a bank employee and not as a sales representative of the broker-dealer. However, the Agencies recognize that in the ordinary course of his or her assigned duties for the bank, a bank employee may encounter customers or potential customers outside the employee's regular business hours or at locations outside of the bank, such as at social or civic functions or gatherings.

130

See, e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, Comerica Bank Letter, and U.S. Trust Letter. For example, some asserted that bank employees may be expected to identify and develop client relationships at social or other events and expressed concern that the language might prevent a bank employee from receiving a referral fee for institutional or high net worth customers encountered in these ways.

A number of commenters contended that the bank and the broker-dealer should not both be required to verify that the bank employee is not subject to statutory disqualification and suggested that the bank and broker-dealer be permitted to allocate this responsibility between themselves.

131

The Agencies have modified the rule to provide for these determinations to be made by the broker-dealer under the terms of the parties' written agreement.

132

The Agencies believe that broker-dealers are better suited to make this determination given their familiarity with the Exchange Act's statutory disqualification standards, provided that they receive the necessary information concerning the employee from the bank. A broker-dealer fulfills its responsibilities under paragraph (a)(3)(ii)(A) of Rule 701 if the broker-dealer determines that a bank employee is not subject to statutory disqualification before the employee first receives a referral fee under Rule 701 and at least once each year thereafter as long as the employee remains eligible to receive referral fees under the rule.

131

See, e.g.

, ABA Letter, BISA Letter, Clearing House Ass'n Letter, Citigroup Letter, PNC Letter, and SIFMA Letter.

132

Rule 701(a)(3)(ii)(A).

As a means designed to ensure that the broker-dealer has the appropriate information to make these determinations, the rule continues to require that, before a higher-than-nominal referral fee is paid to a bank employee under the exemption, the bank provide the broker-dealer the name of the employee and such other identifying information that the broker-dealer may need to determine whether the employee is subject to statutory disqualification.

133

Once the information for a particular employee is conveyed to the broker-dealer, the bank should provide at least annually its broker-dealer partner any changes to the identifying information initially provided under paragraph (a)(2)(iii) of Rule 701 for an employee who continues to make referrals and receive referral fees under the exemption so that the broker-dealer may perform its periodic review of the employee's qualifications under paragraph (a)(3)(ii)(A).

133

Rule 700(a)(2)(iii).

6. Good Faith Compliance and Corrections by Banks

As in the proposal, the final exemption provides that a bank that acts in good faith and that has reasonable policies and procedures in place to comply with the requirements of the exemption will not be considered a “broker” under Section 3(a)(4) of the Exchange Act solely because the bank fails, in a particular instance, to determine that a customer is an institutional or high net worth customer, provide the customer the required disclosures, or provide the broker-dealer the required information concerning the bank employee receiving the referral fee within the time periods prescribed. If the bank is seeking to comply and takes reasonable and prompt steps to remedy the error, such as by promptly making the required determination or promptly providing the broker-dealer the required information, the bank will not lose the exemption from registration in these circumstances. Similarly, to promote compliance with the terms of the

exemption, the bank must make reasonable efforts to reclaim the portion of the referral fee paid to the bank employee for a referral that does not, following any required remedial actions, meet the requirements of the exemption and that exceeds the amount the bank otherwise would be permitted to pay under the statutory networking exception and Rule 700.

134

Rule 701(a)(2)(iv).

A few commenters suggested that the Agencies strike the requirement that the bank seek to reclaim the higher-than-nominal portion of a referral fee. The Agencies have retained this requirement as it helps provide employees an incentive to comply with the rule.

135

One commenter requested that the rule provide a similar safe harbor for broker-dealers.

See

SIFMA Letter. Any obligations of a broker-dealer that arise by reason of Rule 701 run only to its bank partner under the terms of their agreement and the Agencies believe the issue of contractual liability between the parties is best addressed by the parties themselves. As stated in the proposal, the Commission anticipates that it may be necessary for either FINRA or the Commission to propose a rule that would require broker-dealers to comply with the written agreements entered into pursuant to Rule 701.

7. Referral Fees Permitted Under the Exemption

Proposed Rule 701 placed certain limits on how a higher-than-nominal referral fee paid under the exemption may be structured.

136

Some commenters argued that these restrictions are unnecessary in light of the other protections included in the exemption, or that the rule should allow a higher-than-nominal referral fee to be based on a percentage of any type of securities transaction conducted at a broker-dealer (rather than just investment banking transactions).

137

On the other hand, one commenter asserted that, by allowing a referral fee to be based on the total amount of assets maintained in an account with the broker-dealer, the rule would provide an incentive for bank employees to provide ongoing investment advice to customers.

138

136

Proposed Rule 701(d)(4).

137

See, e.g.

, Clearing House Ass'n Letter and JPMorgan Letter.

138

See

NASAA Letter.

The final rule continues to place limits on the types of referral fees a bank employee may receive under the exemption. These limitations are designed to reduce the potential “salesman's stake” of the bank employee in securities transactions conducted at the broker-dealer. Specifically, the exemption provides that a referral fee paid under the exemption may be a dollar amount based on a fixed percentage of the revenues received by the broker-dealer for investment banking services provided to the customer.

139

Alternatively, the referral fee may be a predetermined dollar amount, or a dollar amount determined in accordance with a predetermined formula, so long as the amount does not vary based on (1) the revenue generated by, or the profitability of, securities transactions conducted by the customer with the broker-dealer; (2) the quantity, price, or identity of securities purchased or sold over time by the customer with the broker-dealer; or (3) the number of customer referrals made.

140

For these purposes, “predetermined” means established or fixed before the referral is made. The requirement that the amount of the referral fee not vary based on the number of customer referrals made does not prohibit an employee from receiving a referral fee for each referral made by the employee under the exemption.

139

Rule 701(d)(4)(ii).

140

Rule 701(d)(4)(i). A referral fee paid under the exemption may be contingent on whether the customer opens an account with the broker-dealer or executes one or more transactions in the account during the initial phases of the account.

As the exemption provides, these restrictions do not prevent a referral fee from being paid in multiple installments or from being based on a fixed percentage of the total dollar amount of assets placed in an account with the broker-dealer. Additionally, these restrictions do not prevent a referral fee from being based on a fixed percentage of the total dollar amount of assets (including securities and non-securities assets) maintained by the customer with the broker-dealer. Fees structured in this manner and consistent with the limitations in paragraph (d)(4)(i) of the Rule do not provide a bank employee an incentive to recommend the purchase or sale of particular securities. In fact, the bank employee would have no special incentive to recommend the purchase of any security, as the addition of cash or other non-security instruments to the account would count equally towards the employee's compensation as any addition of securities to the account.

8. Permissible Bonus Compensation Not Restricted

The exemption for high net worth and institutional customers expressly provides that nothing in the exemption prevents or prohibits a bank from paying, or a bank employee from receiving, any type of compensation under a bonus or similar plan that would not be considered incentive compensation under paragraph (b)(1), or that is described in paragraph (b)(2), of Rule 700 (implementing the networking exception).

141

As explained above, these types of bonus arrangements do not tend to create the kind of financial incentives for bank employees that the statute was designed to address.

141

Rule 701(c).

III. Trust and Fiduciary Activities

A. Trust and Fiduciary Exception and Proposed Rules

Section 3(a)(4)(B)(ii) of the Exchange Act (the “trust and fiduciary exception”) permits a bank, under certain conditions, to effect securities transactions in a trustee or fiduciary capacity without being registered as a broker.

142

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.

143

In addition the bank 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.

144

142

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

143

Id.

144

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.

145

In addition, a bank that effects a transaction in the United States of a publicly traded security under the exception must execute the transaction in accordance with Exchange Act Section 3(a)(4)(C).

146

This Section requires that the bank direct the trade to a registered broker-dealer for execution, effect the trade through a cross trade or substantially similar trade either within the bank or between the bank and an affiliated fiduciary in a manner that is not in contravention of fiduciary principles established under applicable federal or state law, or effect the trade in some other manner that the Commission permits.

147

The trust and fiduciary exception recognizes the

traditional securities role banks have performed for trust and fiduciary customers and includes conditions to help ensure that a bank does not operate a securities broker in the trust department.

145

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

146

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

147

15 U.S.C. 78c(a)(4)(C)(i)-(iii). As discussed

infra

at Part VI.C, the Agencies have adopted Rule 775 that permits banks, subject to certain conditions, to effect trades in securities issued by an open-end company and certain variable insurance contracts without sending the trade to a registered broker-dealer. Trades effected by a bank in accordance with Rule 775 are conducted in accordance with Section 3(a)(4)(C) of the Exchange Act.

The proposed rules provided that a bank would meet the “chiefly compensated” condition in the trust and fiduciary exception if the bank's relationship compensation attributable to each trust or fiduciary account exceeded 50 percent of the total compensation attributable to the relevant account.

148

The proposed rules also included an exemption that would permit a bank to use a bank-wide approach to the “chiefly compensated” condition as an alternative to the account-by-account approach. A bank using this proposed alternative would be able to use the aggregate relationship and total compensation that the bank received from its trust and fiduciary business as a whole to monitor its compliance with the chiefly compensated test. The proposed rule allowed a bank to use this bank-wide alternative if, among other things, the bank's aggregate relationship compensation attributable to its trust or fiduciary business as a whole equaled or exceeded 70 percent of the total compensation attributable to its trust or fiduciary business. This bank-wide alternative was designed to simplify compliance, alleviate concerns about inadvertent noncompliance, and reduce the costs and disruptions banks likely would incur under the account-by-account approach.

148

Proposed Rule 721.

The proposal defined the term “relationship compensation” to mean the types of trust and fiduciary compensation specifically identified in the trust and fiduciary exception. The proposed rules also provided examples of fees that would be considered an administration fee or a fee based on a percentage of assets under management for these purposes. For example, the proposed rules provided that fees paid by an investment company pursuant to a plan under 17 CFR 270.12b-1 (“12b-1 fees”) or for personal service or the maintenance of shareholder accounts (“service fees”) would be considered relationship compensation under the rules. The proposed rules also implemented the statute's advertising restriction and provided certain other conditional exemptions.

B. Joint Final Rules

1. “Chiefly Compensated” Test and Bank-Wide Exemption Based on Two-Year Rolling Averages

A majority of commenters supported the general approach taken in the proposed rules implementing the trust and fiduciary exception, including the proposed bank-wide alternative for the chiefly compensated test. For example, a number of commenters stated that the proposed bank-wide approach would provide banks an improved, workable and flexible method of complying with the statutory exception.

149

Some commenters, however, opposed either the account-by-account or bank-wide alternative to the “chiefly compensated” requirement. For example, some commenters argued that the account-by-account approach was inconsistent with the terms and purposes of the trust and fiduciary exception.

150

Another commenter argued that an account-by-account approach to the chiefly compensated test is the only way to help ensure that a bank does not operate a brokerage business out of its trust or fiduciary departments and, for this reason, recommended that the Agencies eliminate the bank-wide alternative.

151

Some commenters also requested that the Agencies lower the 70 percent relationship compensation/total compensation percentage required by the bank-wide exemption to 60 percent or 50 percent to make it more consistent with the percentage required by the account-by-account approach.

152

149

See, e.g.

, ABA Letter, Roundtable Letter, U.S. Trust Letter, WBA Letter.

150

See, e.g.

, Clearing House Ass'n Letter.

151

See

NASAA Letter.

152

See

ACB Letter, CBA Letter.

After carefully considering the comments, the Agencies have retained the two alternative approaches in substantially the same form as proposed. Specifically, Rule 721 provides that a bank meets the “chiefly compensated” condition in the trust and fiduciary exception if the “relationship-total compensation percentage” for each trust or fiduciary account of the bank is greater than 50 percent.

153

The “relationship-total compensation percentage” for a trust or fiduciary account is calculated by (1) Dividing the relationship compensation attributable to the account during each of the immediately preceding two years by the total compensation attributable to the account during the relevant year; (2) translating the quotient obtained for each of the two years into a percentage; and (3) then averaging the percentages obtained for each of the two immediately preceding years.

154

153

Rule 721(a)(1).

154

The rule provides for this process to be accomplished by calculating the “yearly compensation percentage” and the “relationship-total compensation percentage” for the account.

See

Rule 721(a)(2) and (3).

The final rules (Rule 722) also allow a bank to use a bank-wide approach to the “chiefly compensated” condition as an alternative to the account-by-account approach. To use this bank-wide methodology, the bank must meet two conditions. First, the “aggregate relationship-total compensation percentage” for the bank's trust and fiduciary business as a whole must be at least 70 percent.

155

The “aggregate relationship-total compensation percentage” of a bank operating under the bank-wide approach is calculated in a similar manner as the “relationship-total compensation percentage” of an account under the account-by-account, except that the calculations would be based on the aggregate relationship compensation and total compensation received by the bank from its trust and fiduciary business as a whole during each of the two immediately preceding years. In other words, the percentage would be determined by (1) Dividing the relationship compensation attributable to the bank's trust and fiduciary business as a whole during each of the immediately preceding two years by the total compensation attributable to the bank's trust and fiduciary business as a whole during the relevant year; (2) translating the quotient obtained for each of the two years into a percentage; and (3) then averaging the percentages obtained for each of the two immediately preceding years.

156

Second, the bank must comply with the conditions in the trust and fiduciary exception (other than the compensation test in Section 3(a)(4)(B)(ii)(I))

157

and comply with Section 3(a)(4)(C) (relating to trade execution) of the Exchange Act.

158

155

Rule 722(a)(2).

156

The rule provides for this process to be accomplished by calculating the “yearly bank-wide compensation percentage” and the “aggregate relationship-total compensation percentage” for the bank's trust and fiduciary business as a whole.

See

Rule 722(b) and (c).

157

The Agencies have modified the bank-wide exemption to clarify that these conditions include the advertising restrictions contained in the trust and fiduciary exception as implemented by Rule 721(b).

See

Rule 722(a)(1).

158

Rule 722(a)(1).

The Agencies believe that providing banks these two alternatives is consistent with the purposes of the trust and fiduciary exception. In this regard, the availability of these two alternatives is designed to avoid disrupting the trust and fiduciary operations of banks. The

compensation tests in both the account-by-account and bank-wide approaches are designed to ensure that a bank's trust department is not unduly dependent on the types of securities-related compensation not permitted by the statute. The 70 percent compensation threshold in the bank-wide exemption is higher than that required under the account-by-account approach in order to compensate for the loss of particularity when the chiefly compensated test is implemented and monitored on a bank-wide basis, rather than on an account-by-account basis. The Agencies note that several commenters also asserted that the proposed aggregate relationship compensation-total compensation percentage required by the bank-wide alternative (70 percent) would not disrupt the trust and fiduciary operations or customer relationships of banks in light of the proposal's definition of “relationship compensation.”

Some commenters asked that the Agencies modify how the bank-wide exemption could be applied in several ways. For example, some asserted that a bank should be allowed to apply the 70 percent compensation threshold separately to each individual fiduciary business line, operating unit or geographic region of the bank, rather than only on an aggregate bank-wide basis. Others asked that the Agencies allow a bank to use an aggregate compensation approach only for some trust or fiduciary business lines and use the account-by-account approach for the bank's trust or fiduciary accounts in its remaining business lines.

159

In addition, some asked that a bank be permitted to monitor compliance with the 70 percent compensation test on a combined basis with its affiliated entities engaged in trust or fiduciary activities (such as an affiliated bank or a subsidiary or affiliate registered as an investment adviser).

160

Some commenters also asked the Agencies to modify the bank-wide approach to provide for a bank's relationship compensation-total compensation percentage to be calculated based on the compensation attributable to all of the bank's trust and fiduciary accounts rather than the compensation from the bank's “trust and fiduciary business.”

161

159

See

Clearing House Ass'n Letter.

160

See

Citigroup Letter, Clearing House Ass'n Letter, Mellon Bank, N.A. (“Mellon”) Letter, PNC Letter, ABA Letter.

161

See, e.g.

, ABA Letter, Joint ABA/ABASA/Clearing House Ass'n Letter of July 16, 2007, BISA Letter, Clearing House Ass'n Letter, Comerica Bank Letter.

The Agencies believe that the bank-wide alternative as structured provides banks appropriate and adequate flexibility in conducting their trust and fiduciary operations while meeting the statute's goals. The bank-wide approach is designed to reflect both the relationship compensation and total compensation received by a bank through the conduct of its full range of trust or fiduciary services, and, thus, allow banks to avoid tracking their trust or fiduciary revenue back to one or more specific accounts. At the same time, the use of two uniform methodologies (account-by-account or bank-wide) should facilitate the review of bank compliance during the bank supervisory process and aid the development of software and related systems by banks and their service providers for compliance purposes. Furthermore, because the broker exceptions for a bank in Section 3(a)(4)(B), including the trust and fiduciary exception, apply to each bank individually and are not available to a nonbank entity, including a nonbank subsidiary or affiliate of a bank, the Agencies have not modified the rules to allow a bank to monitor its compliance with the compensation limit in Rule 721 on a combined basis with one or more affiliated banks, subsidiaries or affiliates. The Agencies also do not believe that requiring banks to monitor their compliance with the 70 percent compensation test on a bank-wide basis, rather than on an individual business line or operating unit basis, will impose significant additional burdens on banks.

162

The Agencies note, for example, that a bank that operates under the bank-wide approach may use different systems across its trust or fiduciary business lines, units or regions to monitor its compensation within those business lines, units or regions, provided that such information is then aggregated on a bank-wide basis as provided in Rule 722.

A bank has the flexibility to elect to use a calendar year or the bank's fiscal year for purposes of complying with the compensation provisions of either the account-by-account or bank-wide approach.

163

In addition, whether a bank decides to use the account-by-account approach or the bank-wide approach, the bank's compliance with the relevant compensation restriction is based on a two-year rolling average of the compensation attributable to the trust or fiduciary account or the bank's trust or fiduciary business, respectively. This two-year averaging is designed to allow for short-term fluctuations that otherwise could lead a bank to fall out of compliance with the exception or exemption from year-to-year.

163

Proposed Rule 721(a)(6).

Some commenters asked that the Agencies clarify when a bank must commence monitoring its compliance with the two-year rolling compensation test. As discussed

infra

in Part VI.F, a bank must comply with the exceptions in Section 3(a)(4)(B) of the Exchange Act and the final rules starting the first day of the bank's first fiscal year commencing after September 30, 2008. Thus, a bank that operates on a calendar-year basis must start monitoring its compliance with the compensation requirements on either an account-by-account or bank-wide basis beginning January 1, 2009, and would first have to meet the applicable compensation restriction after the conclusion of 2010 (based on the average of the bank's year-end compensation ratios for 2009 and 2010).

164

To allow banks sufficient time to obtain and verify the relevant compensation data, the Agencies have modified both the account-by-account approach and the bank-wide approach to provide banks up to 60 days after the end of a year to calculate their compliance with the relevant compensation restriction.

165

While the rules provide for a bank's compliance with the compensation tests to be determined based solely on calculations as of year-end, banks are encouraged to monitor their trust and fiduciary compensation on a regular basis as appropriate to identify and address potential compliance issues before the end of the relevant two-year period.

164

This same schedule also would apply to a bank that operates on an October 1st to September 30th fiscal year, but that elects to use the calendar year for purposes of monitoring its compliance with the chiefly compensated test. The Agencies believe the delay and phased-in nature of the compensation tests should provide banks as a general matter sufficient notice and time to address potential compensation issues across the full range of their trust and fiduciary accounts, including personal and charitable accounts and estates.

See

Business Law Section Letter.

165

See

Rule 721(a)(3)(ii) and Rule 722(c)(2).

2. “Relationship Compensation”

Both the account-by-account and bank-wide approaches are based on the ratio of the relationship compensation attributable to a trust or fiduciary account or a bank's trust and fiduciary business to the total compensation attributable to the account or business. The proposal defined the term “relationship compensation” to mean the types of trust and fiduciary compensation identified in the statute: an administration fee; an annual fee (payable on a monthly, quarterly or other basis); a fee based on a percentage

of assets under management; a flat or capped per order processing fee that is equal to not more than the cost incurred by the bank in connection with executing securities transactions for trust or fiduciary accounts; or any combination of these fees.

166

The proposed rules also provided examples of fees that would be considered an administration fee or a fee based on a percentage of assets under management for these purposes. For example, the proposed rules provided that 12b-1 fees,

167

service fees,

168

and fees for certain sub-transfer agent, sub-accounting or related services

169

paid by an investment company on the basis of assets under management would be considered relationship compensation under the rules.

166

Proposed Rule 721(a)(4).

167

Proposed Rule 721(a)(4)(iii)(A).

168

Proposed Rule 721(a)(4)(iii)(B).

169

See

Proposed Rule 721(a)(4)(i) and (iii)(C). Specifically, these fees, which are hereinafter referred to as “sub-transfer agent and related fees” are paid for (1) providing transfer agent or sub-transfer agent services for the beneficial owners of investment company shares; (2) aggregating and processing purchase and redemption orders for investment company shares; (3) providing the beneficial owners with account statements showing their purchases, sales, and positions in the investment company; (4) processing dividend payments to the account for the investment company; (5) providing sub-accounting services to the investment company for shares held beneficially in the account; (6) forwarding communications from the investment company to the beneficial owners, including proxies, shareholder reports, dividend and tax notices, and updated prospectuses; or (7) receiving, tabulating, and transmitting proxies executed by the beneficial owners of investment company shares in the account.

The Agencies received numerous comments on the definition of relationship compensation. A number of commenters supported the definition including, in particular, the examples recognizing 12b-1 and service fees as relationship compensation. For example, some commenters stated that treating these fees as relationship compensation is consistent with the terms and purposes of the trust and fiduciary exception and “critical” to ensuring that the rules do not disrupt the trust and fiduciary operations and customer relationships of banks.

170

Other commenters, however, argued that all 12b-1 fees, or the portion of such fees paid for distribution expenses, should be excluded from relationship compensation.

171

These commenters asserted that treating 12b-1 fees as relationship compensation would allow banks to have a “salesman's stake” in their customers” securities transactions in contravention of the purposes of the statute, result in the disparate treatment of banks and registered investment advisers, and create confusion as to how 12b-1 fees should be treated under other aspects of the federal securities laws and rules of the NASD (now FINRA).

170

See

Joint ABA/ABASA/Clearing House Ass'n Letter of June 7, 2007.

171

See

NASD Letter, NASAA Letter.

In addition, many commenters asked that the Agencies clarify whether additional types of fees not mentioned in the proposed rules would qualify as relationship compensation. For example, commenters asked the Agencies to confirm that fees separately charged a trust or fiduciary customer for custodial services and fees charged or earned in connection with securities lending and borrowing transactions conducted for a trust or fiduciary customer are relationship compensation.

After carefully considering the comments, the Agencies have retained, consistent with the statute, the definition of relationship compensation as any compensation that a bank receives that is attributable to a trust or fiduciary account and that consists of (1) an administration fee, (2) an annual fee (payable on a monthly, quarterly or other basis), (3) a fee based on a percentage of assets under management (an “AUM fee”), (4) a flat or capped per order processing fee, paid by or on behalf of a customer or beneficiary, that is equal to not more than the cost incurred by the bank in connection with executing securities transactions for trust or fiduciary accounts; or (5) any combination of these fees.

172

Rule 721(a)(4). For banks operating under the bank-wide alternative, fees of these types are relationship compensation if they are attributable to the bank's trust or fiduciary business as a whole.

See

Rule 722(c)(1).

The final rules also continue to list all 12b-1 fees that are paid on the basis of assets under management and attributable to a trust or fiduciary account (under the account-by-account test) or the bank's trust and fiduciary business as a whole (under the bank-wide test) as examples of AUM fees that are relationship compensation. The Agencies believe that treating 12b-1 fees in this manner is consistent with both the language and purposes of the trust and fiduciary exception. When paid on the basis of a percentage of assets under management these fees fall within the types of fees expressly permitted by the trust and fiduciary exception. 12b-1 fees that are paid on the basis of assets under management also are distinguishable from the types of non-relationship compensation, such as front-end or back-end sales loads

173

or per-order transaction fees that exceed a bank's costs, that are limited by the statute's chiefly compensated test.

173

A front-end sales charge is a charge that is used to finance sales or sales promotion expenses and that is included in the public offering price of the shares of an investment company. A deferred sales charge is an amount properly chargeable to sales or promotional expenses that is paid by a shareholder of an investment company after purchase of the company's shares but before or upon redemption.

See

FINRA Rule 2830(b)(8)(B) and (c); 17 CFR 270.6c-10.

Treating 12b-1 fees in this manner also will avoid significant disruptions to the trust and fiduciary operations of banks and, when viewed in light of other provisions and protections, is consistent with investor protection. Many bank trust and fiduciary departments, particularly those that act as a corporate trustee or as a trustee or fiduciary for employee benefit plans, receive a significant portion of their trust and fiduciary compensation through payments made under a 12b-1 plan.

Importantly, as provided in the trust and fiduciary exception, all 12b-1 fees received by a bank must be consistent with the fiduciary principles and standards governing the bank-customer relationship,

174

and the bank's compliance with these principles and standards will continue to be regularly examined by bank examiners during the bank supervisory and examination process. In addition, the treatment of 12b-1 fees that are paid on the basis of assets under management and service fees as “relationship compensation” for purposes of the trust and fiduciary exception and related rules does not affect the treatment of such fees under other provisions of the federal securities laws, the federal banking laws, applicable trust or fiduciary principles and standards, or the rules of an SRO. Thus, for example, the treatment of 12b-1 fees that are paid on the basis of assets under management and service fees as relationship compensation for purposes of these rules does not alter or affect the

treatment of, or limitations imposed on, these fees under FINRA Rule 2830.

175

174

Section 802(f) of the Uniform Trust Code, for example, provides that a trustee may receive compensation from an investment company in which the trustee has invested trust funds and receipt of such compensation will not be presumed to represent a conflict of interest if the investment otherwise complies with the jurisdiction's prudent investor rule.

See

Uniform Trust Code, § 902(f) and related comment (2005). In addition, a bank's receipt of 12b-1 fees from an employee benefit plan for which the bank acts as a fiduciary is governed by the Employee Retirement Income Security Act (“ERISA”) and the regulations and guidance issued by the Department of Labor thereunder.

See

29 U.S.C. 1001

et seq.

; DOL Advisory Opinion 2003-09A (June 25, 2003) (discussing conditions under which a directed trustee may receive 12b-1 fees under ERISA).

175

The rules also do not alter or affect the ability of a nonbank registered investment adviser to receive 12b-1 fees under the federal securities laws or the rules of an SRO. The “broker” exceptions for banks in Section 3(a)(4)(B) of the Exchange Act, including the trust and fiduciary exception, are not available to nonbank entities such as nonbank investment advisers.

In light of the comments received, the Agencies have modified Rule 721 to provide additional examples of the types of fees that qualify as relationship compensation under the statute and the rules. For example, the Agencies have modified the rule to include, as additional examples of an administration fee, compensation received by a bank (1) for disbursing funds from, or for recording payments to, a trust or fiduciary account; (2) in connection with securities lending and borrowing transactions conducted for a trust or fiduciary account; and (3) for custody services provided to a trust or fiduciary account (whether or not separately charged).

176

In addition, the Agencies have included (1) as an example of an annual fee, an annual fee paid for assessing the investment performance of a trust or fiduciary account or for reviewing such an account's compliance with applicable investment guidelines or restrictions, and (2) as an example of an assets under management fee, a fee based on the financial performance, such as capital gains or capital appreciation, of trust or fiduciary assets under management. The Agencies believe the characterization of these fees comports with the manner in which banks generally receive compensation for these services. Several commenters noted that banks currently may receive 12b-1 fees, service fees or sub-transfer agent and related fees either directly from a mutual fund or from the fund's distributor, transfer agent, administrator or adviser.

177

In light of these comments, the Agencies have eliminated the language in the proposed rules that required that these types of fees be “paid by an investment company.”

176

Rule 721(a)(4)(i)(B), (C) and (D). Because securities lending/borrowing fees and custody fees may be charged on an assets under management basis, the rule also provides that these fees are relationship compensation when charged in this manner. Rule 721(a)(4)(iii)(E). As with other types of relationship compensation, the fees that a bank receives for effecting securities lending/borrowing transactions for a trust or fiduciary account must be consistent with applicable fiduciary principles and standards.

177

See

Investment Company Institute (“ICI”) Letter, Federated Investors, Inc. (“Federated Investors”) Letter.

The examples of an administration fee, annual fee and an asset under management fee included in Rule 721(b) are provided only for illustrative purposes. Other types of fees or fees for other types of services could be an administration fee, annual fee or an AUM fee. In addition, an administration fee, annual fee or assets under management fee attributable to a trust or fiduciary account or a bank's trust or fiduciary business is considered relationship compensation regardless of what entity or person pays the fee, and regardless of whether the fee is related to only securities assets, to a combination of securities and non-securities assets, or to only non-securities assets. These fees are part of the compensation for acting as a trustee or fiduciary.

Some commenters asserted that a bank should be permitted to include within its relationship compensation any per-transaction securities processing fee it charges as a directed trustee or in another fiduciary capacity even if the fee exceeds the bank's costs in processing the transaction.

178

The statute, however, expressly provides that a per-order securities processing fee may be counted towards the statute's chiefly compensated requirement only if the fee is “equal to not more than the cost incurred by the bank in connection with executing securities transactions” for its trust or fiduciary customers. For this reason, the Agencies have not modified the rule in the manner requested.

178

See

e.g.

, Wells Fargo & Company (“Wells Fargo”) Letter, State Street Corp. Letter, Mellon Letter.

However, as discussed further in Part V, the Agencies have modified the custody exemption (Rule 760) to permit banks that accept securities orders as a directed trustee to do so under that exemption in lieu of the trust and fiduciary exception and related rules. In addition, as the Agencies explained in the proposal, a per order processing fee included in relationship compensation may include the fee charged by the executing broker-dealer as well as any additional fixed or variable costs incurred by the bank in processing the transaction. If a bank includes any such additional fixed or variable costs in the per order processing fees it includes in its relationship compensation, the bank should maintain appropriate policies and procedures governing the allocation of these costs to the orders processed for trust or fiduciary customers. This should help ensure that profits derived from per trade charges are not masked as costs of processing the trades and thereby included in relationship compensation.

3. Excluded Compensation

A number of commenters asserted that the revenues derived from securities transactions conducted by a bank for a trust or fiduciary customer under a

different

exception or exemption (such as the exemption provided in Rule 771 for transactions in Regulation S securities) should be excluded from the account-by-account or bank-wide compensation test completely.

179

Others asked that certain other types of fees, such as internal credits from other areas of the bank, credits received from broker-dealers for brokerage or research services in accordance with Section 28(e) of the Exchange Act, or revenues earned from providing trust or fiduciary services to mutual funds, be excluded from the chiefly compensated calculation as well.

179

See

e.g.

, Institute of Int'l Bankers (“IIB”) Letter, Clearing House Ass'n Letter.

As discussed in Part I.C

supra

, if more than one “broker” exception or exemption is available for a securities transaction effected by a bank for a customer, the bank may choose the exception or exemption on which it relies in effecting the transaction. In light of the comments received, the Agencies have modified Rules 721 and 722 to explicitly provide that, if a bank effects a securities transaction for a trust or fiduciary customer in accordance with the terms of an exception or exemption other than Rule 721 or Rule 722, the bank may, at its election, exclude the revenues associated with those transactions from the applicable relationship-total compensation calculation in Rule 721 or Rule 722.

180

As the rules provide, if a bank elects to exclude the revenues associated with transactions conducted under another exception or exemption, the bank must exclude such revenue from

both

the bank's relationship compensation (if the compensation would otherwise qualify as relationship compensation) and total compensation. Of course, the bank also must comply with the conditions applicable to the other available exception or exemption on which the bank chooses to rely.

181

180

Rule 721(b) and Rule 722(d).

181

Some commenters asserted that a bank should be allowed to include in its relationship compensation

all

of the revenue from securities transactions conducted for a trust or fiduciary account under another exception or exemption, regardless of whether that revenue otherwise qualifies as relationship compensation. The Agencies have not amended the rule in this manner as it is inconsistent with the terms of the trust and fiduciary exception which sets forth the types of fees that are included in relationship compensation.

In addition, compensation that is not derived from the provision of trust or fiduciary services should not be

included in a bank's relationship or total compensation under either the account-by-account or bank-wide alternative. Such compensation includes, for example, (1) revenue earned by a trust or fiduciary department from providing back-office services to an affiliated or unaffiliated party,

182

(2) revenue from the sale of an office or assets of the trust department, or from the provision on a stand-alone basis of other services (such as custody services or the sale of portfolio management software to a third party that independently operates and uses the software in connection with its own business) that do not involve trust or fiduciary services as defined in section 3(a)(4)(D) of the Act; and (3) internal payments or credits allocated to a bank's trust or fiduciary department or unit from another department or unit of the bank for deposits and other similar services not involving a security. Credits received by a bank from a broker-dealer for brokerage and research services provided by a broker-dealer in accordance with section 28(e) of the Act (15 U.S.C. 78bb(e)) and the regulations issued thereunder also should be excluded from the compensation tests. The Agencies do not believe these credits constitute compensation to the bank for purposes of the exception and rules because these credits must be reasonable in relation to the value of the brokerage and research provided by the broker-dealer in connection with the bank's exercise of investment discretion for its fiduciary accounts.

182

On the other hand, the revenue derived from providing fiduciary services to investment companies or companies affiliated with the bank should be included in the relevant chiefly compensated calculation.

4. Trust or Fiduciary Accounts

The final rules, like the proposal, define a trust or fiduciary account as an account for which the bank acts in a trustee or “fiduciary capacity” as that term is defined in Section 3(a)(4)(D) of the Exchange Act.

183

This definition is based on the definition of “fiduciary capacity” in part 9 of the OCC's regulations, which relates to the trust and fiduciary activities of national banks, in effect at the time of enactment of the GLB Act.

183

Rule 721(a)(5).

Section 3(a)(4)(D) identifies a number of particular situations where a bank serves in a fiduciary capacity.

184

The definition also provides that a bank acts in a “fiduciary capacity” if it acts “in any other similar capacity” to those specifically identified. Accordingly, the scope of the term “fiduciary capacity” is not fixed in time.

184

Section 3(a)(4)(D) of the Exchange Act provides that a bank acts in a “fiduciary capacity” if, among other situations, the bank has investment discretion on behalf of another. Thus, for example, if a bank has investment discretion over an escrow account on behalf of another, the bank would be acting in a “fiduciary capacity” with respect to the account.

The Agencies recognize, moreover, that different nomenclature may be used to identify a fiduciary capacity in the relevant governing documents or state laws. For example, the Uniform Probate Code uses the term “Personal representative” and similar successor titles in place of the terms “executor” or “administrator” to identify the representative of a decedent; the Uniform Custodial Trust Act uses the terms “Conservator” and “Custodial trustee” to refer to persons that act as a fiduciary for another person who has become incapacitated; and the Uniform Transfers to Minors Act uses both the terms “Conservator” and “Custodian” to refer to fiduciaries that act on behalf of a minor.

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The text of and additional information on these Uniform Codes and Acts, which are developed under the auspices of the National Conference of Commissioners of Uniform State Laws (“NCCUSL”), may be found on NCCUSL's Web site at

http://www.nccusl.org

Some commenters asked whether a bank that engages in trust or fiduciary activities may conduct securities transactions under the trust and fiduciary exception and related rules even if the bank does not maintain a separate trust department or has not had to obtain formal trust powers from its appropriate federal banking agency.

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The trust and fiduciary exception and related rules do not require that a bank effecting securities transactions for a customer in a trust or fiduciary capacity do so through a separate trust department or have obtained formal trust powers from its appropriate federal banking agency. However, securities transactions conducted for a trust or fiduciary customer under the exception and related rules must be effected in a department of the bank “that is regularly examined for compliance with fiduciary principles and standards'' by the bank's appropriate federal or state banking supervisor.

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As stated in the proposal, the Agencies will rely on the appropriate federal banking agency for a bank to determine whether the bank's activities are conducted in the bank's trust department or other department regularly examined by the agency's examiners for compliance with fiduciary principles and standards.

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186

See

e.g.

, ACB Letter, Roundtable Letter. Federal savings associations, for example, are not required to obtain approval from their appropriate federal banking agency to act as a trustee for an individual retirement account under section 408(a) of the Internal Revenue Code.

See

12 CFR 550.580.

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15 U.S.C. 78c(a)(4)(B)(ii); Rule 722(a)(1). A bank effecting transactions for trust or fiduciary customers through a department examined for compliance with trust or fiduciary principles may use other divisions or departments of the bank, or other affiliated or unaffiliated third parties, to handle aspects of these transactions. The bank must continue to act in a trustee or fiduciary capacity with respect to the account and, accordingly, should exercise appropriate diligence in selecting persons to provide services to the bank's trust or fiduciary customers and in overseeing the services provided in accordance with the bank's fiduciary obligations. No party, other than the bank (including, without limitation, a transfer agent or investment adviser), working in conjunction with the bank may rely on the bank's exception or exemption from “broker” status. To the extent that any such third party performs activities that would make that entity a broker under Section 3(a)(4) of the Exchange Act that entity would be required to register as a broker (in the absence of an applicable exemption or regulatory relief) notwithstanding any written or unwritten agreement the third party may have with the bank.

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The OTS, for example, is in the process of revising its examination procedures to provide for the regular examination of individual retirement accounts held by a federal savings association as trustee for compliance with fiduciary principles and standards.

5. Exemptions for Special Accounts, Foreign Branches, Transferred Accounts, and a De Minimis Number of Accounts

The Agencies also proposed a rule (Proposed Rule 723) that would permit a bank to exclude certain types of accounts for purposes of determining its compliance with the account-by-account or bank-wide compensation tests. As proposed, Rule 723 allowed a bank, in calculating its compensation under either approach, to exclude compensation received from any trust or fiduciary account open only for a short period of time (less than 3 months) or acquired within the past 12 months as part of a merger or similar transaction. In addition, the Proposed Rule allowed a bank using the account-by-account approach, subject to certain conditions, to (1) exclude the lesser of 1 percent or 500 of its trust or fiduciary accounts in a year from the chiefly compensated test, and (2) transfer any trust or fiduciary account ultimately determined to be non-conforming to a registered broker-dealer or an unaffiliated entity exempt from registration within 3 months of the end of the relevant year.

Commenters generally favored these exemptions. One commenter, however, argued that these exemptions should be eliminated because they would allow banks to manipulate the chiefly compensated test.

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Several commenters also requested that the Agencies adopt an additional exemption

permitting banks to exclude trust and fiduciary accounts held at a foreign branch of a bank from the chiefly compensated tests.

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These commenters contended that few, if any, of the trust and fiduciary accounts of a foreign branch (other than an offshore “shell”

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