SRC Insights: Fourth Quarter 2009

Regulation R: Is Your Bank in Compliance?

by Linda M. Rojas, Fiduciary Specialist

Overview

In 2007, the Board of Governors of the Federal Reserve System (Board) and the Securities and Exchange Commission (SEC) issued final rules, known as Regulation R.¹ Regulation R implements certain of the broker exceptions for banks from the definition of the term "broker" under the Securities Exchange Act of 1934, as amended by the Gramm-Leach-Bliley Act (GLBA), Title II, and implements the GLBA removal of the blanket exemption from SEC registration for banks that effect securities transactions.² The regulation is intended to provide a flexible framework for banks to continue to meet their customers' demands for banking services that include securities products while ensuring consumer protection. It is important to note that the compliance date for Regulation R for most banks was January 1, 2009.³ The regulation applies to banks, which are defined to include commercial banks, thrifts, trust companies, and U.S. branches and agencies of foreign banks.

As a result of GLBA and Regulation R, if a bank effects securities transactions in trust and fiduciary, custody, or "sweep" accounts, it would need to qualify for an exception or exemption under GLBA or Regulation R or push out these activities to a registered broker-dealer affiliate or third-party broker-dealer.

A banking organization that does not comply with Regulation R may be exposed to the legal and reputational risk of acting illegally as a securities broker.

This article will summarize some key aspects of the Regulation's bank-broker exceptions relating to: 1) third-party networking arrangements, 2) trust and fiduciary activities, 3) deposit "sweep" activities, and 4) custody and safekeeping activities. The GLBA also includes other broker exceptions that are still available for banks to use; however, these exceptions are beyond the scope of this article. The summary is not a substitute for the rule itself and does not constitute legal advice.

Networking Exception

The networking exception permits banks to pay their unregistered employees, such as tellers, loan officers, and private bankers, a one-time, "nominal" cash referral fee for referring bank customers to their broker-dealer affiliates or partners. Regulation R provides several options for determining whether a referral fee is "nominal." One option considers a fee nominal if it does not exceed $25. This dollar amount will be adjusted for inflation on April 1, 2012, and every five years thereafter. Regulation R also provides an exemption to allow banks to pay higher fees for referrals of institutional and high net worth customers as defined by Regulation R.

Trust and Fiduciary Exception

This exception permits a bank to effect securities transactions for its trust or fiduciary customers as long as the bank is chiefly compensated for those transactions by certain types of fees, referred to as "relationship compensation:"⁴

Administration or annual fees
A percentage of assets under management
Flat or capped per-order processing fees that do not exceed the cost the bank incurs in executing such securities transactions
Any combination of such fees

Relationship compensation includes 12b-1 fees, service fees, and sub-transfer and sub-accounting fees that banks receive from mutual funds or their service providers, and Regulation R provides a number of other examples of the types of fees that qualify as relationship compensation.

Regulation R also provides for two alternative approaches to satisfy compliance with the chiefly compensated test: an account-by-account approach or bankwide approach. Under the account-by-account approach, Regulation R provides that a bank meets the chiefly compensated test if the relationship/total compensation percentage for each trust or fiduciary account of the bank is greater than 50 percent.

The second alternative is the bankwide approach. Under the bankwide approach, Regulation R requires the aggregate relationship/total compensation percentage for the bank's trust and fiduciary business as a whole to be at least 70 percent. The bankwide approach is calculated as follows:

Divide the relationship compensation (RC) attributable to the bank's trust and fiduciary business as a whole during each of the immediately preceding two years by the total compensation (TC) attributable to the bank's trust and fiduciary business as a whole during the relevant year
Translate the quotient obtained for each of the two years into a percentage
Average the percentages obtained for each of the two immediately preceding years

Ex:

((RCy-1/TCy-1) + (RCy-2/TCy-2)) x100

= Relationship Total Compensation %

In order to meet the bankwide approach, the relationship total compensation percentage must be greater than or equal to 70 percent. In the example above, y-1 would be the first year of 2009, and y-2 would be 2010, for a bank determining its compliance with the bankwide approach for 2011 (the first year the test will apply).

Regulation R states that a bank may exclude trust and fiduciary accounts that were opened for fewer than three months during the relevant year or that were acquired during the previous 12 months as part of a merger and acquisition transaction. This exclusion applies to both the bankwide approach and the account-by-account approach.

In addition to the above requirements, for a bank to use the trust and fiduciary exception, it must adhere to specific advertising restrictions. Advertisement is defined by Regulation R as any material that is distributed through public media, such as newspapers, radio, television, and websites. A bank may not advertise its securities brokerage services for trust and fiduciary accounts except as part of advertising its broader trust and fiduciary services. Also, a bank may not advertise its securities brokerage services for trust and fiduciary accounts more prominently than other aspects of the trust and fiduciary services provided to these accounts.

Regulation R also requires a bank to direct all transactions in publicly-traded securities for trust and fiduciary customers to a registered broker-dealer for execution.

Sweep Exception

This exception allows a bank to sweep funds from bank accounts into "no-load" money market funds without registering as a broker-dealer. To qualify as a "no-load" fund, a fund must have no front-end or back-end loads and no more than 25 basis points in asset-based sales charges and service fees.

Banks are also permitted to sweep deposits into a "load" money market fund if, among other things, it does not characterize the fund as being "no-load" and provides the fund's prospectus to the customer before the sweep transactions are authorized. Furthermore, a bank is allowed to invest customer funds into a money market mutual fund if it provides the customer with some other product or service that would not require broker-dealer registration, such as an escrow, trust, or fiduciary or custody account.

Custody and Safekeeping Exception

Under Regulation R, banks can continue to accept securities orders in a custodial capacity if the transactions constitute customary banking activities, subject to certain conditions. If a bank does not accept orders for securities transactions from a custody account, then it is not necessary to adhere to the conditions in Regulation R with respect to that account. Furthermore, a bank does not need to rely on the custody exception under the regulation to conduct certain other permitted custodial activities (e.g., facilitating the movement of cash and securities associated with clearing and settling a customer securities transaction).

Regulation R allows a bank to accept orders for securities transactions for an employee benefit plan account or an individual retirement account or similar account for which the bank acts as a custodian. However, this exemption is not available if the bank acts as a trustee or fiduciary for the account, other than as a directed trustee.

A directed trustee is defined in the regulation as a trustee that does not exercise investment discretion with respect to the account. A bank that acts as a directed trustee for these types of accounts may rely on the custody exemption. However, the bank's trustee relationship with the account remains a trust and fiduciary relationship, and, as such, the bank must continue to comply with applicable fiduciary principles and standards in its relationships with the account.

The advertisement restrictions applicable to employment benefit and individual retirement and similar accounts are very similar to the restrictions imposed in the fiduciary exception. For example, a bank may not advertise that it accepts securities transaction orders for employee benefit plan accounts or individual retirement accounts (or similar accounts), except as part of advertising the other custodial or safekeeping services the bank provides to these accounts. Certain additional advertising restrictions apply to individual retirement accounts.

The regulation allows a bank custodian to accept trades for other types of custody accounts on an "accommodation" basis. Regulation R restricts fees that a bank may accept for initiating an accommodation order for a custody account and employee compensation related to these accounts. For "accommodation" accounts, the bank is restricted from providing investment advice, research, or recommendations to the account. Stricter advertising and sales literature requirements also apply to custody accounts for which accommodation orders are accepted.

Compliance

The banking agencies are currently developing recordkeeping rules for banks that rely on the exceptions and exemptions in Regulation R and the GLBA broker push-out provisions. Items that examiners may find useful in determining a bank holding company, state member bank, or U.S. branch/agency of a foreign bank's compliance with Regulation R and GLBA include the following:

Whether the institution's employee training is adequate
Whether the institution has performed an appropriate analysis to identify the specific exceptions and exemptions it will rely on for continuing to effect securities transactions
Whether the institution has written policies and procedures to ensure compliance
Whether the institution has processes in place to document its approach for calculating the chiefly compensated test (account-by-account or bankwide method)
Whether the institution has processes in place to ensure that the advertising restrictions are being followed
Whether the institution's board and/or the board committee has been informed of the institution's approach for and progress in complying with the GLBA broker push-out provisions and Regulation R
Whether the institution has appropriate record retention policies and procedures in place to ensure retention of records to document its calculation of the chiefly compensated test, compliance with advertisement restrictions, and with safekeeping and custody provisions
Whether the software programs used by the institution's service providers for trust recordkeeping and accounting are adequate to ensure compliance with the statute and Regulation R
Whether the institution has reviewed its networking arrangements with broker-dealers and its compensation and bonus programs that may involve effecting securities transactions to ensure compliance with the rules.
Whether the institution has decided to push out any of its securities activities or accounts to a registered brokerage firm/affiliate to comply with the rules

This article highlights only some of the key terms and conditions of Regulation R. If your institution has questions regarding Regulation R, you are encouraged to contact Barbara Cornyn of the Board's Division of Banking Supervision and Regulation at (202) 452-2434 or Michael Waldron of the Board's Legal Division at (202) 452-2798.⁵

¹ 12 CFR Part 218 for the Board and 17 CFR Part 247 for the SEC. The full text of Regulation R is available on the Board's website .
² "Effecting securities transactions" is an SEC term that may include, for example: a bank soliciting a customer's securities purchase or sales order and placing it with a broker-dealer for execution and certain compensation programs designed to encourage employees to refer customers to a broker-dealer.
³ Regulation R's compliance date is the first day of the bank's fiscal year that commences after September 30, 2008, which for most banks was January 1, 2009.
⁴ Securities Exchange Act Section 3(a)(4)(B)(ii).
⁵ Barbara Cornyn of the Board's Division of Banking Supervision and Regulation and Kieran Fallon of the Board's Legal Division contributed to this article.

The views expressed in this article are those of the author and are not necessarily those of this Reserve Bank or the Federal Reserve System.