REG R IS APPROVED … AT LAST
From Washington
Richard D. Starr

Richard D. Starr is BISA Director of Government Affairs and Chairman of BISA's Legislative, Regulatory, and Compliance Committee. He is also President of Financial Institutions Group, Inc., a full-service financial services consulting firm focusing on bank insurance and securities issues. He can be contacted via email at rstarr@bisanet.org. He and Kathleen Collins write the "From Washington" column in alternative issues.

RECENT ACTIVITY inside the Beltway came as a flurry of announcements, final rules, and some new regulations. With Congress preparing for another of its all-too-frequent, extended recesses, it is doubtful we will see anything from the key financial services committees for the remainder of this year.

The Government Sponsored Enterprises (GSEs) are in the eye of the sub-prime mortgage hurricane, but no legislation has survived the most-elementary proposed solutions. GSE matters are extremely important to the BISA, because they have a downstream effect on the growing demand for income products, such as annuities, variable annuities, and bonds. The more time legislative committees spend on other matters, the less time they spend on producing more banking and other financial services legislation that have questionable consumer benefit, unquestionable implementation expense, and ongoing compliance costs.

Eight years later, final approval

On September 24, 2007, we received the news that the Board of Governors of the Federal Reserve gave the final approval of Reg R, just a week after approval by the SEC. Nearly eight years after approval of the Gramm-Leach-Bliley Act (GLBA) in November 1999—and after Congressional action to force the Fed and the SEC to push it over the goal line—it is final. Was this just-in-time execution, or what? Had the SEC vote been delayed, it is quite likely the SEC could not have acted; its five-person constituency lacked Democrats (due to resignations), and the prospect loomed that its actions would be opposed by a highly partisan Congress.

The regulation is complex, and Reg R compliance is even more complex.

Reg R (formerly Reg B) is about definition. The final rules implement certain exceptions for banks when it comes to the definition of "broker' under Section 3(a)(4) of the Securities Exchange Act of 1934 (Exchange Act) as amended by the Gramm-Leach-Bliley Act. Reg R also removes Exchange Act Rules 3a4-2-3a4-6, and Rule 3b-17.

The final 11-part, 211-page release has an introduction summary that is worth reading. Sections II-VI are the heart of the regulation. It is not possible in this article to cover all of these five parts; we will focus only on Part II, "Networking Arrangements." An article addressing the other important elements of Reg R will soon be published on the BISA Website.

With the finalization of Reg R, a bank or its affiliates must register unless they qualify for exception. Credit unions are not subject to Reg R, although they would be well advised to gain an understanding of it and model their policies accordingly. Obtain and read those sections that cover "Trust and Fiduciary Activities," "Safekeeping and Custody," and "Other Exemptions." The regulation is complex, and compliance is even more complex.

Networking arrangements

The section dealing with "Networking Arrangements" addresses some of the compensation restrictions. If a bank has a written, third-party agreement with a registered broker/dealer (a "third-party marketer" or "TPM"), whereby the TPM offers brokerage services to the bank's customers, the bank will generally be considered exempt from being considered a broker—that is, if it does not violate the restrictions on paying non-registered employees.

There has long been a prohibition against compensating non-registered persons for securities transactions. To get the desired results and to encourage unregistered bank employees to refer customers to a licensed person, referral fees are paid. Under Reg R, referral fees must be nominal, one-time cash fees of a fixed dollar amount, and they must meet any one of four conditions in that: (1) They do not exceed twice the average base hourly wage established by the bank for that employee's job family; (2) They do not exceed 1/1,000 of the average annual base salary established by the bank for the employee's job family; (3) They do not exceed twice the employee's actual base hourly wage; or (4) They do not exceed a specified dollar amount ($25), indexed and periodically adjusted for inflation.

So, pick your formula and apply it uniformly, and train your employees consistently and constantly regarding your company's sales practices.

A "job family" is defined as a group of jobs or positions with similar responsibilities, or requiring similar skills, education, or training. A bank or a separate unit, branch, or department establishes and uses the "job family" definition in the ordinary course of business to distinguish among its employees for purposes of hiring. For example, tellers require different skills than branch managers, so "branch employees" would not be classified as a job family. There are distinct differences in skills and hiring qualifications within any branch unit.

Unregistered employees are restricted to minimal functions in connection with brokerage transactions, and they cannot provide investment advice or make specific recommendations. Referral fees may be awarded to more than one employee for the same referral if the employees participated directly in making the referral. Officers and directors may also receive referral fees if they personally participated in making the referral. Branch managers and other similar non-registered employees cannot receive incentive payments if they did not directly participate in making the referral; this includes overrides and derivative bonus payments that are designed to skirt this restriction.

Under Reg R, referral fees must be nominal, one-time cash fees of a fixed dollar amount, and they must meet any one of four conditions.

Under Reg R, all referral fees must be in cash—and only in cash. They may be paid periodically for the sum total of qualified referrals, and there is no requirement that they be paid on a one-by-one basis. There cannot be any bank requirement for a minimum or maximum number of referrals.

Reg R 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. They might be either an existing or prospective customer, and there is no restriction on separate fees paid for referrals of the same customer.

Referral fees must not be contingent on the customer actually transacting the referred business. The payment of the referral fee may, however, be contingent on the customer keeping an appointment with the broker/dealer as the result of the referral and the customer meeting certain minimum financial criteria. Reg R specifically addresses "Incentive Compensation." To qualify for exemption from registration as a broker under "Networking Arrangement," there must be no "Incentive Compensation" of non-registered employees. Incentive compensation is defined as compensation that is intended to encourage a bank employee to refer potential customers to a broker/dealer, or give bank employees a financial interest in the success of a securities transaction at a broker/dealer. The final rules covering plans ensure that exceptions or exclusions are not likely to give bank employees an impermissible promotional interest in the broker/dealer's activities.

If your bank has a networking arrangement with a broker/dealer, and your bank is relying on that networking arrangement as the bank's exemption from registration as a broker, you should seek competent counsel to make sure it qualifies without violating the restrictions.

There is an exception for "Discretionary, Multi-Factor Bonus Plans," but a great emphasis exists here on the term "Multi-Factor." These must include multiple, significant factors or variables that are unrelated to the broker/dealer, such as the number of checking accounts opened, consumer loans made, CD balances, and so forth. Referrals are not a factor in the plan. Referrals made by others may not be referenced in the plan. Any weighting of broker/dealer factors or referrals will be negatives. The plan must be completely discretionary. The plan is discretionary if the amount to be received by the employee 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. Sham plans will be harshly dealt with and could disqualify the bank from the networking exception.

There is a complex, safe harbor for plans based on overall profitability or revenue. This safe harbor is intended to address any potential that payments under the plan would give an employee an undue promotional interest in securities transactions that may occur as the result of a referral. Any bank that attempts to qualify for an exception to filing as a broker and using bonus plans for non-registered persons is strongly advised to seek competent counsel experienced in the nuances of Reg R.

An exception for high-net-worth customers

The final Reg R, Rule 701 addresses the "Exception for Referrals Involving Institutional Customers and High-Net-Worth Customers." When provided appropriate information, these 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.

Under the final rule, this means 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 employees refers the customer to the broker/dealer for investment banking services. The final rule retained provisions that required a determination of suitability or sophistication. The rule also provides that a company controlled by an institutional customer will be considered an institutional customer.

A high-net-worth customer is defined as a natural person who, either individually or with a spouse, has at least $5 million in assets, excluding the primary residence and associated liabilities. This definition includes any irrevocable, inter vivos, or living trust, whose settler is a natural person who, either individually or jointly with a spouse, meets the $5 million asset test.

The final rule requires both the bank and the broker/dealer to determine if the customer meets the definition of institutional or high-net-worth. However, this test can be met by having the customer or institution sign a statement assuring their compliance, and that the bank or its employee does not know of evidence to the contrary. Remember, this whole test is to enable a referral fee that is higher than nominal, as defined above.

In addition, if the bank wants to provide more than a one-time, nominal referral fee for institutional and/or high-net-worth customers, it must provide certain disclosures prior to or at the time of the referral. The disclosures must contain: (1) the name of the broker/dealer; and (2) 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. Payment of this fee might be contingent on whether the referral results in a transaction with the broker/dealer. If the disclosures are written, they must be provided at or prior to the referral. If they are oral, written disclosures must follow within three business days of the date of the referral, or the broker/dealer must provide the disclosures to the customer.

The written networking agreement between a bank and a broker/dealer must provide for the broker/dealer to perform a suitability analysis when a referral fee is contingent on a transaction, as well as for other referrals. This process is to be conducted as if the broker/dealer had recommended the securities. For non-contingent fees under the exemption from registering as a broker/dealer, the written agreement must provide for the broker/dealer to conduct, before the referral fee is paid, either a sophistication analysis of the referred customer or a suitability analysis with respect to all securities transactions requested by the customer.

If the broker/dealer determines the proposed transaction for the high-net-worth or institutional customer does not meet the sophistication or suitability test, the broker/dealer must notify the customer, rather than the bank.

Under the final rule, not all employees qualify for receiving higher-than-normal referral fees. The employee must be predominantly engaged in banking activities other than making referrals to a broker/dealer. He/she must encounter the high-net-worth customer or institutional customer in the ordinary course of assigned business for the bank, must not be qualified or required to be qualified under the rules for a SRO (Self-Regulatory Organization), and not be subject to statutory disqualification conditions. The written agreement must provide that the broker/dealer verify the statutory disqualification status of the employee making the referral if the fee is to be higher than normal. The bank must provide sufficient information to the broker/dealer to enable it to make the appropriate determinations.

Acting in good faith

Banks that seek exception pursuant to the "Networking Arrangement" permissions to pay higher-than-nominal fees must act in good faith. The bank must have written policies and procedures, and it must be able to prove that it operates accordingly, so that the bank will not be considered a "broker" under Section 3(a)(4) of the Exchange Act. If the bank acts in good faith, yet has minor, incidental instances of non-compliance, it must take reasonable, timely steps to remedy them. The bank must also take steps to recover the higher-than-nominal portion of the referral fees.

A high-net-worth customer is defined as a natural person who, either individually or with a spouse, has at least $5 million in assets, excluding the primary residence.

Also, the referral fees must not take the form of a ‘salesman's stake" in the securities transaction. The fee 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. Also, the fee may be a pre-determined dollar amount, or a dollar amount determined in accordance with a pre-determined formula, so long as the amount does not vary based on (1) the revenue generated by, or the profitability of securities transactions; (2) the quantity, price, or identity of securities purchased or sold over time by the customer; or (3) the number of customer referrals made. The employee may receive a fee for each referral, but a quota cannot be part of the formula. There are other restrictions that a bank should consider when constructing its referral-fee payment structure.

Finally, the exemption for high-net-worth and institutional customers expressly permits a bank to pay any type of compensation 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). It was determined these types of bonus arrangements do not tend to create prohibited financial incentives.