[Federal Register Volume 69, Number 125 (Wednesday, June 30, 2004)]
[Proposed Rules]
[Pages 39682-39739]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 04-14138]



[[Page 39681]]

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Part III





Securities and Exchange Commission





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17 CFR Parts 240 and 242



Regulation B; Proposed Rule

  Federal Register / Vol. 69, No. 125 / Wednesday, June 30, 2004 / 
Proposed Rules  

[[Page 39682]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

[Release No. 34-49879; International Series Release No. 1278; File No. 
S7-26-04]
RIN 3235-AJ28


Regulation B

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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

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

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to [email protected]. Please include 
File Number S7-26-04 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov/). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW., 
Washington, DC 20549-0609.
    All submissions should refer to File Number S7-26-04. This file 
number should be included on the subject line if e-mail is used. To 
help us process and review your comments more efficiently, please use 
only one method. The Commission will post all comments on the 
Commission's Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments are also available for public inspection and 
copying in the Commission's Public Reference Room, 450 Fifth Street, 
NW., Washington, DC 20549. All comments received will be posted without 
change; we do not edit personal identifying information from 
submissions. You should submit only information that you wish to make 
available publicly.

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

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction and Background
    A. Statutory Background--The Gramm-Leach-Bliley Act
    B. Regulatory and Procedural Background--The Interim Final 
Rules, Public Comment, and the Temporary Exemptions
II. Discussion of Proposed Regulation B
III. Discussion of Comments on the ``Broker'' Rules and Proposed 
Amendments
    A. Networking Exception
    1. Comments on Definition of ``Nominal One-Time Cash Fee of a 
Fixed Dollar Amount''
    2. Proposed Amendments to Definition of ``Nominal One-Time Cash 
Fee of a Fixed Dollar Amount''
    a. Meaning of ``Nominal''
    b. Meaning of ``One-Time''
    c. Meaning of ``Cash Fee''
    d. Meaning of ``Fixed Dollar Amount''
    3. Comments on Definition of ``Referral'' and Proposed 
Amendments
    4. Proposed New Definition of ``Contingent on Whether the 
Referral Results in a Transaction''
    5. Interpretations of ``Contractual or Other Written 
Arrangement'' and ``Qualified Pursuant to the Rules of a Self-
Regulatory Organization''
    B. Trust and Fiduciary Activities Exception
    1. Chiefly Compensated
    a. Statutory Requirements and Existing Rules
    b. Comments on ``Chiefly Compensated'' Requirement
    c. Proposed Changes in Response to Comments
    d. Proposed Line-of-Business Exemption
    i. Description of Existing Rule
    ii. Description of Proposed Line-of-Business Exemption
    e. Proposed New Living, Testamentary, and Charitable Trust 
Account Exemption
    f. New Conditional Safe Harbor
    g. New Proposed Account-by-Account Exemption
    i. Proposed Account-by-Account Exemption
    ii. New Safe Harbor for Account-Specific Exemption
    h. Other Provisions
    i. ``Chiefly Compensated'' and Related Definitions
    ii. Formulas to Allocate Sales Compensation to Individual 
Accounts
    A. 12b-1 Fees
    B. Other Fees
    iii. Indenture Trustee Exemption
    2. Definition of ``Trustee Capacity'' and Indenture Trustees
    3. Interpretations of ``Fiduciary Capacity'' and ``Similar 
Capacity''
    4. Comments on Definition of ``Investment Adviser if the Bank 
Receives a Fee for Its Investment Advice'' and Proposed Amendments
    5. Comments on ``Other Department That Is Regularly Examined by 
Bank Examiners for Compliance With Fiduciary Principles and 
Standards''
    C. Sweep Accounts Exception
    1. Comments on Definition of ``No-Load'' and Proposed Amendments
    2. Interpretation of ``Program''
    3. Definition of ``Money Market Fund''
    D. Affiliate Transactions Exception
    E. Safekeeping and Custody Activities Exception
    1. Background on Safekeeping and Custody Exception
    2. Comments on Commission's Interpretation Regarding Accepting 
Customer Orders
    3. Comments on Proposed Amendments to the General Bank Custody 
Exemption
    a. Modifications to General Bank Custody Exemption
    1. Bank Compensation
    2. Solicitation Restrictions
    3. Employee Activities and Compensation
    4. Trustee and Fiduciary Activity Accounts
    5. Employee Benefit Plans
    6. Small Bank Exemption
    7. Custody Account Definition
    8. Request for Comments
    9. Carrying Broker Definition
    4. Comments on and Proposed Amendments to the Small Bank Custody 
Exemption
    a. Bank Asset Size Limit
    b. Annual Sales Compensation Limit
    c. Other Conditions
    1. Solicitation
    2. Securities Networking
    3. Employee Staffing Restrictions
    4. Employee Compensation Restriction
    5. Investment Company Shares for Tax-Deferred Accounts
    d. Trust and Fiduciary Activity Accounts
    e. Availability of Exemption to Non-Depository Trust Companies

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    f. Request for Comments
    F. General and Special Purpose Exemptions
    1. General Exemption
    2. Employee Benefit Plan Exemption
    3. Regulation S Transactions with Non-U.S. Persons
    4. Redesignation and Revision of Exemptions for Savings 
Associations and Savings Banks
    5. Credit Unions
    a. Networking
    b. Sweep Accounts
    c. Investment, Trustee, and Fiduciary Transactions
    d. Scope of Credit Union Exemption
    e. Additional Exemptions for Credit Unions
    6. Exemption for the Way in Which Banks Effect Transactions in 
Investment Company Securities
    G. Temporary Exemptions
    1. Extension of Time and Transition Period
    2. Temporary Exemption for Contracts Entered into by Banks from 
Being Considered Void or Voidable
    H. Amendment to Exchange Act Rule 15a-6
IV. Administrative Law Matters
    A. General Request for Comments
    B. Paperwork Reduction Act Analysis
    C. Consideration of Benefits and Costs
    D. Consideration of Burden on Competition, and on Promotion of 
Efficiency, Competition, and Capital Formation
    E. Consideration of Impact on the Economy
    F. Regulatory Flexibility Analysis
     V. Statutory Authority
VI. Text of Proposed Rules and Rule Amendments

I. Introduction and Background

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

    The GLBA amended several federal statutes governing the activities 
and supervision of banks, bank holding companies, and their 
affiliates.\1\ Among other things, it lowered barriers between the 
banking and securities industries erected by the Banking Act of 1933 
(``Glass-Steagall Act''). \2\ It also altered the way in which the 
supervisory responsibilities over the banking, securities, and 
insurance industries are allocated among financial regulators. Among 
other things, the GLBA repealed the complete separation of investment 
and commercial banking imposed by the Glass-Steagall Act, which was 
enacted as a response to the perceived abuses and conflicts of interest 
in the securities industry during the 1920s. The GLBA also revised the 
provisions of the Exchange Act that had completely excluded banks from 
broker-dealer registration requirements.\3\
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    \1\ Pub. L. 106-102, 113 Stat. 1338 (1999).
    \2\ Pub. L. 73-66, ch. 89, 48 Stat. 162 (1933) (as codified in 
various sections of 12 U.S.C.).
    \3\ Congress originally adopted these complete exclusions in 
1934, stipulating that under the Glass-Steagall Act, banks were not 
generally permitted to engage in the securities business. The House 
Committee on Commerce explained the rationale behind the original 
complete bank exclusion from the definitions of ``broker'' and 
``dealer'' and Congress' rationale for its subsequent repeal:
    The [Committee on Commerce] strongly believes that functional 
regulation--regulation of the same functions, or activities, by the 
same expert regulator, regardless of the nature of the entity 
engaging in those activities--has become essential to a coherent 
financial regulatory scheme, as activities and affiliations expand 
and change with the financial marketplace.
    Subtitle A of title II amends the Exchange Act to eliminate the 
blanket exemptions for banks from the definitions of ``broker'' and 
``dealer.'' These exceptions, which have been part of the Exchange 
Act since its inception, were * * * based on the assumption that the 
Glass-Steagall Act, which had become law just one year before the 
Exchange Act, had prohibited all but extremely limited specified 
bank securities activities. Specifically, at the time of its 
enactment, the Glass-Steagall Act included exceptions that permitted 
banks to underwrite and deal in obligations of the United States * * 
* and their subdivisions. Amendments to the Glass-Steagall Act made 
in 1935 permitted banks to provide limited securities brokerage 
services as an accommodation to their customers, by permitting banks 
to engage in stock purchases and sales in an ``agency'' capacity, at 
the request of customers.
    Section 20 of the Glass-Steagall Act forbids affiliation of any 
Federal Reserve member bank with any business entity ``principally 
engaged'' in investment banking activities. For more than fifty 
years following the enactment of the Glass-Steagall Act, bank 
holding companies could not underwrite securities.
    As noted above, however, the limitations on bank securities 
activities have eroded as a result of administrative actions by the 
Federal banking regulators. The rationale for the exemptions in the 
Federal securities laws that apply to banks is, thus, no longer 
sound, given the extensive and increasing securities activities in 
which banks are engaging.
    H.R. 106-74, pt. 3, at 113 (1999).
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    Charters for U.S. banks, unlike those for most for-profit 
corporations, restrict bank activities to the ``business of banking.'' 
\4\ For many years, U.S. banking regulators took a narrow view of what 
constituted the ``business of banking,'' which did not include 
securities activities.\5\ Beginning in the 1980s, commercial businesses 
began directly to access the capital markets and banks faced more 
competitors in extending credit to commercial customers.\6\ Prior to 
passage of the GLBA, many of the regulatory barriers preventing full-
scale integration of commercial bank and securities firms were relaxed. 
For example, in 1982, the Federal Deposit Insurance Corporation 
(``FDIC'') determined that state banks that were not members of the 
Federal Reserve system were not subject to the Glass-Steagall Act's 
affiliation restrictions.\7\ In 1987, the Board of Governors of the 
Federal Reserve System (``Federal Reserve''), through a series of 
administrative actions, began to lower the barrier between banks and 
securities firms by allowing bank holding companies to derive a 
percentage of their revenue from underwriting and dealing in securities 
that were, prior to the Federal Reserve's actions, impermissible for 
banks to underwrite and deal in.\8\ Over time, the

[[Page 39684]]

Federal Reserve increased the percentages of revenue that banks could 
derive from underwriting and dealing in such securities, repealed most 
of the conflict of interest firewalls between banks and securities 
firms, and approved the creation of the first U.S. universal bank--
Citigroup.\9\ During the past two decades, the Office of the 
Comptroller of the Currency (``OCC''), the Office of Thrift Supervision 
(``OTS''), and the FDIC also expanded the types of bank securities 
activities that, in the view of these agencies, were within the 
permissible ``business of banking.''\10\
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    \4\ The ``business of banking'' provision refers to section 24 
(seventh) of the National Bank Act. 12 U.S.C. 24 (seventh). Banks 
are chartered and regulated under a dual banking system--federal and 
state bank charters are available as are federal and state thrift 
charters. Unlike broker-dealers, banks may choose whether to be 
chartered at the state or federal level. Persons that register as 
broker-dealers, however, must be licensed at both the federal and 
state levels.
    \5\ As one observer has noted: ``In 1975, U.S. banks were 
largely barred from entering the securities or insurance businesses. 
The Glass-Steagall Act prohibited banks from underwriting or dealing 
in securities, except for certain narrowly defined categories of 
`bank-eligible' securities such as U.S. government bonds and general 
obligation bonds issued by state and local governments.'' Arthur E. 
Wilmarth, The Transformation of the U.S. Financial Services 
Industry, 1975-2000: Competition, Consolidation, and Increased 
Risks, 2002 U. Ill. L. Rev. 215 at 225-6 (2002) [hereinafter 
``Wilmarth Article''].
    \6\ The development of asset-backed securities, high-yield 
securities, and commercial paper has enhanced the ability of banks' 
traditional commercial borrowers to access capital markets directly 
and forego bank financing. In addition, non-bank competitors have 
entered the commercial and consumer lending markets, further putting 
pressure on banks' profits. At the same time, investors in search of 
higher yields have shifted assets from banks to money market funds 
and other securities. To replace the loss of revenue from 
traditional lending, large banks have shifted their focus to fee-
based activities, including securities activities. As one industry 
observer has noted:
    [C]onsolidation is dividing the banking industry into two 
distinct sets of institutions. The ten largest banks now hold almost 
half of the banking industry's assets, and the fifty largest 
institutions control three-quarters of such assets. These large 
institutions have shifted away from the traditional, relationship-
based business of lending to long-term customers. Instead, big banks 
are pursuing a transaction-based strategy that emphasizes investment 
banking, derivatives, syndicated loans, securitized consumer loans, 
and other activities tied to the capital markets.
    Wilmarth Article, supra note 5, at 251.
    \7\ In 1982, the FDIC adopted a policy statement on the 
applicability of the Glass-Steagall Act to securities activities of 
insured state non-member banks. See 47 FR 38984, (Sept. 3, 1982). In 
1984, the FDIC adopted a rule regulating the securities activities 
of affiliates and subsidiaries of insured state non-member banks 
under the FDI Act. 49 FR 46709 (Nov. 28, 1984) (regulations codified 
at 12 CFR 337.4) (1986). Representatives of mutual fund companies 
and investment bankers unsuccessfully challenged the FDIC's Policy 
Statement (Investment Company Institute v. United States, D.D.C. 
Civil Action No. 82-2532, filed September 8, 1982, dismissed without 
prejudice) and later its regulations (Investment Company Institute, 
v. FDIC, 815 F.2d 1540 (D.C.1987) (regulations were upheld)).
    \8\ In 1987, the Federal Reserve began to permit Section 20 
subsidiaries to underwrite or deal in commercial paper and other 
bank-ineligible securities provided that those activities accounted 
for less than five percent of the bank's annual gross revenues. See 
Citicorp Order, Approving Applications to Engage in Limited 
Underwriting and Dealing in Certain Securities. 73 Fed. Res. Bull. 
473 (1987) and Chase Manhattan Corp., Order Approving Application to 
Underwrite and Deal in Commercial Paper to a Limited Extent. 73 Fed. 
Res. Bull. 369 (1987).
    In 1989, the Federal Reserve provided additional guidance on 
Section 20 subsidiaries, raising the revenue limit on underwriting 
and dealing in bank-ineligible securities from five percent to ten 
percent of the subsidiary's total revenues. Order Approving 
Modifications to Section 20 Orders, 75 Fed. Res. Bull. 751 (1989). 
Subsequently, the Federal Reserve raised the revenue limits from 
non-eligible securities to twenty-five percent, eliminated most of 
the firewalls between banks and securities firms, and added private 
placement services and riskless principal transactions to the list 
of approved non-banking activities. See Regulation Y, 12 CFR 225.
    \9\ Conditional approval of applications by Travelers Group 
Inc., (Sept. 23, 1998). 84 Fed. Res. Bull. 985 (1998). http://www.federalreserve.gov/boarddocs/press/bhc/1998/19980923 19980923
    \10\ See Julie L. Williams and Mark P. Jacobsen, The Business of 
Banking: Looking to the Future, 50 Bus. Law. 783 at 814 (May 1995) 
and Julie L. Williams and James F.E. Gillespie, The Business of 
Banking: Looking to the Future--Part II, 52 Bus. Law. 1279 (Aug. 
1997) (``While the nature of the national bank charter is the grant 
of a banking franchise, it explicitly does not limit national banks 
to banking activities.'').
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    By enacting the GLBA, Congress repealed most of the remaining 
vestiges of the ownership restrictions that prevented banks, 
securities, and insurance firms from combining, thereby allowing them 
to adopt the universal banking model through the creation of financial 
conglomerates known as ``financial holding companies.'' \11\ Congress 
recognized, however, that combined ownership would likely create 
conflicts that would need to be addressed through other safeguards.\12\
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    \11\ For a general discussion, see, e.g., Wilmarth Article, 
supra note 5 at 219-220.
    \12\ In eliminating the ownership separations, Congress 
understood the need to adopt other safeguards to mitigate the 
conflicts of interest that combined ownership could create. One of 
the bill's authors highlighted functional regulation as a key 
requirement of the GLBA:
    The second major feature of the bill is that we promote and 
strengthen functional regulation. Under the bill, the general rule 
is that if you are a bank and you are in the securities business, 
you are regulated by the Securities and Exchange Commission. If you 
are a bank and you are in the insurance business, you are regulated 
by the state insurance commissioner in the area where you are 
engaged in the insurance business. If you are a bank and you are 
engaged in banking, you are regulated by bank regulators. By opting 
for functional regulation, we preserve consumer protection, we lower 
costs.
    Statement of Senator Phil Gramm, 145 Cong. Rec. S13783-01.
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    The Commission has consistently supported Congress' efforts to 
eliminate the few remaining legal barriers among the various types of 
financial service providers.\13\ Because eliminating the legal 
distinctions or separations between commercial and investment banking 
increased the opportunity for conflicts of interest in the purchase and 
sale of securities, however, the Commission supported a system of 
functional regulation to ensure that investors receive the same high 
level of consumer protection no matter where they effect their 
securities transactions.\14\ The Commission testified that complete 
functional regulation would mean that a bank--just like any other 
securities business--would have to obtain a broker-dealer license and 
adhere to consumer protections adopted under the federal securities 
laws to engage as a broker in securities transactions with investors or 
shift those activities to a registered broker-dealer that is obligated 
to provide those protections.\15\
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    \13\ For a list of Commission testimony and related 
correspondence, see Exchange Act Release No. 44291 (May 11, 2001), 
66 FR 27760 (May 18, 2001) at n. 8.
    \14\ Id. The General Accounting Office recognized that investors 
have received unequal levels of investor protection (including 
disclosures) and disparate access to remedies depending on the 
market professional selling them securities. See U.S. General 
Accounting Office, Report to Congressional Requesters: Bank Mutual 
Fund Sales Practices and Regulatory Issues GAO/GGD-95-210, at p. 52 
(Sept. 1995); U.S. General Accounting Office, Report to 
Congressional Requesters: Banks' Securities Activities--Oversight 
Differs Depending on Activity and Regulator, GAO/GGD-95-214, at p. 
25 (Sept. 1995).
    \15\ Testimony of SEC Chairman Arthur Levitt Before the 
Committee on Commerce Concerning H.R. 10, ``The Financial Services 
Act of 1999'' (May 5, 1999).
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    In enacting the GLBA, Congress adopted functional regulation for 
bank securities activities, with limited exceptions from Commission 
oversight. In particular, the GLBA eliminated the complete bank 
exceptions from the definitions of ``broker'' and ``dealer'' in the 
Exchange Act and replaced them with narrower transaction-based bank 
exceptions. Although it granted a number of exceptions for banks' 
securities activities, Congress expressed concerns that banks were 
engaging in securities activities for investors who are not protected 
by the federal securities laws.\16\
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    \16\ See H.R. Rep. No. 106-74, pt. 3, at 114 (1999). In adopting 
the GLBA, Congress also intended to level the playing field between 
banks and broker-dealers. As the House Committee on Commerce noted 
in the legislative history to the GLBA, the complete exception for 
banks from broker-dealer registration created a competitive 
disparity by permitting banks to engage in securities activities 
without being subject to the same regulatory requirements as 
registered broker-dealers. See id. In drafting the bank exceptions 
from broker-dealer registration, the Committee stated that, 
``registration may not be required because the conditions imposed on 
the excepted activities are tailored to protect investors and to 
ensure competitive fairness among different types of financial 
services providers.'' Id. at 162.
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    With respect to the definition of ``broker,'' the Exchange Act, as 
amended by the GLBA, provides that a bank is not considered a broker to 
the extent it meets the requirements of eleven specific exceptions.\17\ 
Each of these exceptions permits a bank to act as an agent with respect 
to specified securities products or in transactions that meet specific 
statutory conditions.
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    \17\ Exchange Act Section 3(a)(4) [15 U.S.C. 78c(a)(4)].
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    In particular, Section 3(a)(4) of the Exchange Act provides 
conditional exceptions from the definition of broker for banks that 
engage in third-party brokerage arrangements; \18\ trust and fiduciary 
activities; \19\ permissible securities transactions; \20\ certain 
stock purchase plans; \21\ sweep accounts; \22\ affiliate transactions; 
\23\ private securities offerings; \24\ safekeeping and custody 
activities; \25\ identified banking

[[Page 39685]]

products; \26\ municipal securities; \27\ and de minimis 
transactions.\28\ As part of the Exchange Act, these provisions are 
subject to Commission interpretation.\29\ A bank that effects 
transactions in securities as agent outside the scope of these 
exceptions is required to register as a broker in accordance with 
Section 15(a) of the Exchange Act.\30\
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    \18\ Exchange Act Section 3(a)(4)(B)(i). This exception permits 
banks to enter into third-party brokerage, or ``networking'' 
arrangements with brokers under nine specific conditions.
    \19\ Exchange Act Section 3(a)(4)(B)(ii). This exception permits 
banks to effect transactions as trustees or fiduciaries for 
securities customers under two specific conditions.
    \20\ 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.
    \21\ 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.
    \22\ Exchange Act Section 3(a)(4)(B)(v). This exception permits 
banks to sweep funds into no-load money market funds.
    \23\ Exchange Act Section 3(a)(4)(B)(vi). This exception permits 
banks to effect transactions for affiliates, other than broker-
dealers.
    \24\ Exchange Act Section 3(a)(4)(B)(vii). This exception 
permits certain banks to effect transactions in privately placed 
securities.
    \25\ 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.
    \26\ Exchange Act Section 3(a)(4)(B)(ix). This exception permits 
banks to buy and sell certain ``identified banking products,'' as 
defined in Section 206 of the GLBA [codified at 15 U.S.C. 
78c(a)(4)(B)(ix)].
    \27\ Exchange Act Section 3(a)(4)(B)(x). This exception permits 
banks to effect transactions in municipal securities.
    \28\ 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.
    \29\ In contrast, the Glass-Steagall Act is interpreted by the 
federal banking agencies.
    \30\ Exchange Act Section 15(a) generally prohibits broker-
dealers that are not registered with the Commission from effecting 
any transactions in, or inducing or attempting to induce the 
purchase or sale of, any security.
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B. Regulatory and Procedural Background--The Interim Final Rules, 
Public Comment, and the Temporary Exemptions

    In 2001, the Commission adopted interim final rules (``the Interim 
Rules'') largely in response to interpretive questions and industry 
concerns about the way in which the Commission would interpret the 
GLBA.\31\ The Interim Rules were designed to provide banks with 
guidance regarding the GLBA by defining certain key terms used in the 
new statutory exceptions. The Interim Rules also provided banks with 
additional targeted exemptions from the definitions of ``broker'' and 
``dealer'' for certain types of ongoing securities transactions or 
activities. The Commission adopted the Interim Rules in interim final 
form to provide the banking industry with immediate guidance and 
exemptive relief while also soliciting public comment. In response, the 
Commission received over 200 letters commenting on the Interim 
Rules.\32\
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    \31\ Exchange Act Release No. 44291, supra note 13.
    \32\ Nearly all of these letters came from the banking industry 
or its representatives. The federal banking agencies (the Federal 
Reserve, OCC, and FDIC) (collectively referred to as the ``Banking 
Agencies'') also submitted comments. See letter and appendix dated 
June 29, 2001 from Alan Greenspan, Chairman, Federal Reserve, John 
D. Hawke, Comptroller of the Currency, and Donna Tanoue, Chairman, 
FDIC (``Banking Agencies letter'').
    Included in the comment letters were 111 comment letters in a 
form letter format. Many of the banking organizations that submitted 
these form comment letters sent multiple copies of a common form 
letter, including 54 letters from one banking organization. The 
following banks and persons submitted 116 form letters (``Bank Form 
Letters''): Amarillo National Bank (54 letters); American Bank 
Holding Co.; American Church Trust Co.; Austin Trust Co.; Bank 
Midwest; Bank of West (two letters); Bonham State Bank; Jeff 
Scribner, Senior Vice President, Financial Services Division 
Manager, Citizens National Bank; Steven M. Dow, Vice President and 
Trust Officer, Community Bank &Trust Extraco Banks; First Command 
Bank; First National Bank; First National Bank of Abilene (seven 
letters); First National Bank; First National Bank of Mineola; First 
State Bank of Texas; First State Bank & Trust Co. (two letters); 
Richard Perryman, CPA, Vice President and Trust Officer, Guaranty 
Bank; Hibernia National Bank (two letters); Hibernia Trust (two 
letters); Murray Pate, Kanaly Trust Company; Legacy Trust Co.; 
Longview Bank & Trust; Lubbock National Bank; David Malleck; Charles 
Hall Jr., CEO, MaximBank; McAllen National Bank (four letters); 
Linda Park; Kimberly Miller, Senior Vice President and Trust 
Officer, PNB Financial; Luptis Rosales, VP & Trust Officer of 
unnamed bank; Secured Trust Bank; Sentinel Trust Co.; Southside Bank 
(two letters); Carol Preston, Senior Vice President and Trust 
Officer, Southwest Bank; Texas Bank; Texas Capital Bank; Wayne 
Spencer, President, Texas Community Bank and Trust; Texas Gulf Bank; 
Texas State Bank (nine letters); Debbie Truman; Willard B. III 
Wagner. Three additional form letters were submitted without 
identifying information.
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    The Commission temporarily suspended the implementation of the 
exceptions in light of concerns that banks needed more time to adjust 
their operations to comply with the Interim Rules.\33\ The Commission 
staff has used this period during the temporary suspension to continue 
discussions with banking industry representatives, staff from the 
Banking Agencies, and other interested parties to refine further the 
guidance and exemptions provided in the Interim Rules.\34\
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    \33\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
27760 (adopting Interim Rules, including Exchange Act Rule 15a-7, 
which gave banks a temporary exemption from the definitions of 
``broker'' and ``dealer'' until October 1, 2001, and provided an 
additional conditional exemption until January 1, 2002); Exchange 
Act Release No. 44570 (July 18, 2001) (providing banks, savings 
associations, and savings banks with an additional conditional 
exemption from the definitions of ``broker'' and ``dealer'' under 
the Exchange Act until May 12, 2002); Exchange Act Release No. 45897 
(May 8, 2002) (order extending the exemption from the definition of 
``broker'' until May 12, 2003, and from the definition of ``dealer'' 
until November 12, 2002); Exchange Act Release No. 46751 (Oct. 30, 
2002) (extending the exemption from the definition of ``dealer'' 
until February 10, 2003); Exchange Act Release No. 47366 (Feb. 13, 
2003) (extending the exemption from the definition of ``dealer'' 
until September 30, 2003); Exchange Act Release No. 47649 (April 8, 
2003) (extending the exemption from the definition of ``broker'' 
until November 12, 2004).
    \34\ During this period, to facilitate a prompt and efficient 
resolution of remaining questions and concerns about the Interim 
Rules, the Commission bifurcated the rulemaking process to address 
the ``broker'' and ``dealer'' issues separately. For an explanation 
of this bifurcation, see Exchange Act Release No. 46745 (Oct. 30, 
2002) 67 FR 67496 (Nov. 5, 2002) (``Dealer Proposing Release''). The 
dealer provisions, along with the Commission's implementing rules, 
became effective September 30, 2003. See Exchange Act Release No. 
47364 (Feb. 13, 2003), 68 FR 8686, 8687 (Feb. 24, 2003) (``Dealer 
Release'').
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II. Discussion of Proposed Regulation B

    After reviewing the comments on the Interim Rules and discussing 
the practical application of those Rules with representatives from the 
banking industry, banking regulators, and other interested parties, the 
Commission is proposing to revise and restructure the Interim Rules and 
to codify them in a new regulation, Regulation B. The proposed new rule 
series is Exchange Act Rule 710 through Rule 781 (17 CFR 242.710 
through 781).
    Proposed Regulation B includes rules designed to define and clarify 
a number of the statutory exceptions from the definition of ``broker.'' 
In addition, proposed Regulation B would grant new exemptions from the 
``broker'' definition to banks and certain other financial 
institutions. These proposed exemptions would supplement the statutory 
exceptions to preserve bank securities activities where consistent with 
the statutory purpose of investor protection. For example, proposed 
Regulation B would provide a broad exemption for certain bank cash 
management services. This proposed exemption would allow banks to buy 
and sell money market securities for qualified investors and certain 
other bank customers who keep funds at banks.
    Moreover, in response to banks' concerns about calculating their 
compensation as fiduciaries on an account-by-account basis, the 
proposal would provide a ``line-of-business'' compensation test that 
would permit banks to bypass the account-by-account test in the trust 
and fiduciary activities exception. In addition, the proposal would 
broaden an exemption for small banks and thrifts, which could greatly 
expand the number of smaller financial institutions that are excluded 
from broker-dealer registration requirements.
    The proposal also would provide a number of specialized exemptions 
to accommodate banks' current business practices, balanced with 
conditions that are designed to protect investors. These proposed 
specialized exemptions include exemptions for banks that effect 
transactions for certain custody customers or pension plans, and those 
that effect transactions in Regulation S securities with non-U.S. 
persons.
    The proposed titles and numbering of the rules in proposed 
Regulation B, including the proposed new rules, appear below, with 
parenthetical explanations added to the titles:

[[Page 39686]]

Regulation B: Securities Activities of Banks and Other Financial 
Institutions

Subpart A--Networking Exception: Defined Terms

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

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

    242.720: Exemption from the ``chiefly compensated'' condition for 
banks with existing personal trust accounts (proposed new rule).
    242.721: Exemption for banks from determining whether they are 
``chiefly compensated'' on a line of business (proposed expansion and 
redesignation of Exchange Act Rule 3a4-2).
    242.722: Exemption for banks from determining whether they are 
``chiefly compensated'' on an account-by-account basis (proposed new 
rule).
    242.723: Exemption from the definition of ``broker'' for banks 
effecting transactions as an indenture trustee in a no-load money 
market fund (proposed expansion and redesignation of Exchange Act Rule 
3a4-3).
    242.724: Defined terms relating to the trust and fiduciary 
activities exception from the definition of ``broker'' (proposed 
amendment to terms in current Exchange Act Rule 3b-17, which would be 
repealed).

Subpart C--[Reserved]

Subpart D--Sweep Accounts Exception: Defined Terms

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

Subpart E--Affiliate Transactions Exception: Defined Terms

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

Subpart F--Safekeeping and Custody Activities Exception: Exemptions

    242.760: Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in a custody account (proposed 
expansion and redesignation of Exchange Act Rule 3a4-5).
    242.761: Exemption from the definition of ``broker'' for small 
banks effecting securities transactions in a custody account (proposed 
expansion and redesignation of Exchange Act Rule 3a4-4).

Subpart G--Special Purpose Exemptions

    242.770: Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in certain employee benefit plans 
(proposed new rule).
    242.771: Exemption from the definitions of ``broker'' and 
``dealer'' for banks effecting transactions in securities issued 
pursuant to Regulation S (proposed new rule).
    242.772: [Reserved]\34a\
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    \34a\ If the Commission adopts proposed Regulation B, it will 
redesignate Exchange Act Rule 15a-11 as Exchange Act Rule 772 
without changing the language of the current rule.
---------------------------------------------------------------------------

    242.773: Exemption from the definitions of ``broker'' and 
``dealer'' for savings associations and savings banks (proposed 
amendment to and redesignation of Exchange Act Rule 15a-9).
    242.774: Exemption from the definitions of ``broker'' and 
``dealer'' for credit unions (proposed new rule).
    242.775: Exemption from the definition of ``broker'' for the way 
banks effect excepted or exempted transactions in investment company 
securities (proposed expansion and redesignation of Exchange Act Rule 
3a4-6).

Subpart H--Temporary Exemptions

    242.780: Exemption for banks from liability under Section 29 of the 
Securities Exchange Act of 1934 (proposed amendment to and 
redesignation of Exchange Act Rule 15a-8).
    242.781: Exemption from the definition of ``broker'' for banks for 
a limited period of time (proposed amendment to and redesignation of 
Exchange Act Rule 15a-7).

III. Discussion of Comments on the ``Broker'' Rules and Proposed 
Amendments

A. Networking Exception

    The third-party brokerage (``networking'') exception in Exchange 
Act Section 3(a)(4)(B)(i)\35\ allows banks to partner with broker-
dealers in offering their customers a wide range of financial services, 
including securities brokerage. Specifically, the exception provides 
that a bank will not be considered a broker if, under certain 
conditions, the bank enters into a contractual or other written 
arrangement with a registered broker-dealer under which the broker-
dealer offers brokerage services to bank customers (``networking 
arrangement''). If the bank's networking activities meet the conditions 
of the exception, it may, without itself being registered as a broker-
dealer, receive compensation related to brokerage transactions the 
broker-dealer effects as a result of the networking arrangement. The 
exception also allows unregistered bank employees \36\ to engage in 
limited securities-related activities and to receive incentive 
compensation in the form of a ``nominal one-time cash fee of a fixed 
dollar amount'' for referring bank customers to the broker-dealer.\37\
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    \35\ 15 U.S.C. 78c(a)(4)(B)(i).
    \36\ ``Unregistered'' bank employees are bank employees who are 
not also employed as registered representatives of a registered 
broker-dealer that supervises their securities activities.
    \37\ The statutory conditions under which banks may rely on the 
networking exception stem from a line of no-action letters in which 
the Commission staff indicated enforcement action would not be 
recommended against thrifts that entered into highly circumscribed 
networking arrangements. H.R. Rep. No. 106-74, pt. 3, at 163 (1999). 
The first of these letters was issued in response to a request from 
Chubb Securities Corp. See Letter re: Chubb Securities Corp. (Nov. 
24, 1993) (``Chubb letter''). Because they are not banks, thrifts 
could not rely on the then-existing general exemption from the 
definition of ``broker'' enjoyed by banks, and these letters 
provided thrifts with a means to compete with banks in making 
securities brokerage services available to their customers. For the 
relief the Commission is proposing to extend to thrifts, see Section 
III.F.4 infra. Although the networking exception in Exchange Act 
Section 3(a)(4)(B)(i) allows banks to continue many of the 
networking activities in which they engaged before the GLBA was 
enacted, it also limits the scope of those activities.
    Various aspects of bank networking activities are also subject 
to limitations and requirements in self-regulatory organization 
(``SRO'') rules, including NASD Rule 2350 (``Broker/Dealer Conduct 
on the Premises of Financial Institutions'') and NASD Rule 3040 
(``Private Securities Transactions of an Associated Person''). See 
also Federal Reserve, FDIC, OCC, and OTS, Interagency Statement on 
Retail Sales of Nondeposit Investment Products (Feb. 15, 1994) 
(``Interagency Statement'').
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    To clarify the way in which bank employees may be compensated 
consistent with the networking exception, the Interim Rules defined 
certain terms used in the exception, such as ``nominal one-time cash 
fee of a fixed dollar amount'' and ``referral.''\38\ These definitions 
establish objective standards for determining whether a referral fee 
would be nominal and the manner in which the fee must be 
structured.\39\ For example, the fee may

[[Page 39687]]

not exceed one hour of wages of the employee making the referral. The 
definition also anticipates that banks may pay referral fees in cash as 
well as through a points-based compensation system so long as the 
number of points the referring employee receives for a securities 
referral does not exceed the number of points the employee receives for 
non-securities related activities. These definitions also specify that 
payment of a referral fee may not be related to certain factors such as 
the value or successful completion of a securities transaction, or the 
financial stature of the customer being referred.
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    \38\ See Exchange Act Rule 3b-17 (g)(1) and (h).
    \39\ Exchange Act Rule 3b-17(g) states:
    (g)(1) The term nominal one-time cash fee of a fixed dollar 
amount means a payment in either of the following forms that meets 
the requirements of subparagraph (2):
    (i) A payment that does not exceed one hour of the gross cash 
wages of the unregistered bank employee making a referral; or
    (ii) Points in a system or program that covers a range of bank 
products and non-securities related services where the points count 
toward a bonus that is cash or non-cash if the points (and their 
value) awarded for referrals involving securities are not greater 
than the points (and their value) awarded for activities not 
involving securities.
    (2) Regardless of the form of payment, the payment may not be 
related to:
    (i) The size, value, or completion of any securities 
transaction;
    (ii) The amount of securities-related assets gathered;
    (iii) The size or value of any customer's bank or securities 
account; or
    (iv) The customer's financial status.
    Exchange Act Section 3b-17(h) states: ``The term referral means 
a bank employee arranging a first securities-related contact between 
a registered broker-dealer and a bank customer, but does not include 
any activity (including any part of the account opening process) 
related to effecting transactions in securities beyond arranging 
that first contact.''
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1. Comments on Definition of ``Nominal One-Time Cash Fee of a Fixed 
Dollar Amount''
    We received numerous comments regarding the Interim Rules' 
definition of ``nominal one-time cash fee of a fixed dollar 
amount.''\40\ The commenters generally opposed the definition, arguing, 
among other things, that it was unnecessary, unworkable, or overly 
restrictive. Some commenters contended that defining the term 
``nominal'' unnecessarily limits referral fees. They maintained that 
the term should be left undefined or interpreted to allow market-rate 
referral fees up to a set amount, such as $25, $100, or $250.\41\ Other 
commenters opined that Congress did not intend for the limitations on 
incentive compensation included in the networking exception to affect 
year-end bank bonus programs even if those programs were in part based 
on the number of referrals made.\42\ Commenters also asserted that the 
definition imposed limits on networking compensation beyond those 
contained in the Exchange Act.\43\ Some commenters contended that the 
definition would unduly limit the fees banks could pay based on points 
for activities involving non-securities products and services.\44\ 
Several commenters stated that tying referral fees to hourly wages is 
impractical or unworkable because it does not permit a single, flat fee 
that would be high enough to provide a meaningful incentive for tellers 
and platform personnel to make referrals to the broker-dealers.\45\ 
Others indicated that

[[Page 39688]]

the definition should not list categories of factors on which referral 
fees could not be made contingent.\46\
---------------------------------------------------------------------------

    \40\ See, e.g., letter dated June 4, 2001 from James D. 
McLaughlin, Director, Regulatory and Trust Affairs, American Bankers 
Association (``ABA'') and Beth L. Climo, Executive Director, 
American Bankers Securities Association (``ABASA'') and the letter 
dated July 17, 2001 from Edward L. Yingling, Deputy Executive Vice 
President and Executive Director, ABA, and Beth L. Climo, Executive 
Director, ABASA (``ABA/ABASA letters''); letter dated July 17, 2001 
from John Duncan, the Banking Law Committee of the Business Law 
Section of the American Bar Association (``ABA Banking Law Committee 
letter''); letter dated July 17, 2001 from Robert M. Kurucza, 
General Counsel, Bank Securities Association (``BSA letter''); 
letter dated July 17, 2001 from Charlotte M. Bahin, Director of 
Regulatory Affairs, Senior Regulatory Counsel, America's Community 
Bankers (``ACB letter''); the Banking Agencies letter; letter dated 
July 17, 2001 from John H. Huffstutler, Associate General Counsel, 
Bank of America Corporation (``Bank of America letter''); letter 
dated July 17, 2001 from J. Michael Shepherd, Executive Vice 
President and General Counsel, Bank of New York (``BONY letter''); 
letter dated July 16, 2001 from John M. Kramer, Deputy General 
Counsel, Bank One Corporation (``Bank One letter''); letter dated 
July 16, 2001 from Roger D. Wiegley, Chair, Committee on Banking 
Law, The Association of The Bar of the City of New York (``Bar of NY 
letter''); letter dated July 13, 2001 from Jim Goudge, President and 
CEO, Broadway National Bank (``Broadway letter''); letter dated July 
12, 2001 from Terry Jones Cox, Vice President, HR/Compliance, 
Central National Bank (``Central letter''); letter dated August 22, 
2001 from Andrew Trainor, President and CEO of Community Banks of 
Southern Colorado (``Community Banks of Southern Colorado letter''); 
letter dated July 17, 2001 from Gerald M. Noonan, President, the 
Connecticut Bankers Association (``Connecticut Bankers letter''); 
letter dated July 16, 2001 from William C. Mutterperl, Executive 
Vice President, General Counsel and Secretary, FleetBoston Financial 
Corporation (``Fleet letter''); the Frost letter; letter dated 
August 30, 2001 from Edward J. Eason, Vice President, Granite Bank 
(``Granite bank letter''); letter dated July 16, 2001 from Paul V. 
Reagan, Senior Vice President and U.S. General Counsel, Bank of 
Montreal Group on behalf of Harris Trust and Savings Bank (``Harris 
Trust letter''); letter dated July 17, 2001 from Robert I Gulledge, 
Chairman, Independent Community Bankers of America (``ICBA 
letter''); letter dated July 17, 2001 from Lawrence R. Uhlick, 
Executive Director and General Counsel, Institute of International 
Bankers (``IIB letter''); letter dated July 16, 2001 from Michael E. 
Bleier, General Counsel, Mellon Financial Corporation (``Mellon 
letter''); letter dated July 16, 2001 from David A. Daberko, 
Chairman and Chief Executive Officer, National City Corporation 
(``National City letter''); letter dated July 17, 2001 from Guy 
Messick, General Counsel to the National Association of Credit Union 
Service Organizations (``NACUSO letter''); letter dated August 1, 
2001 from Jeffrey P. Neubert, President and Chief Executive Officer, 
New York Clearing House (``NYCH letter''); letter dated July 16, 
2001 from Deborah R. Bortner, President, the North American 
Securities Administrators Association (``NASAA letter''); letter 
dated July 17, 2001 from James S. Keller, Chief Regulatory Counsel, 
PNC Financial Services Group (``PNC letter''); letter dated July 17, 
2001 from Samuel E. Upchurch, Jr., Executive Vice President, General 
Counsel and Secretary, Regions Financial Corporation (``Regions 
letter''); letter dated July 17, 2001 from Richard M. Whiting, 
Executive Director and General Counsel, Financial Services 
Roundtable (``Roundtable letter''); letter dated July 17, 2001 from 
Barry P. Harris, Chair, Bank Retail Broker-Dealer Committee, 
Securities Industry Association (``SIA letter''); letter dated July 
17, 2001 from A. Michelle Roberts, Executive Director, The Trust 
Financial Services Division of the Texas Bankers Association 
(``Texas Bankers Trust Division letter''); letter dated July 17, 
2001 from Lawrence A. Knecht, Senior Vice President and Legal 
Counsel, UMB Bank (``UMB Bank letter''); letter dated July 17, 2001 
from Norimichi Kanari, President and CEO, Union Bank of California 
(``Union Bank letter''); letter dated July 12, 2001 from W. Steve 
Meacham, Senior Vice President and Senior Trust Officer, letter 
dated August 31, 2001 from David S. Hickman, Chairman and CEO, 
United Bank & Trust ([ldqu]o;United Bank letter''); letter dated 
July 12, 2001 from W. Steve Meacham, Senior Vice President and 
Senior Trust Officer, First Victoria National Bank (``Victoria 
letter''); and letter dated July 13, 2001 from Bruce Moland, Vice 
President and Assistant General Counsel, Wells Fargo & Company 
(``Wells Fargo letter''). The Bank Form Letters criticized the 
Interim Rules'' limitations on the value of referral fees and 
expressed the view that those limitations are unfair, but did not 
comment specifically on the definition of ``nominal one-time cash 
fee of a fixed dollar amount.''
    \41\ See, e.g., Central letter; ABA Banking Law Committee 
letter; and Wells Fargo letter. Similarly, in a September 23, 2003 
meeting, banking agency staff told the Commission staff that some 
banks pay fees of as much as $100 for referrals of high net-worth 
customers and that members of the banking agencies staff believe 
such fees should be considered nominal, although currently referral 
fees typically range from $5 to $50, with $50 representing the top 
of the range at large banks in coastal metropolitan areas. One 
commenter asserted that because the Commission has considered $250 a 
``de minimis'' amount in the context of Municipal Securities 
Rulemaking Board Rule G-37, the term ``nominal'' should be 
interpreted to allow referral fees of the same amount in this 
context. See Wells Fargo letter. MSRB Rule G-37 relates to political 
contributions that might improperly influence municipal officials in 
awarding underwriting business. The fact that some may look to 
wholly unrelated contexts to argue that a particular amount should 
be considered ``nominal'' in this context underscores the importance 
of giving quantitative meaning to the term in the proposed amended 
definition of ``nominal one-time cash fee of a fixed dollar 
amount.''
    \42\ See,e.g., Bank of America letter; Harris Trust letter; and 
Mellon letter.
    \43\ See, e.g., Bank of America letter; Fleet letter; Harris 
Trust letter; IIB letter; Mellon letter; PNC letter; Regions letter; 
and Wells Fargo letter.
    \44\ See, e.g., Bank of America letter; Harris Trust letter; and 
Mellon letter.
    \45\ See, e.g., SIA letter; Bank One letter; Regions letter; 
Harris Trust letter; PNC letter; and Wells Fargo letter (criticizing 
the definition's methodology for determining nominal value as 
impractical and unworkable); and Bank of America letter; Fleet 
letter; Harris Trust letter; IIB letter; letter dated July 16, 2001 
from Carol L. Klimas, Executive Vice President and Chief Fiduciary 
Officer, KeyBank National Association (``KeyBank letter''); Mellon 
letter; and Roundtable letter (arguing that requiring banks 
regularly to adjust payment of referral fees based on salary levels 
would create an unnecessary administrative burden). See also Bank 
Form Letters, which suggested that the Interim Rules' limitations on 
referral fees would result in banks being charged with calculating 
and tracking referral fee compensation.
    \46\ See ABA/ABASA letters; Banking Agencies letter; Bank of 
America letter; NYCH letter; and SIA letter.
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    The Commission continues to believe that the term ``nominal'' as 
used in the GLBA should be defined as that term is commonly understood. 
Nominal means inconsequential or trifling.\47\ In the context of 
compensation, and in common legal usage, a ``nominal'' fee is a small 
one of no concern to the payor and little value to the payee.\48\
---------------------------------------------------------------------------

    \47\ See, e.g., Webster's New Collegiate Dictionary at 786 
(2002) (indicating that one common meaning of ``nominal'' is 
``existing or being something in name or form only,'' and that 
``nominal'' is synonymous with the terms ``trifling'' and 
``insignificant'').
    \48\ Black's Law Dictionary (7th ed. 1999) defines ``nominal 
consideration'' as, ``Consideration that is so insignificant as to 
bear no relationship to the value of what is being exchanged (e.g., 
$10 for a piece of real estate.'').
---------------------------------------------------------------------------

    Some published data suggests that banks' referral fees have 
increased in recent years and sometimes exceed levels that a reasonable 
person would deem to be ``nominal.''\49\ Thus, leaving ``nominal'' 
undefined could lead some to read the term as meaning ``market rate.'' 
The Commission believes that such an interpretation could lead to 
unregistered bank employees being given an incentive not just to make 
referrals, but actually to sell securities brokerage services to bank 
customers. The Commission and courts have long interpreted the broker-
dealer registration provisions in the federal securities laws to 
require persons with this kind of incentive to register as broker-
dealers or be registered representatives of broker-dealers.\50\
---------------------------------------------------------------------------

    \49\ The Consumer Bankers Association's 2000 Consumer 
Investments Study indicates that in 1998, the latest year for which 
figures were available when the GLBA was being drafted, 79 percent 
of referral fees were $10 or less (approximately $12 or less in 2004 
dollars). However, according to the same study, in 1999 the 
percentage of fees over $10 jumped from 21 percent to 31 percent. 
This recent trend of sharp increases in referral fees is evidenced 
by other data as well. For example, according to an October 17, 1996 
American Banker story, in an effort to compete with larger banks, 
Placer Savings Bank, a Northern California thrift, began paying its 
employees investment referral fees for the first time in August 
1995. The fee initially was $5 per referral (approximately $6 in 
2004 dollars), and then, in September 1996, it was increased to $10 
(approximately $12 in 2004 dollars).
    At some banks, it appears that referral fees may already exceed 
nominal levels. The Consumer Bankers Association's 2001 Consumer 
Investments Study indicates that in 2001, the percentage of banks 
paying cash referral fees of $10 or less was 45 percent. However, 
this figure fell by 4 percent in only one year, from 49 percent in 
2000, and the percentage of banks paying fees between $11 and $25 
rose by 2 percent in this period, from 31 percent in 2000 to 33 
percent in 2001. The report also indicates that no bank included in 
the study paid fees of more than $25 in 2000, but that in 2001, a 
small proportion of banks (2 percent) had begun paying fees of more 
than $25. The available data on referral fee amounts suggests that 
just before the GLBA was enacted in 1999, the great majority of 
referral fees were $10 or less (approximately $12 or less in 2004 
dollars), but that without a definition of nominal value, the 
average amount of a referral fee has been increasing, and in some 
cases clearly has exceeded a nominal value. The Commission staff 
recently learned from staff of the federal banking agencies that 
some large banks pay referrals fees of as much as $100 for 
particularly valuable referrals. Unless they are paid to highly 
compensated bank employees, fees of such amounts clearly are not 
nominal.
    \50\ See Exchange Act Section 15(a)(1). See also SEC v. Hansen, 
Fed. Sec. L. Rep. ] 91,426 (S.D.N.Y. 1984) (receipt of commissions 
instead of salary was factor in identifying broker activity); SEC v. 
Margolin, Fed. Sec. L. Rep. ] 97,025 (S.D.N.Y. 1992) (same). The 
Commission similarly has noted the importance of transaction-based 
compensation in identifying broker activity. See Exchange Act 
Release No. 22172 (June 27, 1985) (adopting release for Exchange Act 
Rule 3a4-1; ``[T]he receipt of transaction-based compensation often 
indicates that [a] person is engaged in the business of effecting 
transactions in securities. Compensation based on transactions in 
securities can induce high pressure sales tactics and other problems 
of investor protection which require application of broker-dealer 
regulation under the Act.''); Litigation Release No. 15654 (Feb. 26, 
1998) (receipt of transaction-based compensation was factor in 
finding violation of broker-dealer registration requirement and 
violation of order barring individual from associating with broker).
---------------------------------------------------------------------------

    Accordingly, in response to many of these comments, we propose only 
to amend the definition of ``nominal one-time cash fee of a fixed 
dollar amount'' to clarify further the application of the statutory 
limitations to banks' existing practices, to give meaning to the 
investor protections embodied in this provision of the Exchange 
Act.\51\
---------------------------------------------------------------------------

    \51\ As indicated above, SRO rules and banking agency guidance 
may also limit networking activities. See supra note 37.
---------------------------------------------------------------------------

2. Proposed Amendments to Definition of ``Nominal One-Time Cash Fee of 
a Fixed Dollar Amount''
    We propose to amend the definition of ``nominal one-time cash fee 
of a fixed dollar amount'' to mean that a referral payment must have a 
value that does not exceed the greater of three alternative measures: 
the employee's base hourly rate of pay, a dollar amount equal to $15 in 
1999 plus an adjustment for inflation, or $25.\52\ The fee could be 
paid to a bank employee no more than one time per customer referred by 
that employee. If the referral is not paid entirely in cash, the value 
of the non-cash payment must be ``readily ascertainable'' (i.e., its 
value or potential value must have been known by the bank and the 
employee at the time of the referral). Also, any non-cash portion of 
the payment would have to have a value such that the value of the 
entire payment is nominal, and the non-cash portion would have to be 
paid under an incentive program that covers a broad range of products 
and that is designed primarily to reward activities unrelated to 
securities. Finally, the fee would have to be the same for any 
securities referral made by that particular employee, with a flat value 
that does not vary based on factors such as the financial status of a 
customer the employee refers, the identity of the broker-dealer to 
which the customer is referred, the number of referrals the employee 
makes, or whether the customer expresses an interest in a particular 
type of securities product.
---------------------------------------------------------------------------

    \52\ See proposed Exchange Act Rule 710(b).
---------------------------------------------------------------------------

a. Meaning of ``Nominal''
    We propose to amend the definition of ``nominal'' to replace the 
standard of ``one hour of gross cash wages'' used in the Interim Rules 
with ``base hourly rate of pay'' to clarify that this alternative 
measure could be used with respect to salaried as well as unsalaried 
employees. As amended, the Commission believes this option would permit 
highly compensated bank employees to receive scaled referral fees 
without giving them an inappropriate promotional interest in the 
brokerage services a broker-dealer offers under a networking 
arrangement. We request comment on this proposed alternative and, in 
particular, on whether it might lead to some highly compensated bank 
employees being given a salesman's stake in the securities activities 
of the bank's customers.
    Second, the proposed amended definition of ``nominal one-time cash 
fee of a fixed dollar amount'' would include a new, specific dollar-
amount measure of nominal value that should simplify compliance with 
the networking exception in Exchange Act Section 3(a)(4)(B)(i). In 
particular, we are proposing a dollar amount of $15 with annual 
adjustments to account for inflation, based on 1999 dollars.\53\ In

[[Page 39689]]

addition, the definition would specify $25 (without an adjustment for 
inflation) as an alternative measure of nominal value.\54\
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    \53\ We propose that the definition specify 1999 as the 
reference year because that is the year in which the GLBA was 
enacted. The definition also would provide that the $15 amount could 
be adjusted for inflation on an annual basis by order of the 
Commission. $15 in 1999 dollars after adjustment for inflation 
equals approximately $17 in 2004 dollars.
    The $15 inflation-adjusted amount is consistent with the range 
of referral fees in thrift networking arrangements that were the 
subject of no-action relief that the Commission staff has granted. 
See, e.g., letter re: Coast Federal Bank, Federal Savings Bank (May 
13, 1993) ($7 in 1993 dollars is equivalent to approximately $8 in 
1999 dollars). See also letter re: First Piedmont Federal Savings 
and Loan Association (July 22, 1991) (the fee specified was $15 
(approximately $18 in 1999 dollars)). This amount also is consistent 
with the $5 to $15 fee range most banks were understood to pay their 
employees for securities brokerage referrals when the GLBA was 
drafted in 1998. FDIC, Nondeposit Investment Products and 
Recordkeeping Requirements--Questions and Answers at 10 (July 16, 
1998) (citing results of a 1996 survey on bank retail investment 
services conducted by American Brokerage Consultants, Inc., which 
``indicated that most banks pay referral fees in a range between $5 
and $15.'').
    Estimates of inflation-adjusted dollar amounts in this footnote 
and elsewhere in this release were calculated with the online 
inflation calculator available on the U.S. Department of Labor 
Bureau of Labor Statistics' website, which uses the average Consumer 
Price Index for a given calendar year, available at http://data.bls.gov/cgi-bin/cpicalc.pl pl.
    \54\ Twenty-five dollars approximates the value of the larger 
fees some banks have begun to pay their employees for brokerage 
referrals in the past few years, although it appears that at such 
levels the fees may be contingent on factors inconsistent with the 
conditions of the networking exception. See infra note 55.
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    The proposed inflation-adjusted $15 and non-adjusted $25 
alternative measures of nominal value should address concerns some 
commenters raised that administering an hourly, wage-based standard 
might be burdensome or unworkable. As proposed, the amended definition 
of ``nominal one-time cash fee of a fixed dollar amount'' should permit 
many banks to continue paying referral fees with values comparable to 
fees they pay under their existing referral incentive programs, but 
others may be required to reduce the amount paid for referrals of 
customers meeting certain financial criteria.\55\
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    \55\ We anticipate that the most significant changes that may be 
required at some banks could involve steps such as discontinuing 
certain types of brokerage-related conditions on referral fees.
    Information on existing incentive programs provided through the 
ABASA, the Bank Insurance Securities Association (``BISA''), and the 
Independent Community Bankers Association (``ICBA'') suggests that 
the proposed amendments would accommodate levels of referral fees 
consistent with the existing referral incentive programs of most 
banks that provided information to the Commission staff, to the 
extent such programs do not create inappropriate sales incentives 
for unregistered bank employees. A representative of the ICBA told 
the Commission staff that $8 is the average referral fee paid by 
community banks. Information from BISA on fees for brokerage 
referrals paid by ten banks that provided a dollar amount in 
response to a survey indicates a range from zero to $30: one bank 
pays $5; one bank pays $7 per qualified referral, which is paid into 
a branch-wide pool of funds that the branch will receive if it meets 
certain goals that include investment and insurance production; 
three banks pay $10; one bank pays a range between zero and $14.84, 
depending on whether employees meet or exceed a threshold number of 
qualified referrals; one bank pays $20; one bank pays $10 for a 
discount brokerage referral and $20 for a full-service brokerage 
referral; one bank pays either $18.75 or $25, depending on whether 
an employee has already made referrals that have resulted in twelve 
meetings with a registered representative; and one bank pays points 
with a value of $25, $25 in cash, or a cash award of between $25 and 
$30 for referrals exceeding quarterly target levels. One sample plan 
from ABASA provides for payments in points having a value of $10 for 
referrals that result in a kept appointment with a registered 
representative. Another, apparently used by multiple banks, provides 
for referral fees of either $25 or $35 in cash, depending on whether 
a bank utilizing the incentive plan selects a minimum investable 
assets amount of $10,000 or $25,000 for ``qualified'' customers--
i.e., those to whom the referring bank employee has spoken 
personally, meet the $10,000 or $25,000 minimum investable assets 
level, and keep an appointment with a registered representative of 
the broker-dealer within 60 days.
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    As discussed above, some commenters criticized the definition of 
``nominal one-time cash fee of a fixed dollar amount'' in the Interim 
Rules \56\ for listing conditions on referral fees that are 
inconsistent with the networking exception.\57\ As amended, the 
definition would not list impermissible referral fee conditions. 
Instead, such conditions would be addressed by the meaning given to the 
phrase ``fixed dollar amount'' in the definition, and the proposed new 
definition of ``contingent on whether the referral results in a 
transaction,'' as described below.
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    \56\ See 17 CFR 240.3b-17(g)(2).
    \57\ See, e.g., Harris Trust letter and QMellon letter (arguing 
that the Interim Rules should not identify impermissible conditions 
on referral fees that are not explicitly identified in the statute).
---------------------------------------------------------------------------

    We request comment on the proposed dollar-amount and hourly 
compensation standards for measuring nominal value in the proposed 
amended definition of ``nominal one-time cash fee of a fixed dollar 
amount.'' In particular, are the $15-inflation adjusted and $25 amounts 
the most appropriate levels?
    The Commission also solicits comments on the merits of providing 
another alternative standard for determining whether a referral fee is 
nominal that would be based on the incentive a bank would pay its 
employee for the sale or renewal of a certificate of deposit (``CD''). 
To avoid such a standard leading to referral fees with non-nominal 
values equivalent to what a bank might pay for the sale of a large, 
long-term CD, the measure would refer to a CD with a term and value 
equal to the term and value of the CDs banks most frequently issue. The 
Commission solicits comments on whether such a standard would provide a 
useful means for measuring a nominal value in this context. In 
particular, we request comment on what compensation, if any, banks pay 
for the sale or renewal of a CD. Does the compensation for the sale or 
renewal of a CD vary based on economic factors such as the bank's level 
of interest in gathering deposits? Does the incentive vary depending on 
whether the transaction is a new purchase or a renewal? Does the 
incentive vary depending on the value of the CD or based on the term of 
the CD? For example, would the average incentive that a bank pays for 
the sale of a one-year, $5,000 CD be nominal? The Commission also 
solicits comments on other possible objective measures banks could use 
to gauge whether the referral fees they pay are nominal.
b. Meaning of ``One-Time''
    Exchange Act Section 3(a)(4)(B)(i)(VI)\58\ permits unregistered 
bank employees to receive a ``one-time'' fee for the referral of a 
customer. Commenters expressed the view that banks should be able to 
pay fees more often than contemplated by the statute.\59\ This could 
include, for example, making a payment at the time of a referral and 
then a second one later if the employee makes a particular number of 
referrals in a period of time covering the referral for which the 
employee was already paid. Such an approach would be inconsistent with 
the plain language of the networking exception, which limits banks to 
paying unregistered employees only ``one-time'' referral fees.
---------------------------------------------------------------------------

    \58\ 15 U.S.C. 78c(a)(4)(B)(i)(VI).
    \59\ See, e.g., NYCH letter.
---------------------------------------------------------------------------

    We therefore propose to include in the amended definition of ``one-
time nominal cash fee of a fixed dollar amount'' an interpretation of 
the term ``one-time'' to clarify that a referral fee may be paid to a 
bank employee no more than one time per customer referred by that 
employee. This proposed amendment should help clarify the issue, raised 
by some commenters, of the circumstances under which compensation paid 
in the form of bonuses falls within the networking exception's 
prohibition on the payment of brokerage-related incentive compensation 
to unregistered bank employees.\60\
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    \60\ The proposed provision would not require a bank to 
determine whether a customer had ever been referred by any of the 
bank's unregistered employees to pay the referring employee a 
referral fee. A bank could not, however, pay additional fees to the 
same unregistered employee based on additional referrals of the same 
customer, including additional referrals for different types of 
brokerage products. In other words, a bank could not pay a 
particular employee more than one referral fee based on multiple 
referrals of the same customer, and an unregistered bank employee 
who referred a customer more than once could receive only one fee 
related to that customer.
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    Some commenters argued that only bonus plans used as a conduit to 
pay

[[Page 39690]]

brokerage-related compensation to unregistered employees under the 
exception are prohibited.\61\ We do not agree. Any bonus or other 
incentive compensation that is payable based in part, directly or 
indirectly, on a referral for which the employee has already received a 
referral fee, would violate the exception's requirement that brokerage-
related incentive compensation paid to unregistered employees under the 
exception be limited to ``one-time'' referral fees. However, consistent 
with the meaning we propose to give ``cash fee'' (described below) in 
the definition of ``nominal one-time cash fee of a fixed dollar 
amount,'' a referral fee could be paid partially in cash at the time of 
the referral and partially in points to be paid to the employee as a 
bonus at a later time, if the total value of the cash and points in 
which the fee is paid has a nominal value under the definition.
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    \61\ See, e.g., July 17, 2001, ABA/ABASA letter; Banking 
Agencies letter; and PNC letter. The Bank One letter, Mellon letter, 
and SIA letter also sought clarification regarding the circumstances 
under which bonuses would not be impermissible incentive 
compensation under the networking exception.
---------------------------------------------------------------------------

    Other types of bonuses that do not give unregistered bank employees 
a promotional interest in securities brokerage would not be prohibited 
by the exception's ``one-time'' requirement. As we explained in 
adopting the Interim Rules, while the exception does not permit 
unregistered bank employees to receive bonuses based on brokerage 
referrals, it does not prohibit bonuses based on the overall 
profitability of a bank that are determined and paid regardless of the 
brokerage-related activities of an employee receiving such a bonus.\62\ 
This is true even though the financial performance of the bank as a 
whole would in part depend on the bank's securities networking 
activities, because such activities are unlikely to represent a 
significant source of the bank's overall profits and such bonuses are 
not likely to give unregistered employees a promotional interest in the 
brokerage services offered by the broker-dealers with which the bank 
networks.
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    \62\ See Exchange Act Release No. 44291, supra note 13, 66 FR at 
27766. The explanation continued with the caveat that a bank could 
not rely on the networking exception and use bonuses as a means of 
indirectly paying their unregistered employees brokerage-related 
incentive compensation based on the performance of a branch, 
department or line of business of the bank. This is also true for 
bonuses based on points paid under the proposed interpretation of 
``cash fee.'' Such bonuses also must not be contingent on factors on 
which the payment of a referral fee, or the value of a referral fee, 
may not be conditioned. See discussions regarding ``fixed-dollar 
amount'' and ``contingent on whether the referral results in a 
transaction,'' infra. Of course, whether an unregistered employee 
receives a bonus based in part on brokerage referrals could be 
contingent on factors unrelated to securities brokerage, such as 
whether the employee opens a certain number of deposit accounts or 
consistently follows the bank's risk management policies. However, 
as explained below, the exception's ``fixed dollar amount'' 
condition means that the value of any points paid for brokerage 
referrals that might count toward the bonus would need to have a 
set, nominal value at the time the referrals were made.
---------------------------------------------------------------------------

    In addition, some commenters stated that a bonus program applicable 
to all employees of a bank holding company, or based on the 
profitability of a bank holding company as a whole, should not be 
limited by the networking exception's restrictions on brokerage-related 
compensation.\63\ The Commission believes that a bonus based on the 
profitability of a bank's ultimate parent company should be analyzed in 
the same way as a bonus based on the bank's profitability. We believe 
that bonuses based on measures more closely related to securities 
brokerage, however, would be inconsistent with the statutory 
limitations on referral fees.
---------------------------------------------------------------------------

    \63\ See e.g., letter dated July 12, 2001 from Michael P. Smith, 
President, New York Bankers Association (``NYBA letter''); Harris 
Trust letter; Mellon letter; and SIA letter.
---------------------------------------------------------------------------

    We request comment on the interpretation of the term ``one-time'' 
in the proposed amended definition of ``nominal one-time cash fee of a 
fixed dollar amount.'' We are also soliciting comment on what 
additional guidance, if any, commenters would find useful with respect 
to bonus programs.
c. Meaning of ``Cash Fee''
    In addition to cash payments, the definition of ``nominal one-time 
cash fee of a fixed dollar amount'' in the Interim Rules provided for 
payments in points in a system or program covering a range of bank 
products and non-securities related services in which points count 
toward a bonus, so long as the value of the points awarded for 
referrals involving securities are not greater than the value of the 
points awarded for activities not involving securities.\64\ While 
Exchange Act Section 3(a)(4)(B)(i) does not contemplate the payment of 
referral fees in points instead of cash, the Commission included this 
provision in recognition of banks' existing practices to give them 
additional flexibility. While some commenters supported the provision, 
others expressed concern or raised questions about it. For example, 
some asserted that it should not be limited to points awarded for 
securities referrals as part of a broader program or argued that it 
unfairly limited the value of fees paid in points.\65\
---------------------------------------------------------------------------

    \64\ See 17 CFR 240.3b-17(g)(1)(ii).
    \65\ See Banking Agencies letter; BSA letter; Harris letter; 
Mellon letter; NYCH letter; Regions letter; and letter dated July 
17, 2001 from Ted T. Cecala, Chairman & CEO, Wilmington Trust 
Company (``Wilmington Trust letter''). Moreover, in meetings with 
the Commission staff, bank representatives explained they were 
uncertain regarding the scope of services a program would need to 
cover to qualify for the exception.
---------------------------------------------------------------------------

    In response to questions and concerns expressed about this 
provision, the Commission is proposing to modify it. The amended 
definition of ``nominal one-time cash fee of a fixed dollar amount'' 
\66\ would allow the payment of referral fees or portions of referral 
fees other than in cash to the extent that: (1) Such payments are in 
units of value with a readily ascertainable cash equivalent;\67\ (2) 
the total value of the referral fee meets the nominal value conditions 
of the proposed amended definition; and (3) the payment is made under 
an incentive program that covers a broad range of products and that is 
designed primarily to reward activities unrelated to securities.\68\ As 
noted above, this interpretation of the networking exception's ``cash 
fee'' requirement would permit banks to continue using certain types of 
point-based incentive programs under which points are accumulated 
toward a cash bonus or other incentive. These provisions are intended 
to maintain the flexibility provided in the Interim Rules for banks to 
continue using such programs, while providing greater certainty as to 
the conditions under which such programs may be used to reward 
securities brokerage referrals. Of course, a referral fee paid in part 
or entirely in points must not only have a nominal value, but it must 
also meet the other conditions of the networking exception.
---------------------------------------------------------------------------

    \66\ See proposed Exchange Act Rule 710(b)(1).
    \67\ The ``readily ascertainable cash equivalent'' condition 
would limit the value of a referral fee paid in points to an amount 
that is determined by a bank and known to an employee before the 
employee makes a brokerage referral. This requirement would not 
permit the value of a ``point'' to be based on the number of points 
an employee earns from brokerage referrals. For example, the size of 
a points-based bonus could not be based on the number of brokerage 
referrals an employee makes over a target number of brokerage 
referrals. Similarly, the value of a points-based bonus could not be 
increased by the percentage of an employee's total points earned 
from securities brokerage referrals.
    \68\ See proposed Exchange Act Rule 710(b)(3). The condition 
that the incentive program cover a broad range of products and be 
designed primarily to reward activities unrelated to securities 
means the program provides incentives for activities such as selling 
bank products or services not involving securities or for making 
referrals for non-securities products such as insurance, and that 
the program is not focused on brokerage referrals.
---------------------------------------------------------------------------

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

[[Page 39691]]

would be sufficient to assure that unregistered bank employees are not 
given incentives to promote a broker-dealer's brokerage business by 
engaging in more than the limited activities permitted under the 
exception. We are also soliciting comment on what additional guidance, 
if any, commenters would find useful with respect to such programs.
d. Meaning of ``Fixed Dollar Amount''
    We also propose to amend the definition of ``nominal one-time cash 
fee of a fixed dollar amount'' to specify that a fee of a ``fixed 
dollar amount'' means a flat fee.\69\ The proposed definition would 
state that fees paid for brokerage referrals made by a particular 
employee must have a set value and may not vary based on factors such 
as the financial status of a customer the employee refers, the identity 
of the broker-dealer to which the customer is referred, the number of 
referrals the employee makes, or whether the customer expresses an 
interest in a particular type of securities product.
---------------------------------------------------------------------------

    \69\ The proposed definition would clarify that rewarding 
referrals with non-flat fees that vary in amount based on 
``success'' factors would be inconsistent with the ``fixed dollar'' 
amount requirement in the statute.
---------------------------------------------------------------------------

3. Comments on Definition of ``Referral'' and Proposed Amendments
    The Interim Rules define the term ``referral'' to exclude any 
activity beyond arranging a first securities-related contact between a 
registered broker-dealer and a bank customer. We received over a dozen 
comments on the definition of ``referral.''\70\ Commenters 
characterized the definition as excessively narrow,\71\ and generally 
took the position that it was more restrictive than required by the 
Exchange Act, the Banking Agencies, and the Interagency Statement.\72\ 
Several commenters indicated that they saw no need to restrict referral 
payments at all.\73\ A few objected to the use of the phrase ``first 
securities-related contact,'' or suggested that the phrase be 
defined.\74\
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    \70\ See, e.g., Banking Agencies letter; Bank of America letter; 
BONY letter; Connecticut Bankers letter; NYCH letter; Regions 
letter; Roundtable letter; UMB Bank letter; and Wells Fargo letter.
    \71\ Id.
    \72\ See Interagency Statement, supra note 37.
    \73\ See Banking Agencies letter; Connecticut Bankers letter; 
and UMB Bank letter.
    \74\ See, e.g., NYCH letter and Wells Fargo letter.
---------------------------------------------------------------------------

    In response to these comments and to address concerns commenters 
expressed about difficulties they might have in meeting the definition 
in the Interim Rules, we propose to eliminate the first securities-
related contact limitation from the definition of ``referral.'' We also 
propose to simplify the definition in a manner consistent with pre-GLBA 
networking arrangements. Under the amended definition, a ``referral'' 
would mean the action taken by a bank employee to direct a customer of 
the bank to a registered broker or dealer for the purchase or sale of 
securities for the customer's account.\75\
---------------------------------------------------------------------------

    \75\ See proposed Exchange Act Rule 710(c). Representatives of 
banks have expressed an interest in paying their unregistered 
employees for broker-related activities other than referrals, such 
as screening potential brokerage customers. The Commission believes 
that such activities constitute brokerage activities beyond those 
intended to be covered by the networking exception. The Commission 
believes it would be inconsistent with the networking exception for 
banks to pay fees to unregistered bank employees to perform 
functions--other than those expressly permitted by the GLBA or an 
applicable exemption--that are traditionally performed by a 
registered representative of a broker-dealer. A broker-dealer has a 
duty to know its customers, which involves obtaining financial 
information from them through its registered representatives. 
Moreover, whether investing in securities through a broker-dealer is 
appropriate for a particular individual must be determined by that 
broker-dealer's registered representative, not unregistered bank 
employees that are not subject to suitability obligations.
---------------------------------------------------------------------------

    The proposed amendment also would specify that a bank may pay a fee 
for a brokerage referral only to the employee who made the referral and 
not to other employees, such as a branch manager or other supervisor. 
This interpretation of the statute is consistent with existing 
networking practices and banking agency guidance. We request comment on 
these proposed changes and clarifications to the definition of 
``referral.'' Commenters are invited to discuss whether banks need 
additional guidance on what constitutes a referral.
4. Proposed New Definition of ``Contingent on Whether the Referral 
Results in a Transaction''
    The Interim Rules stated that the payment of a ``nominal one-time 
cash fee of a fixed dollar amount'' for a referral cannot be related to 
certain enumerated factors, including the value of any securities 
transaction or a customer's financial status.\76\ Although some 
commenters indicated that limitations on the conditions under which 
referral fees may be paid are unnecessary,\77\ the networking exception 
is clear that the payment of referral fees in reliance on this 
exception may not be contingent on whether the referral results in a 
transaction.\78\
---------------------------------------------------------------------------

    \76\ See 17 CFR 240.3b-17(g)(2). Proposed Regulation B uses the 
word ``including'' as expanding or illustrative, not as exclusive or 
limiting. The use of the term ``including, but not limited to'' in 
Exchange Act Rules 10b-10 and 15b7-1 is not intended to create a 
negative implication regarding the use of ``including'' without the 
term ``but not limited to'' in Regulation B or other Exchange Act 
rules.
    \77\ See Bank of America letter and SIA letter.
    \78\ Exchange Act Section 3(a)(4)(B)(i)(VI).
---------------------------------------------------------------------------

    Thus, to provide guidance on those contingencies on which incentive 
compensation may not be based under the exception, we propose to define 
the term ``contingent on whether the referral results in a 
transaction'' to mean, with two exceptions, contingent on any factor 
related to whether the referral results in a transaction, including 
whether it is likely to result in a transaction, whether it results in 
a particular type of transaction, or whether it results in multiple 
transactions.\79\
---------------------------------------------------------------------------

    \79\ See proposed Exchange Act Rule 710(a).
---------------------------------------------------------------------------

    For example, under the proposed definition, a bank could not make 
referral fees contingent on whether a customer opens a brokerage 
account because such a contingency would make it more likely that the 
referral would result in a securities transaction.\80\ Referral fees 
also may not be contingent on whether the customer invests more than a 
specified amount in securities or maintains a brokerage account for a 
specified time.
---------------------------------------------------------------------------

    \80\ Opening a brokerage account is the first step in a 
securities transaction. Typically, opening a brokerage account 
results in the purchase or sale of securities.
---------------------------------------------------------------------------

    In response to commenters' requests,\81\ however, the proposed 
definition specifically would permit referral fees to be contingent on 
two factors. First, the term would permit referral fees to be 
contingent on whether a customer contacts or keeps an appointment with 
a broker-dealer as a result of a referral.\82\ Second, referral fees 
may be contingent on whether a bank customer has assets meeting any 
minimum requirement that the registered broker-dealer, or the bank, may 
have established generally for referrals for securities brokerage 
accounts.\83\ Both of these factors give broker-dealers the flexibility 
to avoid paying fees for worthless referrals without inappropriately 
aligning the financial interests of the bank's employee with those of 
the broker-dealer. A customer could fail to keep an appointment 
scheduled at the time of a referral but still contact a broker-dealer 
as a result of the referral. Banks may wish to pay referral fees in 
those contexts. These contingencies appear to be commonly used in 
existing networking arrangements. In contrast, contingencies based on 
whether a referral results in a customer opening or funding a brokerage 
account, on

[[Page 39692]]

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

    \81\ See Bank of America letter and SIA letter.
    \82\ See proposed Exchange Act Rule 710(a)(1).
    \83\ See proposed Exchange Act Rule 710(a)(2).
---------------------------------------------------------------------------

    We request comment on the proposed definition of ``contingent on 
whether the referral results in a transaction.'' In particular, we seek 
comment on whether there are additional contingencies that banks 
currently place on referral fees that should be permissible under the 
proposed definition of ``contingent on whether the referral results in 
a transaction.'' In addition, we encourage commenters to discuss other 
areas where they believe the Commission should grant exemptive relief 
related to networking arrangements. For example, in addition to the 
asset, net worth, and income contingencies excluded from the proposed 
definition, we seek comment on whether banks should be able to 
condition the payment of referral fees on other criteria relating to 
other aspects of a customer's financial profile, such as tax bracket. 
Banks also are invited to discuss whether they would be able to 
continue their existing networking activities if the current rules were 
amended as described above. If not, banks should explain what proposed 
rule provisions would prevent them from doing so. Banks should also 
explain what changes, if any, they would need to make to their existing 
networking programs to comply with the amended rules.
5. Interpretations of ``Contractual or Other Written Arrangement'' and 
``Qualified Pursuant to the Rules of a Self-Regulatory Organization''
    The Commission has received requests to provide further guidance on 
certain terms used in the Interim Rules in connection with the 
networking exception that were not defined in the Interim Rules. 
Therefore, it may be useful to clarify the meaning of some of these 
terms. First, one commenter proposed that the Commission interpret the 
networking exception requirements expansively to ``apply to any bank 
subsidiary expressly formed for the purpose of engaging in securities 
transactions.'' \84\ We decline to expand the scope of the networking 
exception in this manner. The Exchange Act's functional exceptions for 
banks from the definitions of ``broker'' and ``dealer'' apply only to 
banks, and only under limited circumstances. Non-bank affiliates of 
banks are not subject to the same level of regulation as banks, and 
such entities were not exempted from the Exchange Act's broker-dealer 
registration requirements by the general exemption that the GLBA 
replaced with limited, functional exceptions for banks. Non-bank 
subsidiaries or affiliates of a bank may not rely on a bank exception 
or exemption from broker-dealer registration.\85\ This interpretation 
is consistent with the plain language of the GLBA. Non-bank entities 
that refer customers, including bank customers, to broker-dealers would 
generally have to register as broker-dealers.\86\
---------------------------------------------------------------------------

    \84\ See letter dated July 17, 2001 from Neil Milner, President 
and CEO, Conference of State Bank Supervisors (``CSBS letter''). 
Similarly, the Commission staff has received informal requests for 
guidance on whether the networking exception would permit a bank to 
avoid being considered a broker based on a networking arrangement 
entered into by an affiliate or a subsidiary of the bank, and 
whether a bank could participate in networking activities under 
arrangements entered into by an affiliated insurance agency.
    \85\ See Exchange Act Section 3(a)(6) which defines ``bank.''
    \86\ In general, absent an exception or exemption, a person who 
regularly refers securities business prospects for compensation to a 
broker-dealer would be a broker required to be registered with the 
Commission. See Exchange Act Release No. 27017 (July 11, 1989), 54 
FR 30013, 30017-18 (July 18, 1989).
---------------------------------------------------------------------------

    Second, the Commission has received informal requests to clarify 
the term ``qualified pursuant to the rules of a self-regulatory 
organization.'' This term means to be qualified to effect a securities 
transaction as a natural person associated with a registered broker or 
dealer under Exchange Act Rule 15b7-1, which requires broker-dealers to 
comply with SRO qualification standards.\87\
---------------------------------------------------------------------------

    \87\ See 17 CFR 240.15b7-1.
---------------------------------------------------------------------------

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

B. Trust and Fiduciary Activities Exception

    Section 3(a)(4)(B)(ii) of the Exchange Act \88\ permits a bank, 
under certain conditions, to effect transactions in a trustee or 
fiduciary capacity without registering as a broker. Under this 
exception, a bank must effect such transactions in its trust 
department, or other department that is regularly examined by bank 
examiners for compliance with fiduciary principles and standards.\89\ 
The bank also must be ``chiefly compensated'' for such transactions, 
consistent with fiduciary principles and standards, on the basis of: 
(1) An administration or annual fee, (2) a percentage of assets under 
management, (3) a flat or capped per order processing fee that does not 
exceed the cost the bank incurs in executing such securities 
transactions, or, (4) any combination of such fees.\90\ The term 
``chiefly compensated'' is not defined in the GLBA. Therefore, in the 
Interim Rules, the Commission provided a definition for the term to 
establish clear standards for complying with the ``chiefly 
compensated'' requirement under the GLBA.\91\
---------------------------------------------------------------------------

    \88\ 15 U.S.C. 78c(a)(4)(B)(ii).
    \89\ Id.
    \90\ 15 U.S.C. 78c(a)(4)(B)(ii)(I). Banks relying on this 
exception may not publicly solicit brokerage business, other than by 
advertising that they effect transactions in securities in 
conjunction with advertising their other trust activities. 15 U.S.C. 
78c(a)(4)(B)(ii)(II). The exception also provides that a bank's 
trust and fiduciary activities that result in a transaction in the 
United States of any security that is publicly traded must meet the 
conditions set out in Section 3(a)(4)(C) of the Exchange Act. 15 
U.S.C. 78c(a)(4)(C). These conditions require a bank to direct a 
trade to a registered broker or dealer for execution, to effect the 
trade through a cross trade or substantially similar trade either 
within the bank or between the bank and an affiliated fiduciary that 
is not in contravention of fiduciary principles established under 
applicable federal or state law, or to effect the trade in some 
other manner permitted by the Commission. 15 U.S.C. 78c(a)(4)(C)(i)-
(iii). The term ``assets under management'' is not defined in the 
Exchange Act or in the proposed rules.
    \91\ Exchange Act Rule 3b-17(a) defines the term ``chiefly 
compensated'' to mean that ``the `relationship compensation' 
received by a bank from a trust or fiduciary account exceeds the 
`sales compensation' received by the bank from such account during 
the immediately preceding year. * * *''

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[[Page 39693]]

    Provisions of the Interim Rules relating to the ``chiefly 
compensated'' requirement engendered a great deal of public comment and 
have been a primary focus of the discussions the Commission staff has 
had with banking industry representatives and bank regulators since the 
Interim Rules were adopted. As a result of these comments and 
discussions, the Commission is proposing to modify substantially the 
``chiefly compensated'' provisions in the Interim Rules. In the 
Commission's view, these proposed improvements should facilitate their 
compliance with the ``chiefly compensated'' requirement while 
permitting banks to continue many of their current practices. This, in 
turn, should ease their costs of transition to the new statutory scheme 
without compromising investor protection.
1. Chiefly Compensated
a. Statutory Requirements and Existing Rules
    To qualify for the trust and fiduciary activities exception, 
Exchange Act Section 3(a)(4)(B)(ii) requires a bank to be ``chiefly 
compensated'' for transactions effected in its trustee or fiduciary 
capacity, consistent with fiduciary principles and standards. This 
condition reflects Congress' goals to implement the functional 
regulation of securities activities and to permit banks to continue to 
conduct limited securities activities while acting as, and being paid 
as, fiduciaries.\92\ The statutory conditions that a bank must meet to 
qualify for this exception are designed to ensure that bank trustees 
and fiduciaries conducting securities activities outside of the 
protections of the securities laws are compensated as traditional 
trustees and fiduciaries.\93\
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    \92\ By enacting a trust and fiduciary activities exception in 
the Exchange Act, Congress acknowledged that banks held securities 
in trust accounts. In the GLBA's legislative history, the conference 
committee stated that ``[t]he Conferees expect that the SEC will not 
disturb traditional bank trust activities under this provision.'' 
H.R. Conf. Rep. No. 106-434, 164 (1999).
    The House Committee on Commerce further stated that it expected 
the Commission ``to interpret this exception, and, in particular the 
references to ``chiefly'' and ``fiduciary principles and standards'' 
contained in this exception, so as to limit a bank's ability to 
receive incentive compensation or similar compensation that could 
foster a salesman's stake in promoting securities transactions.'' 
That Committee also stated that it did not intend for a bank to 
conduct a full-scale securities brokerage operation in the trust 
department that would be exempt from Commission regulation and the 
imposition of appropriate investor protections under the Federal 
securities laws. H.R. Rep. No. 106-74, pt. 3, at 164 (1999).
    \93\ The question of when a bank may be acting in a fiduciary 
capacity is separate and distinct from the question of whether a 
specific account is established for a fiduciary purpose. For 
example, a bank may be acting in a fiduciary capacity when it 
provides investment advice to a common investment fund. Such a fund, 
however, will be excluded from the definition of investment company 
under the Investment Company Act of 1940 (``Investment Company 
Act'') only if it is employed solely as an aid to the administration 
of accounts maintained for a traditional fiduciary purpose. See 
Section 3(c)(3) of the Investment Company Act.
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    By its terms, the ``chiefly compensated'' condition divides a 
bank's compensation into qualifying (traditional fees received by 
trustees and fiduciaries) and non-qualifying types (traditional fees 
received by broker-dealers), and limits the amount of non-qualifying 
compensation a bank may receive and still rely on the exception. In 
other words, Section 3(a)(4)(B)(ii) contemplates that a bank relying on 
the trust and fiduciary activities exception will need to limit its 
non-qualifying compensation and will need to have a mechanism in place 
to determine whether it has succeeded in doing so.
    While defining the types of compensation to compare is essential to 
making the test meaningful, the statutory limitations require many 
banks to categorize and compare their compensation in a manner that is 
new to them. Current Exchange Act Rule 3b-17 was intended to facilitate 
that categorization and comparison. The Rule defines ``chiefly 
compensated'' to mean that more of a bank's payments for securities 
transactions must come from qualifying, or ``relationship 
compensation,'' \94\ than from non-qualifying, or ``sales 
compensation.'' \95\
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    \94\ See Exchange Act Rule 3b-17(i). The term ``relationship 
compensation,'' an amended version of which the Commission is 
proposing to codify in Exchange Act Rule 724, includes 
administrative or annual fees (payable on a monthly, quarterly, or 
other basis), fees based on a percentage of assets under management, 
a flat or capped per order processing fee limited by the bank's cost 
in effecting the transaction, or any combination of such fees.
    \95\ See Exchange Act Rule 3b-17(j). The ``sales compensation'' 
definition, an amended version of which the Commission is proposing 
to codify in Exchange Act Rule 724, includes compensation that a 
bank receives for a securities offering that the bank does not 
receive directly from a customer, beneficiary, or the assets of the 
trust or fiduciary account. ``Sales compensation'' also includes 
Rule 12b-1 fees. ``Rule 12b-1 fees'' or ``12b-1 fees'' are fees paid 
out of fund assets pursuant to a distribution plan adopted under 
Rule 12b-1 under the Investment Company Act. 17 CFR 270.12b-1. The 
``sales compensation'' definition reflects the fact that bank trust 
departments, like broker-dealers, receive payments for securities 
transactions from third parties. Many of the sales practice 
provisions of the federal securities laws, including a number of 
NASD rules, are designed to address such conflicts of interest. 
``Sales compensation'' also includes revenue sharing payments that 
bank trust departments receive from mutual fund companies.
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    To determine compliance with the ``chiefly compensated'' condition, 
current Exchange Act Rule 3b-17 requires banks to compare their 
``relationship compensation'' to their ``sales compensation'' annually, 
on an account-by-account basis. Unrelated compensation is not included 
in the ``chiefly compensated'' calculation because it is not relevant 
to whether a bank is acting as a broker.\96\
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    \96\ Any fee a bank receives that is not related to effecting 
securities transactions is considered ``unrelated compensation'' 
and, except as discussed below, is not included in the definition of 
``relationship compensation.'' Unrelated compensation includes fees 
charged separately for activities, including taking deposits, 
lending funds (including margin lending), preparing taxes, or 
providing other services that are not related to managing securities 
accounts pursuant to the trust and fiduciary activities exception. 
Unrelated compensation also includes compensation received as 
permitted under the terms of another bank exception from the 
definitions of ``broker'' and ``dealer.'' This exclusion includes 
any payment made to the bank or one of its employees pursuant to the 
networking exception. See Exchange Act Section 3(a)(4)(B)(i)(VI).
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    The Interim Rules also provided two exemptions from the general 
requirements of the ``chiefly compensated'' condition. First, current 
Exchange Act Rule 3a4-2 exempts banks that receive less than ten 
percent sales compensation from making calculations on an account-by-
account basis. Second, Exchange Act Rule 3a4-3 exempts banks from the 
definition of broker when they act in the narrow role of indenture 
trustees investing in no-load money market funds. These exemptions are 
explained in more detail below.
b. Comments on ``Chiefly Compensated'' Requirement
    We received multiple comments addressing the ``chiefly 
compensated'' condition.\97\ Many commenters agreed

[[Page 39694]]

that the term ``chiefly compensated'' should not be interpreted to 
require a higher percentage threshold than the fifty percent standard 
in the Interim Rules.\98\ Many commenters disagreed with the 
Commission's interpretation, however, that the ``chiefly compensated'' 
calculation should be made on an account-by-account basis.\99\ 
Commenters opposing an account-by-account calculation argued that the 
GLBA does not expressly require such a calculation and that determining 
compliance in this manner would be unduly costly and complicated. Some 
commenters expressed the view that the ``chiefly compensated'' 
condition should instead be interpreted to allow banks to determine 
compliance on a line-of-business basis because they believe that 
Congress intended a line-of-business approach.\100\
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    \97\ See, e.g., ABA/ABASA letters; ACB letter; Bank of America 
letter; ABA Banking Law Committee letter; Bank One letter; Banking 
Agencies letter; BONY letter; Broadway letter; CSBS letter; letter 
dated July 17, 2001 from Jerry W. Powell, General Counsel, Compass 
Bancshares (``Compass letter''); Connecticut Bankers letter; letter 
dated July 2, 2001 from Melanie L. Fein, Attorney at Law, on behalf 
of Federated Investors, Inc. and letter dated June 18, 2001 from 
Eugene F. Maloney, Executive Vice President and Corporate Counsel, 
Federated Investors, Inc. (``Federated letters''); letter dated July 
10, 2001 from William Nappi, CTCP, Trust Compliance Officer, 
FirstMerit Corp., N.A. (``FirstMerit letter''); letter dated July 
13, 2001 from Michael Watkins, Senior Vice President and Deputy 
General Counsel, First Union Corporation (``First Union letter''); 
Fleet letter; Harris Trust letter; IIB letter; Mellon letter; 
National City letter; Bar of NY letter; NYCH letter; PNC letter; 
Regions letter; Roundtable letter; letter dated July 17, 2001 from 
Stewart P. Greene, Chief Counsel, Securities Law, Teacher Insurance 
and Annuity Association (``TIAA-CREF letter''); Texas Bankers Trust 
Division letter; UMB Bank letter; Victoria letter; Virginia Bankers 
letter; Wells Fargo letter; letter on behalf of an unnamed client, 
dated July 17, 2001 from Satish M. Kini of Wilmer, Cutler & 
Pickering (``Wilmer, Cutler letter''); and letter dated July 16, 
2001 from W. David Hemingway, Chief Financial Officer, Zions Bank 
Capital Markets, Zions First National Bank, letter dated July 17, 
2001 from Rick D. Burtenshaw, Senior Vice President, Investment 
Division, Zions National Bank (``Zions Bancorporation letters'').
    \98\ See, e.g., Banking Agencies letter.
    \99\ See, e.g., ABA/ABASA letters; ACB letter; Banking Agencies 
letter; BONY letter; Compass letter; Connecticut Bankers letter; 
Mellon letter; NYCH letter; PNC letter; Regions letter; UMB Bank 
letter; Wells Fargo letter; and Wilmer, Cutler letter.
    But see Statement of the ABASA Before the Committee on Banking 
and Financial Services, U.S. House of Representatives, on The 
Financial Services Act of 1999, H.R. 10, February 16, 1999:
    [H.R. 10's] fee provisions . . . will force every trust bank to 
analyze each fiduciary account to ensure that the account satisfies 
the exemption's fee requirements. . .. Despite the regulatory 
burdens associated with complying with the fee aspect of the 
exemption, the overall exemption is, ABASA believes, workable. . . .
    The Commission notes that H.R. 10 contained language regarding 
bank securities activities within a trust and fiduciary exception to 
the definition of broker that was virtually identical to the version 
that Congress ultimately adopted.
    \100\ See, e.g., ABA/ABASA letters.
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    Some commenters also raised concerns about the way in which the 
Commission proposed to categorize certain types of compensation. For 
example, under the Interim Rules, Rule 12b-1 fees are considered 
``sales compensation'' rather than ``relationship compensation.'' Some 
commenters believed that 12b-1 fees should be categorized as 
``relationship compensation.''\101\ In addition, one commenter asserted 
that banks should be able to treat fees based on a percentage of assets 
under management, such as separately charged fees for managing real 
property, as ``relationship compensation.''\102\
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    \101\ See NYCH letter and PNC Bank letter.
    \102\ See Texas Bankers Trust Division letter.
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    One commenter recommended that the Commission ``grandfather'' trust 
and fiduciary arrangements that were entered into prior to the 
establishment of the parameters for categorizing compensation.\103\ 
Others emphasized the need for a cure period or ``safe harbor'' for 
banks that inadvertently failed to meet the ``chiefly compensated'' 
condition during a particular time period.\104\
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    \103\ See NYCH letter.
    \104\ See ABA/ABASA letters; Banking Agencies letter; Roundtable 
letter; Bar of NY letter; and Wilmer, Cutler letter. The Commission 
also received a number of comments regarding the exemptions from the 
``chiefly compensated'' requirement in current Exchange Act Rules 
3a4-2 and 3a4-3. These comments are discussed below in connection 
with proposed amendments to those exemptions.
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c. Proposed Changes in Response to Comments
    In response to comments on provisions of the Interim Rules dealing 
with the ``chiefly compensated'' condition, the Commission is proposing 
new exemptions and expanding the existing exemptions. To simplify 
compliance, the Commission also is proposing to expand the definition 
of ``relationship compensation'' to expand the types of assets that 
could qualify for assets under management fees paid directly by the 
customer, beneficiary, or account.\105\ The Commission believes that 
the proposed amendments to the provisions of the Interim Rules that 
address the ``chiefly compensated'' condition should significantly 
simplify compliance with the condition, alleviate concerns about 
inadvertent noncompliance, and reduce the costs banks were likely to 
have incurred in making the ``chiefly compensated'' calculation under 
the Interim Rules.
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    \105\ Although the term ``assets under management'' is defined 
in Section 203A(a)(2) of the Advisers Act, it is not defined in the 
Exchange Act or in these proposed rules and would include non-
securities assets. See section III.B.1.h infra.
---------------------------------------------------------------------------

    For example, the Commission is proposing a ``line-of-business'' 
alternative to the account-by-account methodology in response to 
requests by representatives from the banking industry. Moreover, the 
Commission is proposing to exempt existing living, testamentary, and 
charitable trust accounts from the ``chiefly compensated'' calculation. 
Finally, the Commission is proposing to establish a multi-tiered ``safe 
harbor'' for banks determining compliance on an account-by-account 
basis that find themselves out of compliance with respect to particular 
accounts. The proposed safe harbors would provide banks with legal 
certainty during those periods in which they were not compliant and 
would provide them opportunities to come into compliance with the 
``chiefly compensated'' condition. These proposed changes to the 
Interim Rules, as well as Commission guidance on other aspects of the 
Interim Rules, are discussed below.\106\
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    \106\ Despite commenters' suggestions, an annual account-by-
account calculation is consistent with implementing functional 
regulation to protect investors. It also is consistent with the way 
in which both broker-dealers and banks establish their obligations 
and duties to their customers which, in turn, defines the capacity 
in which they will act. It is also consistent with accounting 
requirements and other fundamental determinations that trustees must 
make under state trust law. Moreover, bank trust departments 
primarily charge fees at the same level at which securities 
transaction fees are assessed--the account level.
---------------------------------------------------------------------------

d. Proposed Line-of-Business Exemption
i. Description of Existing Rule
    Exchange Act Rule 3a4-2 permits a bank to rely on the trust and 
fiduciary activities exception from broker registration under the GLBA 
if the bank's total ``sales compensation'' during the previous year was 
less than ten percent of its total ``relationship compensation'' for 
that period, provided the bank meets other conditions in the 
exception.\107\ The rule was intended to provide banks with an 
alternative to the account-by-account calculation of the ``chiefly 
compensated'' requirement.
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    \107\ A bank relying on the Exchange Act Rule 3a4-2 exemption 
must comply with all other terms of the trust and fiduciary 
activities exception and must maintain procedures reasonably 
designed to ensure compliance with the ``chiefly compensated'' 
requirement with respect to a trust or fiduciary account. Exchange 
Act Rule 3a4-2 currently requires those procedures to provide that 
an account will be reviewed when it is opened, when the compensation 
arrangement for the account is changed, and when sales compensation 
received from the account is reviewed by the bank for purposes of 
determining an employee's compensation. Exchange Act Section 
3(a)(4)(C) requires that a bank must also execute any securities 
orders through a broker-dealer (or in a cross trade or other means 
that the Commission may prescribe).
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    Commenters generally agreed that an alternative to the account-by-
account ``chiefly compensated'' calculation was desirable. \108\ Some 
argued, however, that the alternative that the Commission adopted in 
Exchange Act Rule 3a4-2 was unduly restrictive and in practice would 
not provide meaningful relief from the account-by-account calculation. 
In particular, several commenters stated that the procedural conditions 
in the exemption essentially require an account-by-account calculation, 
thereby defeating the purpose of the exemption.\109\
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    \108\ See, e.g., Banking Agencies letter and BSA letter.
    \109\ See, e.g., Banking Agencies letter; BONY letter; Bank One 
letter; Federated letters; Fleet letter; ICBA letter; Mellon letter; 
PNC letter; Regions letter; and UMB Bank letter. Commenters 
expressed concern about the costs and burdens associated with these 
requirements. See, e.g., Mellon letter. One commenter suggested 
eliminating one of the procedural conditions so that banks could 
adopt an across-the-board fee increase without triggering an 
account-by-account compliance review. See Federated letters.

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[[Page 39695]]

ii. Description of Proposed Line-of-Business Exemption
    In response to comments, we propose to adopt a ``line-of-business'' 
approach in proposed Exchange Act Rule 721.\110\ The proposal would 
define a ``line of business'' as an identifiable department, unit, or 
division of a bank organized and operated on an ongoing basis for 
business reasons with similar types of accounts and for which the bank 
acts in a similar type of fiduciary capacity as listed in Exchange Act 
Section 3(a)(4)(D).\111\ Under the proposal, a bank could use an 
alternative calculation for ``chiefly compensated'' during one year if 
it could demonstrate that during the preceding year its ratio of 
``sales compensation'' to ``relationship compensation'' was no more 
than one to nine either on a line-of-business or bank-wide basis (i.e., 
``one to nine ratio'').\112\
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    \110\ See proposed Exchange Act Rule 721(c). We do not expect 
banks to be in compliance with the ``chiefly compensated'' condition 
during the delayed compliance period for the Interim Rules. 
Moreover, given that the exemption we are proposing under Exchange 
Act Rule 721 depends on compliance during the preceding year, this 
condition would not apply during the first year that the broker 
exceptions apply to banks. Of course, banks would be expected to 
demonstrate compliance at the end of the first year after the 
delayed compliance period. Then, by demonstrating year-end 
compliance, a bank would have legal certainty for the following year 
under the terms of the proposed exemption.
    \111\ See proposed Exchange Act Rule 724(e).
    \112\ We are proposing a one to nine ratio, which is similar to 
the test in the Interim Rules, because we understand that many banks 
would fit within this proposed exemption using this threshold. See 
Exchange Act Release No. 44291, supra note 13. A one to nine ratio 
allows banks to receive slightly more than ten percent in sales 
compensation and not run afoul of the proposed exemption. The 
proposal would require that the comparison be made based on 
compensation from accounts within the scope of Exchange Act Section 
3(a)(4)(D). For this exception and all of the proposed related 
exemptions, year continues to be defined as a calendar year or other 
fiscal year consistently used by a bank for recordkeeping and 
reporting purposes.
---------------------------------------------------------------------------

    A bank could use this proposed alternative on a line-of-business 
basis provided that the ``sales compensation'' and ``relationship 
compensation'' from all trust and fiduciary activity accounts within a 
particular line of business (or all such accounts within a particular 
line of business established before a single date certain) is used to 
determine whether the bank meets this condition.
    For example, the bank could limit the accounts in a personal trust 
line of business that would be used in the line-of-business 
compensation comparison to all of the accounts established before a 
single date certain. The enhanced flexibility in this part of the 
proposal would permit a bank to phase in the use of account-by-account 
exemptions for qualifying fiduciary activities as long as the bank 
establishes a specific cut-off date for older accounts within a line of 
business. This flexibility also should allow them to use this proposal 
consistent with their changing business practices.
    Banks relying on the proposed line-of-business alternative would be 
required to meet the other conditions in the trust and fiduciary 
activities exception and would be required to maintain procedures 
reasonably designed to ensure that, before opening or establishing an 
account, the bank reviews the account to ensure that the bank is likely 
to receive more ``relationship compensation'' than ``sales 
compensation'' with respect to that account.\113\ In addition, in 
contrast to the requirement in current Exchange Act Rule 3a4-2 that the 
bank review an existing account whenever the compensation arrangement 
for the account changes, the proposal would only require the bank to 
maintain procedures reasonably designed to ensure that, after opening 
or establishing an account, at such time as the bank individually 
negotiates with the accountholder or beneficiary of that account to 
increase the proportion of ``sales compensation'' as compared to 
``relationship compensation,'' the bank reviews the account to ensure 
that the bank is likely to receive more ``relationship compensation'' 
than ``sales compensation'' with respect to that account.\114\ In other 
words, only when the bank is revising the fees of a particular account 
with the accountholder or beneficiary in a way that would increase the 
proportion of ``sales compensation,'' would it also have to review the 
account to ensure that it is likely to receive more ``relationship 
compensation'' than ``sales compensation.'' \115\
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    \113\ See proposed Exchange Act Rule 721(a)(3).
    \114\ See proposed Exchange Act Rule 721(a)(4). This proposed 
requirement would not be triggered, for example, when the fees 
received by the bank change due to changes in assets or asset 
allocation, or if the bank makes across-the-board changes in fees to 
address inflation.
    \115\ We also propose to eliminate the requirement in current 
Exchange Act Rule 3a4-2 that a bank review an account when sales 
compensation is reviewed for purposes of determining an employee's 
compensation. See Exchange Act Rule 3a4-2(a)(2)(iii).
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    The proposed line-of-business alternative is intended to give banks 
legal certainty for each year based on their demonstrated compliance 
for the previous year.
    We request comment on the line-of-business alternative in proposed 
Exchange Act Rule 721. Generally, would the proposed line-of-business 
alternative make it easier for banks to comply with the ``chiefly 
compensated'' condition? If so, please provide quantitative information 
regarding the cost savings banks that choose the line-of-business 
alternative could expect versus the account-by-account calculation. In 
this regard, we request comment on how banks are generally compensated 
with respect to their existing trust and fiduciary activity accounts. 
The one to nine ratio is essentially the same comparison used in the 
Interim Rules, but expressed as a ratio rather than as a percentage to 
align the comparison in the proposed rules more closely with the 
``chiefly compensated'' condition in the statute. We request comment on 
whether the use of a ratio makes the comparison more clear, or whether 
the comparison should be expressed as a percentage. We also request 
comment on whether a one to nine ratio (or, if expressed as a 
percentage, 11 percent) is the most appropriate comparison, if a one to 
ten ratio would be sufficient to accommodate banks' current business, 
or if another ratio would be more practicable. Commenters should 
include specific information on each particular bank's ``sales 
compensation'' compared to its ``relationship compensation.''
    In addition, we request comment on what impact the expanded 
definition of ``relationship compensation,'' which would now include 
separately charged assets under management fees for managing other 
assets (such as real property, oil and gas, etc.), would have on banks' 
ability to meet the proposed line-of-business alternative.\116\
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    \116\ See proposed Exchange Act Rule 724(h) and section 
III.B.1.h infra.
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    Further, we solicit comment on the procedural requirement that a 
bank review an account when the proportion of ``sales compensation'' is 
increased, and the impact of this condition on waiving ``relationship 
compensation'' for a particular account.\117\ Is there an alternative 
that would allow for fee waivers without allowing the bank to be 
continually compensated by a significant number of accounts entirely 
through ``sales compensation''?
---------------------------------------------------------------------------

    \117\ See proposed Exchange Act Rule 721(a)(4).
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    We also request comment on what impact the requirement that the 
bank use the compensation from all trust and fiduciary activity 
accounts within a particular line of business would have on the bank's 
ability to use the other exemptions proposed in this release,

[[Page 39696]]

such as the exemptions in proposed Exchange Act Rules 720 and 776. In 
particular, we solicit comment on whether living, testamentary, and 
charitable trust accounts are grouped with other non-exempt accounts in 
a line of business. We also request comment on whether banks place 
employee benefit plan accounts and other accounts not subject to a 
special purpose exemption within a particular line of business. Banks 
that believe they will need additional flexibility for their personal 
trust and retirement business should provide a detailed explanation of 
the type of relief they believe would be useful and discuss the sources 
of their compensation in connection with that business. In addition, we 
request comment on whether the definition of line of business is 
practicable. Is this definition subject to manipulation by banks that 
may have difficulty meeting the line-of-business test in a particular 
year, and if so, how should it be modified to prevent this?
    We also request comment on whether it is appropriate that banks be 
permitted to use the proposed line-of-business alternative for some 
lines of businesses, and use an account-by-account calculation or other 
proposed exemptions for its other lines of business if available. In 
addition, we request comment on whether it is appropriate for banks to 
choose whether to use this proposed exemption for particular accounts 
based on a cut-off date that the bank determines.
    Bank representatives informed Commission staff that it would be 
simpler and more cost effective if banks were permitted to compare 
``sales compensation'' to a bank's total trust and fiduciary activities 
compensation rather than to ``relationship compensation.'' Presumably, 
total trust and fiduciary activities compensation would include 
``relationship compensation,'' ``sales compensation,'' and any 
compensation that a bank receives for the sale of other products and 
services. We are soliciting comment on the feasibility and desirability 
of amending the ``one to nine ratio'' in the line-of-business 
calculation to require banks to compare their ``sales compensation'' to 
their total compensation from qualifying fiduciary activities, as 
opposed to the current comparison of ``sales compensation'' to 
``relationship compensation.'' What ratio would be appropriate if the 
basis were expanded?
    In particular, we solicit comment on what compensation items, in 
addition to ``sales compensation'' and ``relationship compensation,'' 
would be included in a bank's total compensation for qualifying 
fiduciary activities and the quantitative impact of including these 
compensation items on the line-of-business proposal. In addition, what 
impact, if any, would such a change in the calculation have on the 
number of banks that could meet the trust and fiduciary activities 
exception? Moreover, what would be the cost savings to banks in 
complying with the ``chiefly compensated'' condition if we were to 
permit banks to compare ``sales compensation'' to total compensation 
rather than to ``relationship compensation?'' We would like to know the 
types of compensation that banks would include in total compensation 
from qualifying fiduciary activities. To evaluate the recommendation 
that we permit banks to compare ``sales compensation'' to total 
compensation for trust and fiduciary activities, we are soliciting 
quantitative information from banks that would illustrate how such a 
bank would fare under each of the tests.\118\ What other changes, if 
any, do commenters believe should be made to the ``chiefly 
compensated'' calculation?
---------------------------------------------------------------------------

    \118\ To the extent that such information would be deemed 
proprietary, banks could request confidential treatment for that 
information.
---------------------------------------------------------------------------

    Finally, we are seeking comment on the way in which banks are 
likely to use the proposed calculation alternatives to determine 
whether additional flexibility is needed in this particular exemption 
and how best to provide it. For example, do banks have lines of 
business containing both accounts covered by the special purpose 
exemptions (e.g., for Regulation S or employee benefit plan accounts) 
and accounts that are not? If so, which lines of business contain both 
types of accounts?
e. Proposed New Living, Testamentary, and Charitable Trust Account 
Exemption
    Commenters indicated that banks need flexibility with respect to 
established personal trust accounts that have terms that cannot readily 
be changed without consequences to both the bank and the trust 
beneficiaries. These commenters explained that fees received in 
connection with these accounts were negotiated in the past and may be 
difficult to change to meet the ``chiefly compensated'' condition based 
on, for example, the age or type of the trust.\119\ Banks may 
administer trusts that were created by settlors who have died or who 
may have become incompetent. In addition, we understand that state law 
may make it impracticable to change the compensation structure of 
existing trusts.
---------------------------------------------------------------------------

    \119\ See, e.g., Banking Agencies Letter and NYCH letter.
---------------------------------------------------------------------------

    In response to these concerns, we are proposing new Exchange Act 
Rule 720. This proposed rule would exempt a bank from meeting the 
``chiefly compensated'' condition to the extent that it effects 
transactions for a living, testamentary, or charitable trust account 
opened, or established before July 30, 2004, in a trustee or fiduciary 
capacity if the bank does not individually negotiate with the 
accountholder or beneficiary of the account to increase the proportion 
of ``sales compensation'' as compared to ``relationship compensation'' 
after July 30, 2004.\120\ For purposes of this proposed rule, a 
testamentary trust may be deemed to be established as of the date of 
the will that directed that the trust be established. Banks making an 
account-by-account calculation that rely on a particular exemption must 
comply with all of the requirements in that exemption, but have the 
option of choosing the exemption or exemptions they need to match their 
business.
---------------------------------------------------------------------------

    \120\ This date was chosen for administrative simplicity.
---------------------------------------------------------------------------

    We invite comment on the proposed exemption for existing personal 
trust accounts. Banks are particularly invited to explain the ways in 
which they are compensated for administering existing personal trust 
accounts.
f. New Conditional Safe Harbor
    We also propose to adopt a one-year conditional safe harbor for a 
bank that exceeds the one to nine ratio that it would need to meet to 
rely on the line-of-business alternative in proposed Exchange Act Rule 
721.\121\ Under this safe harbor, a bank that exceeds the one to nine 
ratio in any given year may continue to rely on the proposed line-of-
business alternative for the following year if it meets three 
requirements.\122\ First, it must meet the other requirements of the 
rule and the other requirements of the trust and fiduciary activities 
exception. Second, the bank's ratio of ``sales compensation'' to 
``relationship compensation'' the bank received from its qualifying 
fiduciary business must have been no more than one to seven.\123\ 
Third, it may not have relied on this safe harbor during any of the 
five preceding years.
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    \121\ See proposed Exchange Act Rule 721(b).
    \122\ See supra note 112 for a discussion of the term ``year.''
    \123\ The one to seven ratio is intended to provide legal 
certainty to banks that are working in good faith to comply with the 
terms of the proposed exemption.
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    Used in conjunction with the line-of-business alternative, 
discussed above,

[[Page 39697]]

this proposed new safe harbor should provide banks with time to adjust 
their ``sales compensation,'' when necessary, to ensure that it does 
not exceed the exemption's limit. For example, a bank that finds its 
``sales compensation'' is likely to exceed the one to nine compensation 
ratio could begin to adjust its compensation immediately. The legal 
assurance that it would have time to make this adjustment without 
consequence should permit banks to refine their compensation 
sufficiently to assure that they will remain in compliance.
    This new safe harbor should supplement the rule's general exemption 
in addressing banks' concerns that if they inadvertently exceed the 
exemption's ``sales compensation'' percentage in one year, they would 
immediately need to conduct an account-by-account analysis to determine 
whether they are in compliance with the ``chiefly compensated'' 
condition. We understand that banks relying on proposed Exchange Act 
Rule 721 may not have compliance procedures in place to do account-by-
account monitoring. Banks could rely on the proposed new safe harbor 
for one year while taking steps to ensure that they will meet the terms 
of the general exemption before the end of that year.\124\
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    \124\ These steps could include employing brokers to execute 
transactions for trust and fiduciary activity accounts, or charging 
those accounts only a flat or capped per order processing fee equal 
to not more than the cost incurred by the bank in connection with 
executing securities transactions for trustee and fiduciary 
customers. A bank could also rebate 12b-1 fees to the account. 
Alternatively, the bank could restructure the compensation from some 
or all of its trust and fiduciary activity accounts to change the 
proportion of ``relationship compensation'' by reducing the price it 
charges for executing transactions, executing transactions at cost 
so the reimbursement would be characterized as ``relationship 
compensation,'' or raising the bank's annual fee and offering 
unlimited securities transactions at no additional cost to the 
account.
    A bank could implement any, or several, of these alternatives at 
any time during the year. For example, a bank might identify a 
problem in November of a calendar year that it finds is caused by a 
large account with high ``sales compensation'' that would likely 
cause the bank to fail its compensation comparison. The bank could 
waive securities transaction fees, or refund fees already charged to 
the account. The bank could also restructure the compensation in the 
account by not charging for additional securities transactions, or 
by converting to an annual fee that includes unlimited transactions.
---------------------------------------------------------------------------

    We invite comment on the proposed one-year safe harbor in proposed 
Exchange Act Rule 721, including whether an additional year is a 
sufficient amount of time and whether one to seven is the appropriate 
ratio.
g. New Proposed Account-by-Account Exemption
    Proposed Exchange Act Rule 722 would provide banks with a new 
exemption designed to give additional flexibility and legal certainty 
to banks that determine their compliance with the ``chiefly 
compensated'' requirement on an account-by-account basis.
    i. Proposed Account-by-Account Exemption
    Proposed Exchange Act Rule 722 is intended to provide banks that 
determine compliance with the ``chiefly compensated'' condition through 
an account-by-account calculation with legal certainty for one year 
based on their demonstrated compliance for the previous year. Under 
proposed paragraph (a) of Rule 722, a bank would be exempt from the 
``chiefly compensated'' condition with respect to a particular account 
during any year if it meets four conditions. First, the bank would be 
required to meet the other conditions of the trust and fiduciary 
activities exception. Second, the bank must have met the ``chiefly 
compensated'' condition with respect to that particular account during 
the preceding year.\125\ Third, a bank would be required to maintain 
procedures reasonably designed to ensure that, before opening or 
establishing an account, the bank reviews the account to ensure that 
the bank is likely to receive more ``relationship compensation'' than 
``sales compensation'' with respect to that account. Fourth, a bank 
would be required to maintain procedures reasonably designed to ensure 
that, after opening or establishing an account, at such time as the 
bank individually negotiates with the accountholder or beneficiary of 
that account to increase the proportion of ``sales compensation'' as 
compared to ``relationship compensation,'' the bank reviews the account 
to ensure that the bank is likely to receive more ``relationship 
compensation'' than ``sales compensation'' with respect to that 
account.
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    \125\ This condition would not apply during the first year that 
the broker exceptions apply to banks. During that first year, banks 
will be expected to demonstrate compliance at the end of the year. 
By demonstrating compliance during the first year that the broker 
exceptions are implemented for banks, a bank will have legal 
certainty for the following year under the terms of the exemption.
---------------------------------------------------------------------------

    We request comment on the proposed exemption. Banks are 
particularly invited to discuss the extent to which the proposed 
exemption would provide them with legal certainty. In addition, we are 
seeking comment from those who believe that the account-by-account 
calculation should be eliminated. In particular, we invite comment on 
how banks would satisfy the ``chiefly compensated'' requirement of the 
trust and fiduciary exception in the absence of an account-by-account 
calculation requirement.
ii. New Safe Harbor for Account-Specific Exemption
    Commenters expressed concern that banks that determine their 
compliance with the ``chiefly compensated'' condition on an account-by-
account basis would need flexibility if they discovered that their 
``sales compensation'' for a particular account had exceeded their 
``relationship compensation'' in a particular year.\126\ To mitigate 
banks' compliance concerns, we are proposing a one-year conditional 
safe harbor for a bank that does not meet the ``chiefly compensated'' 
requirement with respect to a particular account.\127\ This new safe 
harbor would provide a bank the time to bring its compensation 
arrangements for that account into compliance with the ``chiefly 
compensated'' condition.
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    \126\ Some commenters indicated that occasionally, prudent 
financial management of an individual customer account, such as a 
position concentration, could result in a particular account 
exceeding the chiefly compensated requirement in a particular year. 
For example, a bank could need to lessen a customer's concentration 
in a particular investment. See, e.g., Banking Agencies Letter.
    In addition, the Banking Agencies, bank trade associations and a 
law firm stated that banks would be at risk of unintentionally 
violating the securities laws because a bank can fall out of 
compliance with the exception for the preceding year based on one 
account without any type of cure period. See Roundtable letter and 
Wilmer, Cutler letter.
    We note that there are many ways that a concentrated portfolio 
may be diversified without incurring high transaction payments to 
the bank.
    \127\ See proposed Exchange Act Rule 722(b) and (c). This 
alternative safe-harbor is not necessary until after the first year 
that the bank broker exceptions apply.
---------------------------------------------------------------------------

    Under the proposed safe harbor, a bank with one or more accounts 
that exceed the ``chiefly compensated'' requirement could continue to 
rely on the trust and fiduciary activities exemption in the next year 
for these ``sales compensation'' accounts so long as these accounts 
represent ten percent or less of the total number of accounts for which 
the bank acts in a trustee or fiduciary capacity.\128\ A bank relying 
on this exemption would need to meet two requirements. First, it must 
meet the other requirements of the rule, as well as the other 
requirements of the trust and fiduciary activities exception. Second, 
the bank may not have relied

[[Page 39698]]

on this safe harbor with respect to the particular ``sales 
compensation'' account during any of the five preceding years.
---------------------------------------------------------------------------

    \128\ The ten percent limitation is intended to provide legal 
certainty to banks that are working in good faith to comply with the 
terms of the proposed exemption.
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    This safe harbor is intended to provide banks with time to 
restructure the compensation arrangement with respect to a particular 
account or accounts. It would not require banks to expand or otherwise 
modify their overall compliance procedures. Rather, it would permit 
them to target particular accounts and adjust their compensation 
accordingly.
    We would expect banks to use the safe harbor period to ensure that 
their new compensation arrangement with respect to the ``sales 
compensation'' account will allow them to meet the ``chiefly 
compensated'' condition in the future for that account. While this 
should theoretically mean that an account that exceeds the ``chiefly 
compensated'' threshold would not exceed that threshold again, the 
character of an account can change over time. Therefore, the safe 
harbor would be available for a bank to use for the same account once 
every five years.
    Banks that choose to calculate their compliance with the ``chiefly 
compensated'' condition on an account-by-account basis will need to 
have systems in place to monitor their own compliance. We would expect 
banks' systems to ensure that few accounts actually exceed the 
``chiefly compensated'' threshold. While the proposed safe harbor would 
permit up to ten percent of a bank's trust and fiduciary activities 
accounts to exceed the compensation threshold in a given year, we would 
expect banks to monitor their compliance closely enough that their 
percentage of non-complying accounts remains small. We request comment 
on the ten percent limit. Banks that believe the limit should be higher 
are encouraged to discuss what limit would be consistent with the 
compliance systems they plan to put in place.
    In addition to the general one-year safe harbor, we are proposing 
to give additional flexibility to banks when a small number of accounts 
do not meet the ``chiefly compensated'' condition more frequently than 
once in a five-year period. Under this proposal, a bank can continue to 
be exempt even though the lesser of 500 accounts or 1 percent of the 
total number of its qualifying fiduciary activity accounts continued 
not to meet the ``chiefly compensated'' condition, provided the bank 
has documented the reason that each such account continued not to meet 
the condition and linked that reason to the bank's exercise of 
fiduciary responsibility.\129\
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    \129\ See proposed Exchange Act Rule 722(c)(4). For example, 
during a particular year, an accountholder may have unexpectedly 
inherited a large number of shares of stock that a trust instrument 
required to be deposited into an account for which the bank was 
acting in a trust or fiduciary capacity. This proposed threshold is 
intended to provide banks that are working in good faith to comply 
with the provisions of the proposed exemption with an additional 
safety valve.
---------------------------------------------------------------------------

    Commenters are invited to discuss the utility of the proposed safe 
harbors and whether they would provide banks with sufficient legal 
certainty. We also request comment on whether the general limit on 
using the exemption once every five years for a particular account 
together with the additional flexibility for a few accounts that 
exceeded the ``chiefly compensated'' condition more than once in a 
five-year period would provide banks with sufficient flexibility while 
remaining consistent with the statutory purpose. We also solicit 
comment on the additional safe harbor for a small number of accounts 
that fail the ``chiefly compensated'' test more than once in a five-
year period and on whether the lesser of 500 or one percent of the 
total number of a bank's qualifying accounts is the appropriate 
threshold. Banks likely to need additional flexibility are invited to 
include a discussion of their planned compliance systems.
h. Other Provisions
i. ``Chiefly Compensated'' and Related Definitions
    In addition to expanding the exemptions to facilitate banks' 
compliance and eliminate unnecessary burdens, we are proposing several 
technical changes to the definitions and proposing to expand the 
definition of ``relationship compensation.'' Otherwise, we are not 
proposing to change substantially the definition of ``chiefly 
compensated'' or related definitions. The technical changes to these 
rules are intended to simplify and clarify the definitions. Moreover, 
we believe the proposed exemptions discussed above should address many 
of the practical problems commenters noted in discussing these 
definitions.\130\
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    \130\ For example, we address commenters' concerns about 
defining Rule 12b-1 fees as ``sales compensation'' by proposing 
amendments to simplify the exemption in Exchange Act Rule 3a4-2 to 
allow banks to compare ``sales compensation'' to ``relationship 
compensation'' derived from its trust and qualifying fiduciary 
activity accounts on a line-of-business basis and proposing a 
separate exemption in proposed Exchange Act Rule 770. We also note 
that an investment company may restructure its fee arrangement to 
pay shareholder servicing fees that are not being paid for sales or 
distribution outside of a Rule 12b-1 plan. This type of fee 
arrangement is unrelated compensation under the Interim Rules rather 
than ``sales compensation.'' We also propose to replace the term 
``trust or fiduciary account'' with the term ``an account for which 
the bank acts in a trustee or fiduciary capacity.'' Because this 
language more closely matches the statutory language in the trust 
and fiduciary activities exception, it should reduce confusion.
    We also note that the definition of ``sales compensation'' 
includes revenue sharing payments. As we discussed in proposing 
targeted disclosure requirements for broker-dealers selling mutual 
funds, revenue sharing arrangements not only pose potential 
conflicts of interest for the recipient, but also may have the 
indirect effect of reducing investors' returns by increasing the 
distribution-related costs incurred by funds. See Exchange Act 
Release No. 49148 (Jan. 29, 2004), 69 FR 6437 (Feb. 10, 2004). 
Revenue sharing arrangements may give broker-dealers heightened 
incentives to market the shares of particular mutual funds, or 
particular classes of fund shares. These incentives may be reflected 
in the use of ``preferred lists'' that explicitly favor the 
distribution of certain funds, or they may be reflected in other 
ways, including incentives or instructions to employees of a bank or 
broker-dealer. The magnitude of revenue sharing payments--estimated 
in 2001 at $2 billion annually--suggests that those arrangements 
influence the mutual fund choices presented to investors. See ``How 
high can costs go?,'' Institutional Investor, May 2001 at 56.
---------------------------------------------------------------------------

    The expansion of the definition of ``relationship compensation'' 
that we are proposing would add types of assets that could qualify for 
assets under management fees paid directly by the customer, 
beneficiary, or account. This amended definition would include, for 
example, separately charged assets under management fees for managing 
real property, and would affect the ratio in the line-of-business 
exemption in proposed Exchange Act Rule 721 discussed above.\131\ While 
the original definition of ``relationship compensation'' required the 
bank to be engaged in securities management activities for these fees 
to be included in the definition, we propose this change to address 
banks' accounting and systems concerns that it would be difficult to 
treat assets under management fees differently for managing different 
types of assets.
---------------------------------------------------------------------------

    \131\ Banks determining compliance on an account-by-account 
basis would not need to consider accounts that did not contain 
securities, such as an account that only contained real estate, 
since broker-dealer registration is not necessary for these 
accounts.
---------------------------------------------------------------------------

    One commenter urged the Commission to amend the definition of 
``flat or capped per order processing fee equal to not more than the 
cost incurred by the bank in connection with executing securities 
transactions for trustee and fiduciary customers;'' in current Exchange 
Act Rule 3b-17(b) to allow banks to include the cost of shared 
resources as opposed to the ``exclusively dedicated'' standard in the 
Interim Rules.\132\ In response, we propose to amend the definition to

[[Page 39699]]

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

    \132\ See ABA/ABASA letters.
---------------------------------------------------------------------------

    We request comment on these proposed amendments to the definitions. 
Commenters are invited to discuss whether the ``sales compensation'' 
definition should include additional sales-related arrangements that 
may create conflicts of interest, such as sales or distribution-related 
payments to affiliates or employees of banks. We also invite banks to 
provide us with any specific information on their compensation 
arrangements that might help us to further simplify the ``chiefly 
compensated'' calculation while implementing the statutory provisions.
ii. Formulas to Allocate Sales Compensation to Individual Accounts
A. 12b-1 Fees
    Rule 12b-1 under the Investment Company Act permits investment 
companies to use their assets to finance sales-related expenses.\133\ 
Unlike fees for assets under management by the bank, which do not 
differ depending on the investment that the bank selects, Rule 12b-1 
fees paid to banks and other distributors often vary from investment 
company to investment company. Rule 12b-1 fees create incentives to 
distribute particular investment company securities and create 
conflicts between the bank and investors. Such conflicts of interest 
drive much of broker-dealer regulation. Accordingly, Rule 12b-1 fees 
are included in the ``sales compensation'' definition.\134\
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    \133\ See Investment Company Act Release No. 11414, 45 FR 73898 
(Nov. 7, 1980).
    \134\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
at 27775.
---------------------------------------------------------------------------

    Commenters pointed out that because Rule 12b-1 fees are paid based 
on the amount of assets in an omnibus account, it would be difficult to 
allocate such fees on an account-by-account basis.\135\ We therefore 
propose to add a formula to the definition of ``sales compensation'' in 
proposed Exchange Act Rule 724 to allow banks to estimate the amount an 
individual account pays annually in Rule 12b-1 fees that are paid on an 
entity basis. The proposed formula would allow a bank to calculate the 
Rule 12b-1 fees for each account using one of two methods. First, a 
bank could calculate the 12b-1 fees based on the number of each class 
of an investment company's shares held in each account on the last 
business day of the preceding year, multiplied by the net asset value 
per share on that day and by the annual Rule 12b-1 fee rate applicable 
to that class of securities. Alternatively, a bank could use another 
allocation method if it fairly and consistently measures the amount of 
``sales compensation'' attributable to each account during the 
preceding year.\136\
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    \135\ See NYCH letter and PNC Bank letter. We note, however, 
that in connection with E*Trade's Rule 12b-1 fee rebate program, 
E*Trade explains its fifty percent rebate formula as follows: ``For 
example, if the average daily value of your eligible mutual fund 
holdings for the year is $200,000 and we receive 12b-1 fees at the 
annual rate of 0.25% (25 basis points) from the funds you selected, 
you would receive an annual rebate of $250 (0.0025 x $200,000/2).'' 
See (https://us.etrade.com/e/t/home?SC=LBH4249).
    \136\ We chose the year-end formula to allow banks performing 
the ``chiefly compensated'' calculation on an account-by-account 
basis to make a reasonable estimate, consistent with the chiefly 
timeframe, of the amount of 12b-1 fees paid by an account during the 
preceding year. The proposed formula also is intended to provide 
banks with the additional flexibility to measure the changing value 
of an account during the year to determine the amount of 12b-1 fees 
paid by that account, provided that the bank uses the same fair 
method for each account.
---------------------------------------------------------------------------

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

B. Other Fees

    We also propose to amend the definition of ``sales compensation'' 
in proposed Exchange Act Rule 724(i)(4) and (6) to allow a bank to 
estimate the amount that it receives annually that is attributable to 
an individual account, but that is not paid directly from the account. 
This formula would allow a bank to calculate these fees for each 
account by using one of two methods. First, a bank could divide the 
number of shares of each class of each type of investment company held 
in each account on the last business day of the preceding year by the 
total number of the same type of investment company shares that the 
bank held in a trustee or fiduciary capacity on the same day, and 
multiply the resulting number by the total dollar amount of these fees 
the bank received in connection with that class during the preceding 
year. Second, a bank could use its own method of allocation if it 
fairly and consistently measures the amount of ``sales compensation'' 
attributable to each account during the preceding year. \137\
---------------------------------------------------------------------------

    \137\ See id. for a discussion of the reasons why we are 
proposing this formula.
---------------------------------------------------------------------------

    We request comment on the proposed formula. Commenters are invited 
to discuss whether it will facilitate banks' allocation of these fees 
to individual accounts. We also invite comment on whether there would 
be a simpler method that would provide a reasonably accurate allocation 
of these fees to individual accounts. We also invite comment on how to 
address the problem of the sale of shares at the end of the year. For 
example, an account that held a substantial proportion of a bank's 
total holdings in a given fund for most of a year, but whose shares 
were sold just before year-end, may be allocated none of the bank's 
fees earned from that fund. At the same time, an account with 
relatively small holdings in the same fund that did not sell at the end 
of the year might be allocated a disproportionately large amount of the 
bank's fees earned from that fund. In addition, we invite comment on 
whether this formula should be revised to make it more consistent with 
other proposals on which the Commission is currently seeking comment 
regarding revenue sharing payments that occur at the fund complex 
level, as opposed to the fund level.\138\ Commenters are specifically 
requested to consider whether the formula should compare the value of 
the account with the value of all assets held by the bank in a fund 
complex if revenue sharing is paid on a fund complex basis.
---------------------------------------------------------------------------

    \138\ See infra note 405.
---------------------------------------------------------------------------

iii. Indenture Trustee Exemption
    Exchange Act Rule 3a4-3 currently provides a limited exemption from 
broker registration for a bank that serves

[[Page 39700]]

as an indenture trustee in a no-load money market fund, provided that 
it meets certain conditions. Comments we received on this rule 
criticized its utility in part based on the definition of ``indenture 
trustee,'' which is currently codified in Exchange Act Rule 3b-17.\139\ 
For example, two commenters recommended that we expand the ``indenture 
trustee'' definition to include trustees appointed pursuant to pooling 
and servicing agreements, trust agreements, bond resolutions, and 
mortgages, given that, according to these commenters, documents 
appointing trustees generally are not limited to indentures.\140\
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    \139\ 17 CFR 240.3b-17(c). Current Exchange Act Rule 3a4-3 
permits banks to effect transactions as indenture trustees in no-
load money market funds without meeting the ``chiefly compensated'' 
condition in the trust and fiduciary activities exception.
    \140\ See ABA/ABASA letters and Bank One letter.
---------------------------------------------------------------------------

    In lieu of modifying the ``indenture trustee'' definition (which we 
are proposing to move to Exchange Act Rule 724), as discussed 
previously, the Commission is proposing a broad general exemption 
(proposed Exchange Act Rule 776) that would permit banks to effect 
transactions for qualified investors and certain other investors in 
money market funds.\141\ As discussed below, we propose to eliminate 
the definition of ``trustee capacity,'' which defined the term to 
include the capacity of a trust indenture trustee. As a result, banks 
acting in an indenture trustee capacity would not need to look to the 
definition of ``indenture trustee'' to determine whether they qualify 
for the trust and fiduciary activities exception.
---------------------------------------------------------------------------

    \141\ See Section III.F.1 supra for discussion of proposed 
Exchange Act Rule 776, under which banks not acting in an indenture 
trustee capacity could effect transactions for customers who are 
``qualified investors'' and customers for whom they act in a trustee 
or fiduciary capacity or in certain escrow capacities in money 
market funds, including those that charge a ``load.''
---------------------------------------------------------------------------

    We propose to move the definition of ``indenture trustee'' to 
proposed Exchange Act Rule 724(c), where the term would be defined for 
purposes of the exemption in proposed Exchange Act Rule 723, which 
would provide an exemption from the ``chiefly compensated'' calculation 
for banks to effect transactions as an indenture trustee in no-load 
money market funds. While the exemption would still be available on the 
same terms as before, we believe that banks acting as indenture 
trustees may opt for the exemption in proposed Exchange Act Rule 776.
    We request comment on proposed Exchange Act Rule 723. Commenters 
are specifically invited to discuss whether the exemption would be 
necessary if we adopt proposed Exchange Act Rule 776.
2. Definition of ``Trustee Capacity'' and Indenture Trustees
    We received numerous comments on the definition of ``trustee 
capacity,'' which was included in the Interim Rules to clarify that for 
purposes of the trust and fiduciary activities exception, the term 
includes indenture trustees and trustees for tax-deferred account 
described in sections 401(a), 408, and 408A under subchapter D and in 
section 457 under subchapter E of the Internal Revenue Code of 1986 (26 
U.S.C. 1, et seq.) \142\ Some commenters supported the definition's 
provision of legal certainty for indenture trustees and trustees for 
certain tax-deferred accounts.\143\ However, some commenters urged the 
Commission to expand the definition to cover banks acting as custodial 
trustees for Individual Retirement Accounts (``IRAs'').\144\ Commenters 
also indicated that the definition should cover both indenture trustees 
operating under appointive documents other than indentures, and 
indenture trustees serving on issues or transactions outside those 
delineated in the Interim Rules.\145\ Some commenters urged the 
Commission to withdraw the definition of ``trustee capacity'' and 
instead interpret the trust and fiduciary activities exception to cover 
all types of ``trustees.'' \146\ Several commenters indicated that 
defining ``trustee capacity'' as including an indenture trustee or a 
trustee for certain tax-deferred accounts may create ambiguity by 
suggesting that other ``trustees'' may not be able to rely on the trust 
and fiduciary activities exception.\147\ One commenter took issue with 
the analysis of trustee relationships because, in the commenter's view, 
it focused on whether a bank exercises investment discretion.\148\ This 
commenter asserted that there are numerous trustee relationships in 
which a bank may not exercise investment discretion, but would still be 
subject to fiduciary duties, such as personal trusts, charitable 
foundation trusts, insurance trusts, rabbi trusts, secular trusts, 
conservatorships and guardianships.\149\ Two commenters stated that the 
governing trust instrument under state and federal fiduciary law, and 
not the Commission, should determine the nature of a trust or fiduciary 
relationship.\150\ One commenter maintained that it is unclear how 
banks could ``push out'' trust accounts to broker-dealers.\151\
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    \142\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
27767-69. See, e.g., ABA/ABASA letters; Bank One letter; Banking 
Agencies letter; BONY letter; Bar of NY letter; Fleet letter; 
KeyBank letter; Mellon letter; NASAA letter; NYCH letter; PNC 
letter; Regions letter; letter dated August 31, 2001 from Andrew 
Cecere, Vice Chairman, Private Client and Trust Services, U.S. 
Bancorp (``U.S. Bancorp letter''); Wells Fargo letter; and Zions 
Bancorporation letters.
    \143\ See, e.g., ABA/ABASA letters and Federated letters.
    \144\ See ABA/ABASA letters; Federated letters; and Wells Fargo 
letter.
    \145\ See ABA/ABASA letters.
    \146\ See, e.g., Banking Agencies letter; BONY letter; Federated 
letters; PNC letter; Roundtable letter; and Wells Fargo letter.
    \147\ See, e.g., Banking Agencies letter; BONY letter; Federated 
letters; Frost letter; Harris Trust letter; NYCH letter; PNC letter; 
Roundtable letter; UMB Bank letter; and Wells Fargo letter.
    \148\ See Roundtable letter.
    \149\ Id.
    \150\ See ICBA letter and National City letter.
    \151\ See NYCH letter.
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    After considering these comments, we propose to withdraw the 
definition of ``trustee capacity'' and not specifically identify the 
types of trustee capacities in which banks may act in reliance on the 
trust and fiduciary activities exception. This should simplify 
compliance and allow banks that effect transactions in a trustee 
capacity to continue doing so even if they do not assume significant 
fiduciary responsibilities as trustee. As discussed in more detail 
below, however, we do not propose to broaden the meaning of the term 
``trustee capacity'' to include banks acting in non-trustee capacities, 
such as IRA bank custodians, for purposes of Exchange Act Section 
3(a)(4)(B)(ii).\152\ We request comment on our proposal to eliminate 
the definition of ``trustee capacity'' and not specifically identify 
trustee capacities that would provide a basis for relying on the trust 
and fiduciary activities exception. We also request comment on whether 
additional clarification regarding the meaning of ``trustee capacity'' 
would be helpful.
---------------------------------------------------------------------------

    \152\ As discussed above and below, however, we propose other 
exemptions that may address some of the business needs of banks that 
are not trustees but act in capacities that commenters suggest 
should be recognized as such--e.g., IRA custodians, escrow agents, 
and paying agents.
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3. Interpretations of ``Fiduciary Capacity'' and ``Similar Capacity''
    The definition of ``fiduciary capacity'' in Exchange Act Section 
3(a)(4)(D) provides that a bank may qualify for the trust and fiduciary 
activities exception if it acts in certain specified fiduciary 
capacities or ``in any other similar capacity.'' In adopting the 
Interim Rules, the Commission identified several capacities from state 
uniform acts and codes that were not expressly listed in the statutory 
definition of

[[Page 39701]]

``fiduciary capacity.'' \153\ The Commission also noted that in some 
cases, state authorities used different nomenclature to refer to the 
same fiduciary capacity.\154\ The Commission did not expand the term 
``similar capacity'' to include agency activities that are not subject 
to the standards applicable under trust and fiduciary law to banks 
acting as fiduciaries.
---------------------------------------------------------------------------

    \153\ For example, the Uniform Probate Code uses the term 
``Personal Representative'' and similar successor titles in place of 
executor or administrator as the representative of a decedent. 
Similarly, under the Uniform Custodial Trust Act, the terms that are 
used for fiduciaries who act for persons who have become 
incapacitated include ``conservator'' and ``custodial trustee.''
    \154\ For example, Exchange Act Section 3(a)(4)(D)(i) refers 
only to the capacity of a ``custodian under a uniform gift to minor 
act,'' while the Uniform Transfers to Minors Act uses both the terms 
``conservator'' and ``custodian'' for fiduciaries that act for 
minors.
---------------------------------------------------------------------------

    Some commenters indicated that, because the definition of 
``fiduciary capacity'' in Exchange Act Section 3(a)(4)(D) \155\ is 
similar to the definition of the same term in regulations issued by the 
OCC,\156\ the Commission should interpret the term to include the same 
range of activities.\157\ Some commenters suggested, for example, that 
the Commission should treat banks that act as IRA custodians as if they 
were IRA trustees for purposes of the trust and fiduciary activities 
exception.\158\ Other commenters urged us to define a bank that 
performs escrow services to be acting in a similar capacity to an 
indenture trustee.\159\ Similarly, commenters have suggested that the 
Commission consider various other capacities as ``similar'' to the 
fiduciary capacities listed in the statute. Examples of such other 
capacities include escrow agent, commercial paper listing and paying 
agent, debt securities paying agent, collateral agent, custodian for 
mortgage loan files, and titleholder or qualified intermediary in like-
kind exchange transactions. As discussed above in connection with 
indenture trustees, some of these capacities would be within the scope 
of proposed Exchange Act Rule 776.
---------------------------------------------------------------------------

    \155\ 15 U.S.C. 78c(a)(4)(D).
    \156\ See 12 CFR 92(e). Notably, the range of permitted banks 
activities under the OCC's regulations is significantly broader than 
activities in which banks could engage in reliance on the trust and 
fiduciary activities exception under our definition. In particular, 
the OCC's regulations provide that a national bank may act in any 
fiduciary capacity in which national banks' competitors may act 
under the law of the state where the national bank is located. See 
66 FR 34792 (July 2, 2001). In addition to the enumerated fiduciary 
capacities, OCC staff has identified escrow agent and personal 
investment management (other than in the capacity of an investment 
adviser for a fee) as functions they believe should be added to 
those a bank may perform in reliance on the exception.
    \157\ See, e.g., July 17, 2001 ABA/ABASA letter; Banking 
Agencies letter; PNC letter; and NYCH letter. Commenters suggested 
adding to the list of permissible fiduciary capacities certain non-
fiduciary capacities such as escrow agent, commercial paper issuer, 
distribution agent, collateral agent, exchange accommodation, 
titleholder, and qualified intermediary. To the extent that any of 
these capacities do not involve effecting transactions in 
securities, a bank would not need to rely on any exception or 
exemption to engage in that activity.
    \158\ See ABA/ABASA letters; Federated letter; and Wells Fargo 
letter.
    \159\ See, e.g., ABA/ABASA letters; Compass letter; and 
Federated letters.
---------------------------------------------------------------------------

    We do not propose to identify additional capacities as similar to 
those specified in the statute because such capacities, for example the 
capacity of IRA custodian, do not involve fiduciary duties similar to 
those exercised by banks acting in true fiduciary capacities; nor are 
they trustees, which are separately identified in the statute as well 
as included within the definition of fiduciary.\160\ In addition, the 
Commission understands from discussions with bank representatives that 
many of the capacities some commenters suggest should be considered as 
``similar to fiduciary capacities'' typically do not involve investing 
in securities, but rather involve financial record keeping. While we 
recognize that some state laws may use nomenclature different from that 
used in the Exchange Act to refer to certain fiduciary capacities,\161\ 
we do not consider additional capacities that are merely the functional 
or economic equivalent of capacities listed in Exchange Act Section 
3(a)(4)(D) \162\ to be ``similar'' capacities for purposes of the 
definition of ``fiduciary capacity.'' These capacities do not 
necessarily involve fiduciary obligations or carry the same legal 
obligations as those assumed by the types of fiduciaries identified in 
the statute. Banks acting in some of these types of agency capacities, 
however, would be able to rely on the general exemption contained in 
proposed Exchange Act Rule 776.\163\
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    \160\ For example, we would not consider a bank, if effecting 
transactions in securities as an IRA custodian which may act in a 
capacity that is the functional equivalent of a directed trustee, to 
be acting in a capacity that is similar to one of the capacities 
listed in Exchange Act Section 3(a)(4)(D). In guidance to trust 
examiners, the OCC states, ``Agency service arrangements that do not 
involve the exercise of discretion or other similar 
responsibilities, such as escrow, safekeeping and custody, may be 
performed by a bank under the incidental powers of banking, without 
having trust powers.'' OCC, Handbook for Trust Examiners at 9.2600.
    \161\ See discussion of ``other similar capacity'' in Exchange 
Act Release No. 44291, supra note 13, 66 FR at 27772.
    \162\ 15 U.S.C. 78c(a)(4)(D).
    \163\ See Section III.F.1 supra.
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    In contrast to a bank's ability under banking law to engage in a 
wide variety of activities not implicating the broker-dealer 
registration requirements, a bank cannot rely on the trust and 
fiduciary activities exception to avoid being considered a broker 
merely because it is performing any function under state law that is 
permitted for a competitor of that national bank. A term does not 
necessarily have the same meaning under different statutes enacted for 
different purposes.\164\ Moreover, the purpose of the functional 
regulation approach taken in the GLBA's bank exceptions from ``broker'' 
and ``dealer'' was to ensure that broker-dealer functions outside the 
scope of certain narrow bank activities specifically identified in the 
statute will be performed by registered broker-dealers.
---------------------------------------------------------------------------

    \164\ Just as the meaning of the term ``security'' under the 
securities law does not determine the term's meaning under the 
Glass-Steagall Act, the meaning of the terms ``fiduciary capacity'' 
and ``similar capacity'' under Exchange Act Section 3(a)(4)(D) is 
not determined by meanings these terms may have been given by the 
OCC's regulations and interpretations for purposes of the federal 
banking laws. See Investment Co. Institute v. Conover, 790 F. 2d 
925, 933 n.7 (D.C. Cir. 1986) (citing Securities Industry Ass'n v. 
Board of Governors of Fed. Reserve Sys., 468 U.S. 137, 175, 104 S. 
Ct. 2979, 2999-3000, 82 L. Ed. 2d 107 (1984) (O'Connor, J., 
dissenting) as support for the proposition that the definition of 
the term ``security'' under the securities laws should be different 
than the definition under the Glass-Steagall Act because ``the 
purposes of the banking and securities laws are quite different'') 
cert. denied, Investment Co. Inst. v. Clarke, 479 U.S. 939, 107 S. 
Ct. 421, 93 L. Ed. 2d 372 (1986).
---------------------------------------------------------------------------

    We request comment on this approach. We specifically invite comment 
on any capacities similar to the fiduciary capacities listed in the 
statute in which banks assume fiduciary obligations equivalent to those 
assumed by banks acting in the listed capacities.
4. Comments on Definition of ``Investment Adviser if the Bank Receives 
a Fee for its Investment Advice'' and Proposed Amendments
    Exchange Act Section 3(a)(4)(D) defines the term ``fiduciary 
capacity'' to include acting as an ``investment adviser if the bank 
receives a fee for its investment advice.'' \165\ The Interim Rules 
defined ``investment adviser if the bank receives a fee for its 
investment advice'' to mean that a bank investment adviser provides, in 
return for a fee, continuous and regular investment advice to a 
customer's account that is based upon the individual needs of the 
customer, and that under state law, federal law, contract, or customer 
agreement, the bank owes the customer a duty of loyalty, including an 
affirmative duty to make full and fair

[[Page 39702]]

disclosure to the customer of all material facts relating to conflicts 
of interest.\166\
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    \165\ See 15 U.S.C. 78c(a)(4)(D).
    \166\ See current Exchange Act Rule 3b-17(d).
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    We received multiple comments on the definition of ``investment 
adviser if the bank receives a fee for its investment advice.'' \167\ 
One commenter stated that this definition is appropriate because it is 
consistent with current law regarding investment advisers.\168\ Another 
stated that the ``continuous and regular'' requirement is consistent 
with its understanding of how such activities are performed by bank 
trust departments.\169\ This commenter suggested that the Commission 
provide banks with a safe harbor if they review customers' accounts at 
least annually.\170\ In addition, this commenter also urged the 
Commission to take the position that periodic rebalancing of asset 
allocation models by banks would be viewed as providing ``continuous 
and regular'' investment advice.\171\
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    \167\ See, e.g., ABA/ABASA letters; Banking Agencies letter; 
Frost letter; Harris Trust letter; NASAA letter; Regions letter; 
Roundtable letter; TIAA-CREF letter; UMB Bank letter; and Wilmer, 
Cutler letter.
    \168\ See NASAA letter.
    \169\ See Federated letters.
    \170\ Id.
    \171\ Id.
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    In contrast, several commenters viewed the definition as contrary 
to their understanding of the statute, inconsistent with their 
interpretation of congressional intent, or too restrictive.\172\ One 
commenter stated that some customers may only want or need a one-time 
portfolio review.\173\ Another commenter indicated that a ``continuous 
and regular'' requirement could create undesirable pressure on banks to 
recommend inappropriately frequent transactions in a customer's 
investment account.\174\ One commenter expressed the view that banks 
should be able to provide advice that is based principally on market 
events.\175\
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    \172\ See ABA/ABASA letters; ABA Banking Law Committee letter; 
ACB letter; Banking Agencies letter; Bank One letter; BSA letter; 
Fleet letter; Frost National letter; Harris Trust letter; ICBA 
letter; IIB letter; KeyBank letter; Mellon letter; NationalCity 
letter; NYCH letter; Regions letter; Roundtable letter; TIAA-CREF 
letter; UMB Bank letter; Wells Fargo letter; and Wilmer, Cutler 
letter.
    \173\ See ICBA letter.
    \174\ See Federated letters. We note, however, that the Interim 
Rules do not require banks relying on this exception to provide 
continuous and regular advice to trade.
    \175\ See Wilmer, Cutler letter.
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    Three commenters urged the Commission to eliminate the condition 
that a bank must have a duty of loyalty to its customer.\176\ The 
Banking Agencies expressed a similar opinion.\177\ In their view, a 
duty of loyalty may arise as a consequence of a bank or other person 
acting as an investment adviser, but is not a precondition to acting as 
an investment adviser.\178\ While the Banking Agencies agreed that 
banks providing investment advice for a fee have fiduciary obligations 
to their customers, including the duty to disclose potential conflicts 
of interests, they asserted that the bank regulation and examination 
process provides the most appropriate method for ensuring banks' 
compliance with these important duties.\179\ Another commenter stated 
that a duty of loyalty is not determinative of whether an entity or an 
individual is functioning as an investment adviser.\180\ This commenter 
indicated that the duty of loyalty is derived from bank regulation, 
ERISA, federal tax law, state statutes, common law, and case law.\181\ 
Other commenters remarked that there is no need to place another duty 
of loyalty on banks under the federal securities laws.\182\ Another 
commenter stated that because disclosure of material facts relating to 
fiduciary conflicts of interest is an area that has historically been 
regulated by state fiduciary laws, it would not be appropriate for the 
Commission to scrutinize the fiduciary disclosure obligations of 
banks.\183\
---------------------------------------------------------------------------

    \176\ See ACB letter and Regions letter.
    \177\ See Banking Agencies letter.
    \178\ Id.
    \179\ Id.
    \180\ See ABA/ABASA letters.
    \181\ Id. National banks, however, are not subject to uniform 
disclosure obligations with respect to their material conflicts. The 
source of fiduciary law governing national banks' fiduciary 
relationships may include federal law, state laws, the terms of the 
instrument governing a fiduciary relationship, and any court order 
pertaining to the relationship. See OCC, Fiduciary Activities of 
National Banks, 61 FR 68543, 68544 (Dec. 30, 1996).
    \182\ See ABA/ABASA letters; ABA Banking Law Committee letter; 
and NYCH letter.
    \183\ See TIAA-CREF letter.
---------------------------------------------------------------------------

    While it appears that most banks conduct continuous and regular 
reviews of the accounts of customers to whom they provide investment 
advice for a fee, we understand that they may not necessarily 
communicate with each customer on a continuous and regular basis. 
Accordingly, we propose to revise the definition of ``acting as an 
investment adviser if the bank receives a fee for the investment 
advice'' to eliminate the implication that a bank must communicate 
continuously and regularly with customers.\184\ The revised definition 
would omit the phrase ``continuous and regular.'' Instead, the amended 
definition would provide that to rely on the exception a bank must have 
an ongoing responsibility to review, select, or recommend specific 
securities for its customers.\185\
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    \184\ See proposed Exchange Act Rule 724(d).
    \185\ This interpretation is consistent with the view expressed 
by staff of the Banking Agencies, who indicated that a bank may not 
fairly be considered to be acting as an ``investment adviser if the 
bank receives a fee for its investment advice'' unless the bank 
provides investment advice based on the particular needs of a 
customer and the bank's advice or recommendations to the customer 
concern the purchase or sale of specific securities. See appendix to 
the Banking Agencies letter at 14 (citing 12 CFR 9.101(a), and 12 
CFR 9.101(b)(2)(i) (``[a] bank does not provide `investment advice' 
merely by providing market information to customers in general.'')). 
Similarly, instructions to the Commission's Form ADV Uniform 
Application for Investment Adviser Registration explain that an 
investment adviser without discretionary authority over an account 
provides continuous and regular supervisory or management services 
with respect to the account if the adviser has ``ongoing 
responsibility to select or make recommendations, based upon the 
needs of the client, as to specific securities or other investments 
the account may purchase or sell and, if such recommendations are 
accepted by the client, [the adviser is] responsible for arranging 
or effecting the purchase or sale.'' See Form ADV: Instructions for 
Part 1A, at 4 (available at http://www.sec.gov/about/forms/formadv.pdf) (emphasis added).
---------------------------------------------------------------------------

    The proposed amendment recognizes that a bank's advice must relate 
to specific securities or other investments the customer may purchase 
or sell, and is intended to ensure that the securities transactions the 
bank effects in an investment advisory capacity are effected subject to 
the bank's fiduciary obligations that attach when it is acting as an 
investment adviser for a fee.\186\ Under the amended definition, a bank 
would be able to rely on the trust and fiduciary activities exception 
to continue to effect transactions for advisory customers such as 
mutual fund wrap account customers, provided the investment advice the 
bank provides to its wrap account customers includes the review, 
selection or recommendation of specific securities, and the 
transactions result from customers acting on the bank's advice. A bank 
providing only general asset allocation advice not relating to specific 
securities, however, could not rely on the exception to effect 
transactions resulting from that advice.
---------------------------------------------------------------------------

    \186\ See proposed Exchange Act Rule 724(d). This proposal is 
consistent with the definition in the Interim Rules. See Exchange 
Act Rule 3b-17(d).
---------------------------------------------------------------------------

    The amended definition would also retain the concept that a bank 
acting as an investment adviser for a fee has a duty of loyalty to the 
customer and must make full and fair disclosure of all conflicts. This 
duty, in part, differentiates a bank acting as an investment adviser 
from one acting as a broker.\187\ As we recently explained, an

[[Page 39703]]

investment adviser must act for the benefit of its clients and not use 
its clients' assets for its own benefit.\188\ This duty of loyalty is 
implicit in the role of an investment adviser.\189\
---------------------------------------------------------------------------

    \187\ As explained by the Supreme Court in 1963 in SEC v. 
Capital Gains Research Bureau, Inc.,
    Nor is it necessary in a suit against a fiduciary, which 
Congress recognized the investment adviser to be, to establish all 
the elements required in a suit against a party to an arm's-length 
transaction. Courts have imposed on a fiduciary an affirmative duty 
of ``utmost good faith, and full and fair disclosure of all material 
facts,'' as well as an affirmative obligation ``to employ reasonable 
care to avoid misleading'' his clients.
    SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 194 
(1963) (footnotes omitted) (citing Prosser, Law of Torts (1955), 
534-535; Keeton, Fraud--Concealment and Non-Disclosure, 15 Texas L. 
Rev. 1 (1936); 1 Harper and James, The Law of Torts 541 (1956)). In 
contrast, although a broker may have disclosure obligations with 
respect to matters entrusted to it by a client with whom it has a 
relationship of trust and confidence, absent such a relationship 
``there `is no general fiduciary duty inherent in an ordinary 
broker/customer relationship.' '' See United States v. Szur, 289 
F.3d 200 (2d Cir. 2002) (quoting Independent Order of Foresters v. 
Donaldson, Lufkin & Jenrette, Inc., 157 F.3d 933, 940 (2d Cir. 
1998)).
    \188\ See In re Alliance Capital Management, L.P., Investment 
Advisers Act Release No. 2205, Order Instituting Administrative and 
Cease-and-Desist Proceedings Pursuant to Sections 203(e) and 203(k) 
of the Investment Advisers Act of 1940 and Sections 9(b) and 9(f) of 
the Investment Company Act, Making Findings, and Imposing Remedial 
Sanctions and a Cease-and-Desist Order (Dec. 18, 2003), available at 
http://www.sec.gov/litigation/admin/ia-2205.htm (adviser's 
activities permitting inappropriate market timing were found to have 
constituted breaches of the investment adviser's fiduciary duty).
    \189\ See Investment Advisers Act Release No. 2209, Investment 
Company Act Release No. 26337, Investment Adviser Codes of Ethics 
(Jan. 20, 2004), 69 FR 4039, 4040 (Jan. 27, 2004) (proposing new 
rule and related rule amendments under the Investment Advisers Act 
of 1940 (``Investment Advisers Act'') that would require registered 
advisers to adopt codes of ethics, and citing Capital Gains Research 
Bureau at 375 U.S. 181, 181-82 for the proposition that ``[a]dvisers 
are fiduciaries that owe their clients a duty of undivided 
loyalty.'').
---------------------------------------------------------------------------

    We propose to clarify that the trust and fiduciary activities 
exception is available to a bank providing investment advice for a fee 
only if the bank does so in a fiduciary capacity in which the bank owes 
its advisory customer a duty of loyalty. In other words, a bank may 
only rely on the exception if it takes on fiduciary obligations, 
including obligations to disclose conflicts of interest and other 
material facts. This duty of loyalty requirement is inherent in the 
fiduciary obligations of a bank that is in a position to rely on the 
exception based on the bank's acting in an investment advisory 
capacity--which include a duty of loyalty to the customer for whom the 
bank is effecting securities transactions under the exception. Because 
this duty is implicit in the role of an investment adviser, the amended 
definition would not specify any particular source of such a duty, such 
as contract or state law.\190\ We request comment on the proposed 
amendments to the definition of ``investment adviser if the bank 
receives a fee for its investment advice.'' We are particularly 
interested in receiving information about activities commenters believe 
the proposed definition would, but, in the commenter's view, should 
not, preclude. We also would appreciate descriptions of any fiduciary 
obligations that banks acting in such capacities owe their customers.
---------------------------------------------------------------------------

    \190\ The duty is not established by the definition, but rather 
an element of the relationship between an investment adviser and its 
fee-paying client that must exist if the bank is to satisfy the 
definition of ``fiduciary capacity'' on that basis--that is, it is 
acting as an investment adviser for a fee.
    Of course, a fiduciary has a duty to disclose fully all material 
conflicts of interest. For guidance on the fiduciary disclosure 
obligations that characterize the status of a bank acting as an 
investment adviser for a fee, a bank seeking to rely on the 
exception may look to the disclosure obligations applicable to an 
investment adviser under the Investment Advisers Act. See 15 U.S.C. 
80b et seq. See also Rule 204-3 under the Investment Advisers Act 
and Form ADV, Part II.
---------------------------------------------------------------------------

5. Comments on ``Other Department That Is Regularly Examined by Bank 
Examiners for Compliance With Fiduciary Principles and Standards''
    Exchange Act Section 3(a)(4)(B)(ii) requires a bank to effect 
transactions in a trustee or fiduciary capacity in a trust department 
or other department that is ``regularly examined by bank examiners for 
compliance with fiduciary principles and standards.'' In adopting the 
Interim Rules, we explained that this statutory requirement means that 
``all aspects'' of effecting securities transactions in compliance with 
the trust and fiduciary activities exception must be conducted in the 
part of a bank that is regularly examined by bank examiners for 
compliance with fiduciary principles and standards.\191\ Moreover, at 
that time we clarified that effecting transactions in securities 
includes more than just executing trades or forwarding securities 
orders to a broker-dealer for execution.\192\
---------------------------------------------------------------------------

    \191\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
at 27772.
    \192\ Id. at 27772-73.
---------------------------------------------------------------------------

    Some commenters expressed the view that requiring ``all aspects'' 
of securities transactions conducted by a bank for its trust and 
fiduciary customers to be conducted in a part of the bank regularly 
examined by bank examiners for compliance with fiduciary principles and 
standards is overly broad and could unduly restrict new business and 
cross-selling efforts.\193\ Other commenters noted that banks 
conducting fiduciary activities often delegate securities processing 
and settlement activities for cost or operational efficiencies to 
either a separate department, an affiliate or a third-party service 
provider, and that those entities may not be regularly examined for 
compliance with fiduciary principles and standards.\194\ Some banks and 
bank trade groups also explained that banks may use the trading desk of 
a registered investment adviser to process trades in fiduciary activity 
accounts, or bank fiduciaries may find it more economical to outsource 
certain trust back office functions.\195\ One commenter maintained that 
the examination requirement set forth in the Interim Rules would 
require banks to set up parallel back offices and other facilities 
solely for the purpose of relying on the trust and fiduciary activities 
exception and asked the Commission to clarify that this requirement 
would only apply to the part of the bank managing fiduciary activity 
accounts.\196\ Another commenter stated that because certain activities 
are not typically examined for compliance with fiduciary standards and 
principles, the Interim Rules' interpretation would constrain a bank's 
normal business operations.\197\ One commenter noted that small banks 
often conduct trust activities outside of their trust departments and 
urged us to clarify that it is the activity that qualifies for the 
exception, and not where the activity is conducted.\198\
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    \193\ See, e.g., UMB Bank letter.
    \194\ See, e.g., Bank Agencies letter; letter dated July 17, 
2001, from Maureen W. Sullivan, Associate General Counsel, 
Manufacturers and Traders Trust Company (``M&T letter''); IIB 
letter; Bankers Trust (Iowa) letter; and Harris Bank letter.
    \195\ See, e.g., ABA/ABASA letters; KeyBank letter; and M&T 
letter.
    \196\ See NYCH letter.
    \197\ See Harris Bank letter.
    \198\ See ICBA letter.
---------------------------------------------------------------------------

    In light of these comments, we propose to recast the examination 
requirement to more closely correlate with how bank trust and fiduciary 
activities are currently examined. We propose to interpret this 
requirement to mean that ``all aspects'' of effecting securities 
transactions in compliance with the trust and fiduciary activities 
exception must be regularly examined by bank examiners for compliance 
with fiduciary principles and standards. In other words, we would view 
this requirement to mean that the activities, rather than the 
department in which they are conducted, would need to be regularly 
examined. For example, a bank could meet the terms of the exception if 
bank examiners regularly examined a trading desk located outside of the 
trust department for compliance with fiduciary principles and standards 
in executing the trades for the bank's trust and fiduciary customers. 
Similarly, advertising for the trust department activities could be 
examined without

[[Page 39704]]

reviewing the other advertising of the bank. As noted in the Interim 
Rules, we rely primarily on the Banking Agencies to ensure that banks 
meet the examination requirements of this condition.\199\
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    \199\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
at 27772. We note the use by the federal financial institutions' 
regulators of the Uniform Interagency Trust Rating System in 
evaluating financial institutions' fiduciary activities. In 2000, 
there were 2,886 banks and trust companies (both insured and 
uninsured) that were subject to reporting requirements of the 
Federal Financial Institutions Examinations Council regarding their 
trust assets. See http://www2.fdic.gov/structur/trust/00trustdata.asp. Any institution that intends to rely on a bank 
exception from broker-dealer regulation must determine whether it 
falls within the definition of ``bank'' in Exchange Act Section 
3(a)(6).
---------------------------------------------------------------------------

    This interpretation does not extend to bank affiliates and third-
party service providers that carry out brokerage activities. Bank 
affiliates and third-party service providers cannot rely on any bank 
exception from registration, unless these affiliates and third-party 
service providers are themselves banks.\200\ This means that if some 
aspect of a securities transaction occurs outside of a bank, unless the 
securities-related activity in question is located within a registered 
broker-dealer,\201\ the bank would be unable to rely upon the trust and 
fiduciary activities exception for that transaction. Moreover, an 
affiliate participating in key points of securities transactions would 
be required to register as a broker-dealer, absent an exemption or no-
action relief.
---------------------------------------------------------------------------

    \200\ See also Division of Market Regulation, Staff Compliance 
Guide to Banks on Dealer Statutory Exceptions and Rules (Sept. 
2003), which clarified the exceptions found in the GLBA and that the 
additional exemptions granted by the Commission apply only to bank 
activities. Available at http://www.sec.gov/divisions/marketreg/bankdealerguide.htm.
    ``Question 1: May a bank holding company, subsidiary of 
a bank, or affiliate of a bank use the bank exceptions in the 
Exchange Act?
    Answer 1: No. The exceptions in the Exchange Act only 
exclude banks' securities activities from broker-dealer regulation, 
and then only in certain specified circumstances. Only the bank 
itself may claim an exception or exemption. The exceptions and 
exemptions are not available to a subsidiary or affiliate of a bank 
(unless the subsidiary or affiliate is itself a bank).'' (emphasis 
omitted)
    \201\ Certain securities related activities may occur in a 
registered investment adviser. Trustees routinely turn to registered 
investment advisers for professional asset management of a trust's 
portfolio. The adviser is hired as an agent, usually pursuant to a 
limited power of attorney, and the trustee is able to receive client 
disclosure and, when necessary, provide client consent.
---------------------------------------------------------------------------

    We note that the Banking Agencies distinguish between core and 
ancillary bank fiduciary activities.\202\ The Banking Agencies' 
analysis and our analysis serve two different purposes.\203\ A bank 
intending to qualify for the exception would need to rely on its 
banking regulator to ensure that all of its activities that constitute 
effecting securities transactions are regularly examined for compliance 
with fiduciary principles and standards.
---------------------------------------------------------------------------

    \202\ Activities that are considered to be ancillary to a bank's 
or savings association's business include many activities that 
constitute key points of a securities transaction, such as 
advertising, marketing, or soliciting fiduciary business. See, e.g., 
12 CFR 9.2(k) (OCC) (``Examples of ancillary activities include 
advertising, marketing, and soliciting for fiduciary business; 
contacting existing or potential customers, answering questions, and 
providing information about matters related to their accounts; 
acting as liaison between the trust office and the customer (e.g., 
forwarding requests for distribution or changes in investment 
objectives, or forwarding forms and funds received from the 
customer); inspecting or maintaining custody of fiduciary assets or 
holding title to real property.''); See also 12 CFR 550.60 (OTS).
    \203\ The Banking Agencies focus on providing guidance to 
national banks regarding their multi-state fiduciary activities. For 
example, the OCC explains at the Supplementary Information section 
of its release on this topic that ``[t]he purpose of the rulemaking 
was to provide clarity and certainty for national banks' multi-state 
fiduciary activities.'' See 66 FR 34792 (July 2, 2001); See also 67 
FR 76293 (Dec. 12, 2002) (OTS) (amending 12 CFR 550.60 to include a 
definition of the term ``activities ancillary to your fiduciary 
business.'' The amendment codified OTS legal opinions that concluded 
that a Federal savings association is not ``located'' in a state for 
purposes of Section 5(n) of the Home Owners'' Loan Act when the 
association conducts in that state activities that are ancillary to 
the association's fiduciary business.).
    In contrast, our interpretation is intended to provide guidance 
to banks on the requirements necessary to qualify for the trust and 
fiduciary activities exception from registering as a broker pursuant 
to Section 15 of the Exchange Act.
---------------------------------------------------------------------------

    The proposed amendments should give banks increased flexibility in 
satisfying this statutory requirement, while ensuring that investors 
receive all of the protections contemplated by this exception to the 
definition of broker. We also expect it to accommodate the needs of the 
Banking Agencies in fulfilling their supervisory functions by 
permitting them to target their examination resources more precisely. 
We solicit comment on the proposed amendments to this interpretation of 
the ``other department that is regularly examined by bank examiners for 
compliance with fiduciary principles and standards'' requirement of 
trust and fiduciary activities exception. Do commenters believe that 
this proposed approach would make it easier for banks to comply with 
this statutory requirement?

C. Sweep Accounts Exception

    In general, any person that induces transactions in securities for 
the account of others by selling securities products or services 
together with other, non-securities products or services sold by that 
person would be a broker required to register with the Commission.\204\ 
The sweep accounts exception set out in Exchange Act Section 
3(a)(4)(B)(v), however, permits a bank to participate in mixed product 
arrangements in which the bank offers a mutual fund ``sweep'' service 
linked to deposit accounts under certain conditions. Specifically, this 
section excepts a bank from the definition of ``broker'' to the extent 
it ``effects transactions as part of a program for the investment or 
re-investment of deposit funds into any no-load, open-end management 
investment company registered under the Investment Company Act that 
holds itself out as a money market fund.'' \205\
---------------------------------------------------------------------------

    \204\ See Exchange Act Release No. 27017, supra note 86, 54 FR 
at 30017-18 (explaining, in the context of the broker-dealer 
registration requirements as applied to foreign broker-dealers, that 
the Commission generally views solicitation requiring broker-dealer 
registration ``as including any affirmative effort by a broker or 
dealer intended to induce transactional business for the broker-
dealer or its affiliates,'' and stating, ``[s]olicitation includes 
efforts to induce a single transaction or to develop an ongoing 
securities business relationship.'').
    \205\ See Exchange Act Section 3(a)(4)(B)(v).
---------------------------------------------------------------------------

    To provide guidance to banks seeking to rely on the sweep accounts 
exception, the Interim Rules defined the terms ``money market fund'' 
and ``no-load.'' We propose to retain the definition of ``no-load'' 
substantially as in the Interim Rules, with a minor adjustment to 
recognize that some investment companies offer both load and no-load 
shares. We are also proposing to provide a new exemption for banks 
effecting transactions for certain customers in money market funds, 
including, with certain disclosures, money market funds that would not 
qualify as ``no-load'' funds.\206\
---------------------------------------------------------------------------

    \206\ See proposed Exchange Act Rule 776.
---------------------------------------------------------------------------

1. Comments on Definition of ``No-Load'' and Proposed Amendments
    Exchange Act Rule 3b-17(f)\207\ provides that an investment company 
is ``no-load'' for purposes of the sweep accounts exception if: (1) it 
does not have a sales load \208\ or a deferred sales load; and (2) its 
total charges against net assets to provide for sales-related expenses 
and service fees (including

[[Page 39705]]

12b-1 fees)\209\ do not exceed 0.25 of one percent of average net 
assets annually and are disclosed in the mutual fund's prospectus. This 
definition is consistent with the way in which the term ``no-load'' is 
used under the federal securities laws. In particular, it is consistent 
with the NASD's definition of ``no-load'\210\ and the interpretative 
position taken by Commission staff,\211\ under which NASD member firms 
and others may not describe a fund as being ``no-load,'' or as having 
``no sales charge,'' if it is subject to Rule 12b-1 fees exceeding a 
minimal amount.
---------------------------------------------------------------------------

    \207\ 17 CFR 240.3b-17(f).
    \208\ For purposes of determining whether a fund is a ``no-
load'' fund, ``sales load'' includes any charges related to the 
offering price of a fund, such as contingent deferred sales charges. 
See Order Approving Proposed Rule Change Relating to the Limitation 
of Asset-Based Sales Charges as Imposed by Investment Companies, 
Exchange Act Release No. 30897 (July 13, 1992), 57 FR 30985 n.8 
(citing interpretation of definition of ``sales load'' in Section 
2(a)(35) of the Investment Company Act [15 U.S.C. 80a-2(a)(35)] in 
NASD Notice to Members 89-35, Apr. 1989).
    \209\ As we noted in adopting the Interim Rules, 12b-1 fees, 
which funds are permitted to impose under Investment Company Act 
Rule 12b-1, are asset-based charges whose purpose may be entirely 
for the distribution of fund shares. See Exchange Act Release No. 
44291, supra note 13, 66 FR at 27775 and 27779 n.167.
    \210\ See NASD Rule 2830(d)(4).
    \211\ See letter dated August 22, 1994 from Barry P. Barbash, 
Director, Division of Investment Management, to Paul Schott Stevens, 
General Counsel, Investment Company Institute, regarding use of 
``no-load'' terminology (observing that investors ``have a 
reasonable expectation that terminology will be used uniformly for 
all funds with similar fees,'' and that using a description such as 
``no-load'' or ``no sales charge'' in connection with a fund having 
a Rule 12b-1 fee or service fee of more than 0.25% of average net 
assets per year, ``may be misleading and may constitute a violation 
of the antifraud provisions of the federal securities laws,'' 
whether or not the description is attributable to an NASD member 
firm).
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    We received numerous comments on the definition of ``no-
load.''\212\ One commenter expressed the view that defining the term to 
be consistent with the NASD definition of ``no-load'' was a ``logical 
and appropriate'' approach.\213\ Most commenters asserted that the term 
should be interpreted to mean only that a fund is not subject to front-
end or back-end sales charges. In their view, this approach would be 
consistent with Congressional intent.\214\ Some claimed that the 
definition of ``no-load'' in the Interim Rules would require revisions 
to banks'' existing sweeps programs that would involve significant 
administrative expense for banks, as well as inconvenience for bank 
customers.\215\
    Commission staff consulted with banks and bank representatives to 
gather more information about sweep account practices. Industry groups 
confirmed that mutual fund transactions in sweep programs are effected 
regularly, typically on a daily or overnight basis.\216\ One group 
indicated that banks often charge account-level fees for sweep 
services, typically on a monthly basis.\217\ In addition to possibly 
receiving Rule 12b-1 fees that exceed 25 basis points, this group 
indicated that banks might directly charge customers ``rate spread 
fees''\218\ as well as direct servicing fees.
---------------------------------------------------------------------------

    \212\ See, e.g.,, ABA/ABASA letters; Bank of America letter; 
Bank One letter; Banking Agencies letter; BONY letter; Compass 
letter; Fleet letter; Frost letter; Harris Trust letter; KeyBank 
letter; Mellon letter; NASAA letter; National City letter; NYCH 
letter; PNC letter; Regions letter; Roundtable letter; Shaw Pittman 
letter; Texas Bankers Trust Division letter; and Wells Fargo letter.
    \213\ See NASAA letter.
    \214\ See, e.g., ABA/ABASA letters; Compass letter; and NYCH 
letter.
    \215\ See, e.g., Banking Agencies letter; PNC letter; and 
Regions letter.
    \216\ See Letter dated January 22, 2004 from America's Community 
Bankers, the American Bankers Association, the Bank Insurance and 
Securities Association, the Financial Services Roundtable, the 
Independent Community Bankers of America, the Institute of 
International Bankers, and the New York Clearing House Association 
(``ACB/ABA letter''). The letter does not comment on the definition 
of ``no-load'' in the Interim Rules.
    \217\ See ACB/ABA letter.
    \218\ We understand a rate spread fee to be the difference 
between the return that the money market fund pays the bank's 
customer whose deposit funds are swept into the fund and the fee the 
bank charges the customer for the sweep service.
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    We understand that banks generally offer sweep account services to 
customers seeking higher interest rates than the rates that banks pay 
on deposits. The most common types of sweep account fee structures 
appear to involve a minimum balance requirement, and some banks also 
charge a monthly fee of between $25 and $100. Banks also receive Rule 
12b-1 fees from funds into which deposit balances are swept, which we 
understand range from 25 to 55 basis points.\219\
---------------------------------------------------------------------------

    \219\ In addition, some banks may retain a portion of the yield 
on a money market account, but this does not appear to be a common 
practice. In the rare cases in which a bank and its customer agree 
that the bank will retain a portion of the yield from a fund in a 
sweep arrangement, it appears that the retained yield would likely 
be between 25 and 50 basis points. For example, the bank might 
reduce a 2 percent yield on a fund to 1.5 percent and keep the 0.5 
percent difference. This type of fee appears to be the same as the 
``rate spread fee'' discussed above.
---------------------------------------------------------------------------

    After considering comments, we continue to believe that ``no-load'' 
as used in the statute should be given its customary meaning under the 
securities laws. We believe customers have come to rely on this term 
no-load as denoting not more than minimal Rule 12b-1 fees and no front-
end or deferred sales charge. Thus, consistent with common industry and 
investor understanding, Commission staff guidance, and NASD rules, a 
bank may not use the sweep accounts exception, which covers only 
transactions in no-load money market fund securities, to effect 
transactions in securities that are subject to more than 25 basis 
points in charges against net assets for distribution. Although 
payments by investment companies of asset-based fees to distributors of 
their securities create conflicts of interest for the distributors, the 
sweep accounts exception mitigates these conflicts by restricting the 
funds eligible to be used under the exception to no-load money market 
funds that are subject to only certain types of minimal distribution 
fees. In addition, limiting the type of funds that may be used in sweep 
arrangements offered under the exception to no-load money market funds 
regulated under Rule 2a-7 under the Investment Company Act \220\ limits 
the risks to investors. The customary emphasis of such funds on 
maintaining a constant net asset value, the absence of a sales load, 
and the minimal distribution fees that funds could pay to their bank 
distributors under the Interim Rules are also important conditions of 
the exception that could reduce the risks to investors who choose to 
invest in mutual funds through sweep accounts without using a broker.
---------------------------------------------------------------------------

    \220\ 17 CFR 270.2a-7.
---------------------------------------------------------------------------

    Allowing banks that rely on the sweep accounts exception to use 
mutual fund shares subject to asset-based sales fees exceeding a level 
that sweep account holders might expect to pay for a ``no-load'' fund 
would effectively strike the term ``no-load'' from the exception. 
Indeed, interpreting the term to mean only that a fund does not charge 
a front-end or deferred sales load could mislead investors, who would 
end up with accounts paying distribution fees they reasonably did not 
expect to pay. As understood by the investing public and the securities 
industry when the GLBA was being drafted and after it was enacted, the 
term ``no-load'' meant having Rule 12b-1 fees of not more than 25 basis 
points.\221\
    We considered the comment that the definition of ``no-load'' in 
Exchange Act Rule 3b-17 would create significant administrative 
expenses for banks and

[[Page 39706]]

inconvenience bank customers. We understand that the conditions of the 
statutory exception may require banks to modify some sweep arrangements 
involving funds that impose more than minimal charges against fund 
assets. In particular, some banks that wish to rely on the exception 
may need to begin charging customers directly for sweep services if 
they wish to continue receiving fees for the services equivalent to 
what they currently may receive from funds in the form of sales loads, 
deferred sales loads, Rule 12b-1 fees, and shareholder service fees. As 
we explained in adopting the Interim Rules, banks are not prohibited by 
the statute's ``no-load'' condition or our interpretation of it from 
directly charging their customers for sweep services, because those 
direct charges would not be charges against fund assets.\222\ While 
some banks may need to restructure some of their sweep arrangements to 
comply with the statute's ``no-load'' condition, and such restructuring 
may entail some expense to banks or inconvenience to bank customers, 
these considerations do not justify changing our interpretation of 
``no-load'' in ways that could subject bank customers to unexpected 
fees. Identifying funds that meet the definition of ``no-load'' should 
not be burdensome because the Commission's definition is the industry 
standard.\223\
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    \221\ For example, the Glossary of Mutual Fund Terms in the 1997 
edition of the Investment Company Institute's publication A Guide to 
Understanding Mutual Funds defines a ``no-load fund'' as, ``[a] 
mutual fund whose shares are sold at net asset value,'' and the 
1998, 2000 and 2002 editions of the same publication define a ``no-
load fund'' as, ``[a] mutual fund whose shares are sold without a 
sales commission and without a 12b-1 fee of more than .25 percent 
per year.'' A banking trade group also communicated this commonly 
understood meaning of the term to Congress as it considered the bill 
that became the Gramm-Leach-Bliley Act. See The Financial Services 
Modernization Act of 1999: Hearings on H.R. 10 Before the House 
Comm. on Banking and Fin. Services, 106th Cong., 1st Sess. 354 
(1999) (``Statement for the Record of the ABA Securities Association 
(``ABASA'')'' citing NASD Rule 2830 as support for the statement, 
``Mutual funds that assess service fees that do not exceed .25 of 1% 
of average net assets per annum are generally understood to be no-
load.'').
    \222\ Therefore, direct charges by banks of sweep fees would not 
affect the fund's status as a ``no-load'' fund. See Exchange Act 
Release No. 44291, supra note 13, 66 FR at 27779.
    \223\ As we explained in adopting the Interim Rules, a bank 
could satisfy its obligation to assure that any money market fund 
included in the bank's sweep program is in fact a no-load fund by 
using only money market funds that hold themselves out as no-load 
funds or by obtaining written confirmation from the money market 
fund that it is a no-load fund before including the fund in its 
sweep program. See Exchange Act Release No. 44291, supra note 13, 66 
FR at 27779 n.169.
---------------------------------------------------------------------------

    Some commenters indicated that our definition of ``no-load'' should 
be changed because limitations on asset-based sales charges might cause 
some banks to increase their account fees to offset losses of fees from 
money market funds or cause them to stop offering sweep accounts. If a 
bank can only offer sweep services by charging its customers additional 
fees above the built-in fees of true no-load funds, however, we believe 
investors should understand that and make their investment decisions 
accordingly.\224\ Fees charged directly to the account of a sweep 
account customer would permit the customer to evaluate the worth of the 
sweep services provided by the bank.
---------------------------------------------------------------------------

    \224\ As mentioned above, according to the ACB/ABA letter, banks 
often charge their sweep customers monthly, account-level fees.
---------------------------------------------------------------------------

    Moreover, banks offering sweep account services have incentives 
other than earning fees to sweep balances out of deposit accounts. 
Notably, sweeping allows banks to reduce the amount of assets they are 
required to hold in vault cash or Federal Reserve accounts, neither of 
which earns interest. Sweep accounts, therefore, inherently allow banks 
to use more of their assets to generate income.\225\ They also provide 
a means by which a bank may direct investments into proprietary funds 
from which the bank or an affiliate of the bank may receive advisory 
fees and other revenue.
---------------------------------------------------------------------------

    \225\ See Paul Bennett and Stavros Peristiani, Are U.S. Reserve 
Requirements Still Binding?, 8 Economic Policy Review of the Federal 
Reserve Bank of New York 53 (May 2002) (available at http://www.ny.frb.org/research/epr/02v08n1/0205benn.pdf); Remarks of 
Treasury Under Secretary Gary Gensler Before the House Banking and 
Financial Services Committee, May 3, 2000 (available at http://www.ustreas.gov/press/releases/ls600.htm).
---------------------------------------------------------------------------

    One mutual fund company \226\ suggested amending the definition to 
reflect the fact that different classes or series of shares issued by a 
particular fund may be subject to different distribution-related 
charges. This commenter noted that many investment companies offer 
multiple classes or series of shares, and some, but not others, may be 
subject to sales loads or deferred sales loads. In response to this 
comment, we propose to amend the definition of ``no-load'' to refer to 
loads applicable to a class or series of investment company security, 
rather than to the securities of an investment company in general.\227\ 
We request comment on the proposed amendment to the definition of ``no-
load,'' and specifically on the provision that ``no-load'' means not 
subject to Rule 12b-1 fees and certain other charges of more than 25 
basis points. We also invite comment on whether rate spread or retained 
yield fees should be counted as sales charges in determining whether 
money market funds in a sweep account program involving such fees 
should be considered ``no-load'' for purposes of the exception.
---------------------------------------------------------------------------

    \226\ See letter dated October 2, 2002 from Steve Keen, General 
Counsel, Federated Investors, Inc.
    \227\ See proposed Exchange Act Rule 740(c).
---------------------------------------------------------------------------

2. Interpretation of ``Program''
    Counsel for banks and investment companies asked the Commission 
staff whether the sweep accounts exception would permit a bank to sweep 
deposit balances into mutual funds less frequently than daily. They 
also asked whether a bank could rely on the exception to effect sweep 
transactions only at the direction of a customer rather than 
automatically. In addition, one commenter asked the Commission staff 
whether the exception would permit a bank to effect money market mutual 
fund transactions for a customer of another bank.\228\
---------------------------------------------------------------------------

    \228\ See Federated letters.
---------------------------------------------------------------------------

    In light of the legislative history, we do not believe that the 
sweep accounts exception permits other than regular, automatic 
sweeps.\229\ Moreover, we do not believe, and there is nothing in the 
legislative history to suggest, that this exception permits a bank to 
effect money market mutual fund transactions for another bank using 
deposits held at the other bank. Therefore, to limit potential 
confusion, we are clarifying that the term ``program'' in Exchange Act 
Section 3(a)(4)(B)(v)\230\ refers to arrangements for the automatic 
transfer of funds on a regular basis. We also interpret the term 
``program'' as referring to a bank's investment and reinvestment of 
deposit balances held at the bank by the bank's own customers. We 
request comment on our interpretation of the term ``program,'' and on 
whether the term should be defined by a rule.
---------------------------------------------------------------------------

    \229\ Legislative history suggests the scope of the sweep 
accounts exception could be limited to overnight sweeps. See H.R. 
Rep. No. 106-74, pt. 3, at 167 (1999) (``Section 201 [of the GLBA] 
contains a limited exception for banks that `sweep' depositors` 
funds on an overnight basis into a no-load money market account. The 
exception has the effect of permitting banks to continue investing 
depositors' funds from depository accounts into no-load money market 
accounts.'') (emphasis added). However, we interpret the term 
``program'' to include programs that involve regular, automatic 
sweeps of deposit balances meeting preset levels, even if the 
transactions are effected on a periodic basis less frequently than 
daily.
    \230\ 15 U.S.C. 78c(a)(4)(B)(v).
---------------------------------------------------------------------------

3. Definition of ``Money Market Fund''
    The Interim Rules defined the term ``money market fund'' as an 
open-end management investment company registered and regulated as a 
money market fund pursuant to Rule 2a-7 under the Investment Company 
Act.\231\ We did not receive any comments on this definition, and we 
propose to leave it unchanged.\232\ We request comment on whether the 
definition should remain unchanged.
---------------------------------------------------------------------------

    \231\ 17 CFR 270.2a-7.
    \232\ See proposed Exchange Act Rule 740(b).
---------------------------------------------------------------------------

D. Affiliate Transactions Exception

    Exchange Act Section 3(a)(4)(B)(vi) excepts from the definition of 
broker a bank that ``effects transactions for the account of any 
affiliate of the bank.''\233\

[[Page 39707]]

The affiliate transactions exception applies to a bank effecting trades 
for the accounts of its affiliates, other than those affiliates that 
are registered broker-dealers or engaged in merchant banking. 
Affiliates, including operating subsidiaries and other subsidiaries of 
the bank, may not use the bank exceptions and exemptions from the 
definitions of broker and dealer. While none of the Interim Rules 
addressed the affiliate transactions exception, in the release adopting 
the Interim Rules, the Commission interpreted the exception as not 
covering a bank effecting trades with non-affiliated customers, even 
when the customer transaction also is effected as part of a trade 
involving an affiliate.\234\
---------------------------------------------------------------------------

    \233\ 15 U.S.C. 78c(a)(4)(B)(vi). Bank Holding Company Act 
Section 2(k) [12 U.S.C. 1841(k)] defines affiliate to mean ``any 
company that controls, is controlled by or that is under common 
control with another company.''
    \234\ See Exchange Act Release No. 44291, supra note 13, 66 FR 
at 27783.
---------------------------------------------------------------------------

    We received two comments relating to the Commission's 
interpretation of this exception.\235\ One of these commenters stated 
that the Commission's interpretation, if construed literally, would 
effectively negate the statutory exception by prohibiting a bank from 
completing a brokerage transaction with non-affiliated customers under 
the affiliate transactions exception.\236\ The other commenter said 
that this exception should cover transactions with non-affiliates if 
one of the parties to the transaction is an affiliate of the bank.\237\
---------------------------------------------------------------------------

    \235\ See Banking Agencies letter and ICBA letter.
    \236\ See Banking Agencies letter.
    \237\ See ICBA letter.
---------------------------------------------------------------------------

    Under the interpretation of the exception that these commenters 
have proffered, a bank could avoid broker-dealer registration for a 
securities brokerage transaction if an affiliate is involved in the 
transaction. The Commission believes that this interpretation is 
contrary to the plain meaning of the GLBA. As a result, we are 
proposing to clarify the Commission's interpretation of this exception 
by defining the term ``effects transactions for the account of any 
affiliate.''\238\ Under this proposed definition, the affiliate must be 
acting as a principal or as a trustee or fiduciary purchasing or 
selling securities for investment purposes.\239\ Moreover, the 
affiliate may not act as a riskless principal for another person, as a 
registered broker-dealer, or be engaged in merchant banking.\240\ 
Finally, the bank would be required to obtain the securities to 
complete the subject transaction from a registered broker-dealer, from 
a person acting in that capacity that is not required to register, or 
pursuant to another exception or exemption from Exchange Act Section 
3(a)(4)(B).
---------------------------------------------------------------------------

    \238\ See proposed Exchange Act Rule 750.
    \239\ The securities laws and rules, however, distinguish 
``dealers'' (which buy and sell securities as part of a regular 
business) from ``traders'' (which buy and sell securities for 
investment and not as part of a regualr business). For additional 
information on distinguishing ``dealers'' from ``traders,'' see 
Exchange Act Release Nos. 46745 (Oct. 31, 2002), 67 FR 67496, 67498 
(Nov. 5, 2002) and 47364, (Feb. 14, 2003), 68 FR 8686, 8688 (Feb. 
24, 2003).
    \240\ The affiliate may not be a registered broker-dealer or be 
engaged in merchange banking because the statute contains these 
conditions. Exchange Act Section 3(a)(4)(B)(vi). The affiliate may 
not act as a riskless principal because that would effectively be 
acting for another person who would be a customer of the affilaite.
---------------------------------------------------------------------------

    We request comment on this proposed definition. In particular, 
commenters are invited to discuss whether this definition would enhance 
the clarity of the affiliate transactions exception.

E. Safekeeping and Custody Activities Exception

1. Background on Safekeeping and Custody Exception
    Exchange Act Section 3(a)(4)(B)(viii) provides an exception from 
broker-dealer registration with respect to certain securities-related 
safekeeping and custody services that banks may perform for their 
customers.\241\ The exception explicitly allows a bank that holds funds 
and securities for its customers as part of ``customary banking'' 
activities to perform specified securities-related functions with 
respect to those securities without registering as a broker.\242\ In 
particular, a bank may, among other things, exercise warrants or other 
rights, facilitate the transfer of funds or securities in connection 
with clearing and settling customers' securities transactions, effect 
securities lending or borrowing transactions and invest cash collateral 
pledged in connection with such transactions, and hold securities 
pledged by a customer or facilitate the pledging or transfer of 
securities that involve the sale of those securities. In addition, the 
exception expressly permits a bank to ``serve as a custodian or 
provider of other related administrative services'' to IRAs, pension, 
retirement, profit sharing, bonus, thrift savings, incentive, or other 
similar benefit plans without being considered a broker. The exception 
does not apply, however, to a bank that acts as a carrying broker or 
clearing broker in connection with securities transactions (other than 
with respect to government securities).\243\
---------------------------------------------------------------------------

    \241\ 15 U.S.C. 78c(a)(4)(B)(viii).
    \242\ In the absence of an exception or exemption, holding 
customer funds and securities in connection with securities 
transactions typically would require broker registration. See, e.g., 
SEC v. Margolin, [1992 Transfer Binder] Fed. Sec. L. Rep. (CCH) ] 
97,025 (S.D.N.Y. 1992) (noting that evidence of brokerage activity 
included receiving transaction-based compensation, advertising for 
clients, and possessing client funds and securities). See letter re: 
Financial Surveys, Inc. (July 30, 1973) (persons in the business of 
effecting transactions in securities include persons who hold 
customer funds or securities in connection with securities 
transactions). See also 15 David A. Lipton, at 1.04[3] (having 
custody or control over funds and securities of others is a badge of 
being a broker).
    \243\ Exchange Act Section 3(a)(4)(B)(viii)(II).
---------------------------------------------------------------------------

    In the release adopting the Interim Rules, the Commission provided 
interpretive guidance with respect to the exception. In particular, the 
Commission stated:

``custody'' or ``related administrative services'' do not include 
accepting orders from investors to purchase or sell securities. In 
particular, we do not believe that by its terms the safekeeping and 
custody exception covers a bank that accepts orders from investors 
to purchase or sell securities other than those specifically 
permitted in the exception, such as with respect to securities 
lending and borrowing or investing collateral.\244\

    \244\ 66 FR at 27781.
---------------------------------------------------------------------------

    To mitigate unnecessary disruptions in banks' existing safekeeping 
and custody practices that the GLBA might have caused, the Interim 
Rules provided conditional exemptions to permit banks to effect 
transactions in securities over which they have custody. In particular, 
current Exchange Act Rule 3a4-5 permits all banks to effect 
transactions in any security for custody accounts under narrow 
conditions.\245\ In addition, current Exchange Act Rule 3a4-4 permits 
small banks to effect transactions in mutual funds for tax-deferred 
custody accounts.\246\
---------------------------------------------------------------------------

    \245\ See 17 CFR 240.3a4-5.
    \246\ See 17 CFR 240.3a4-4. Both exemptions are subject to 
limits on solicitation activities, compensation, and use of bank 
employees. The exemptions also require banks to execute the 
resulting transactions pursuant to Exchange Act Section 3(a)(4)(C), 
which requires banks that accept orders to the extent they engage in 
transactions under a specified safekeeping and custody function 
either to transmit orders to be executed to a registered broker-
dealer or internally cross those orders.
---------------------------------------------------------------------------

    We received numerous comments on the safekeeping and custody 
exception.\247\ These comments focused

[[Page 39708]]

primarily on the Commission's interpretation with respect to accepting 
orders, the general custody exemption, and the small bank custody 
exemption.
---------------------------------------------------------------------------

    \247\ See ABA/ABASA letters; Banking Agencies letter; BONY 
letter; Bank One letter; BSA letter; CSBS letter; FirstMerit letter; 
FirstUnion letter; Fleet letter; Frost letter; Harris Trust letter; 
ICBA letter; KeyBank letter; letter dated August 30, 2001 from D. 
Rodman Thomas, Senior Vice President and Senior Trust Officer, The 
Ledyard National Bank (``Ledyard letter''); Mellon letter; letter 
dated August 29, 2001 from Bill Beyer, President and CEO, Meredith 
Village Savings Bank (``Meredith Village Savings Bank''); National 
City letter; NYCH letter; PNC letter; Shaw Pittman letter; 
Roundtable letter; UMB Bank letter; Wells Fargo letter; State Street 
letter; M&T Bank letter; Fulton Street Financial letter; Union Bank 
of California letter; ICBA letter; IIB letter; Wilmer, Cutler 
letter; Wilmington Trust letter; Regions Financial letter; TIAA-CREF 
letter; Virginia Bankers Association letter; and Compass Bank 
letter.
---------------------------------------------------------------------------

2. Comments on Commission's Interpretation Regarding Accepting Customer 
Orders
    A number of commenters criticized the Commission's interpretation 
that the safekeeping and custody exception generally does not permit 
banks to accept their customers' securities orders. These commenters 
argued that the interpretation was contrary to the GLBA and its 
legislative history.\248\ In particular, they contended that order 
taking is a customary banking activity in custody accounts and that in 
adopting the GLBA Congress did not intend to disturb such activities. A 
few commenters also opined that with respect to retirement and other 
benefit plans, the plain meaning of the exception and Congressional 
intent should expressly permit a bank to handle orders because the 
exception permits banks to engage in ``related administrative 
services'' for investors through retirement and benefit plans.\249\ 
Moreover, two commenters stated that, whether under the trust and 
fiduciary exception or the safekeeping and custody exception, Congress 
clearly intended to allow banks to continue effecting transactions in 
securities for custodial IRAs.\250\ Some commenters also asserted that 
the Commission staff has recognized that entities offering a bundle of 
custodial and administrative services may accept and process orders for 
retirement plans.\251\
---------------------------------------------------------------------------

    \248\ See, e.g., ABA Banking Law Committee letter; ABA/ABASA 
letters; Banking Agencies letter; Financial Services Roundtable 
letter; and IIB letter.
    \249\ See, e.g., ABA/ABASA letters; Banking Agencies letter; and 
NYCH letter.
    \250\ See, e.g., Federated letters and Mellon letter.
    \251\ See, e.g., Banking Agencies letter; PNC letter; and TIAA-
CREF letter. Commenters cited Letter re: Universal Pensions, Inc. 
(Jan. 30, 1998). Pursuant to that staff no-action letter, a third-
party pension plan administrator acted in a mechanical order-taking 
role subject to independent supervision, could not influence the 
purchase of securities by plan participants, did not receive 
transaction-based compensation related to those purchases, was not 
permitted to handle funds or securities, recommend any mutual funds, 
or provide any other investment advice. Broker-dealers worked 
directly with plan sponsors and advised the sponsors in which mutual 
funds to invest. While the administrator could receive and invest 
new participant contributions for each plan according to directions 
from the plan fiduciary, it could not net or match orders. An 
independent trust company independently calculated net orders and 
forwarded them along with cash to settle trades. We note that banks 
relying on the safekeeping and custody exception could not meet the 
terms of the Universal Pensions letter because they handle funds and 
securities.
---------------------------------------------------------------------------

    Although we understand the concerns of the commenters discussed 
above, the Commission continues to believe that accepting orders to 
purchase or sell securities is a core broker-dealer function and was 
not intended to be permitted under the safekeeping and custody 
exception.\252\ Therefore, we continue to believe that the combination 
of handling funds and securities with order taking, absent a specific 
exemption, requires broker-dealer registration. Although the 
safekeeping and custody exception generally does not provide for banks 
to take orders for securities, the Commission has proposed several 
exemptions to allow banks to accept orders from a custody account, 
subject to certain conditions.
---------------------------------------------------------------------------

    \252\ See H.R. Rep. No. 106-74, pt. 3, at 169 (1999) (``This 
exception is not intended to allow banks to engage in broader 
securities activities.'').
    Although the term ``related administrative services'' is not 
defined in the securities laws, in the broker-dealer industry, 
administrative services generally are considered to be those that 
are ``clerical and ministerial.'' Clerical and ministerial 
activities include, for example, mechanical tasks such as 
bookkeeping and record keeping, performing calculations, and data 
processing functions. Accepting general orders to buy and sell 
securities, however, is not a ``clerical and ministerial'' activity. 
See Exchange Services, Inc. v. S.E.C., 797 F.2d 188, 189-190 (4th 
Cir. 1986) (court determined that the Commission was not being 
arbitrary and capricious when it relied, as a reason to deny an 
exemption, on NASD's policy that anyone taking orders from the 
public must register as a broker-dealer).
---------------------------------------------------------------------------

3. Comments on and Proposed Amendments to the General Bank Custody 
Exemption
    Current Exchange Act Rule 3a4-5 provides a limited exemption from 
the definition of ``broker'' for banks seeking to operate in the 
broader role of order takers for all types of securities while holding 
clients' funds or securities. To qualify for the exemption, however, a 
bank may not receive any compensation for effecting such transactions. 
In addition, the exemption would limit the ways in which banks: (1) 
Solicit orders; (2) use their employees to engage in brokerage 
activities; and (3) compensate their employees for the sale of 
securities.\253\
---------------------------------------------------------------------------

    \253\ See Exchange Act Rule 3a4-5(a). For example, the rule 
restricts banks that wish to rely on the exemption from soliciting 
securities transactions except through one of four means specified 
in the rule. See Exchange Act Rule 3a4-5(a)(5)(i)-(iv). A bank 
relying on the exemption also must comply with the order execution 
condition in Exchange Act Section 3(a)(4)(C). See Exchange Act Rule 
3(a)(3).
---------------------------------------------------------------------------

    We received multiple comments regarding the general bank custody 
exemption.\254\ One commenter argued that the safekeeping and custody 
exception is clear and unequivocal, and therefore an exemptive rule in 
this area is unnecessary.\255\ Another explained that taking orders to 
execute securities transactions for its custody clients historically 
has been an important aspect of its custody business that it provides 
as an accommodation and convenience for clients rather than as a 
substitute for the brokerage business.\256\
---------------------------------------------------------------------------

    \254\ See, e.g., ABA/ABASA letters; Banking Agencies letter; 
BONY letter; Bank One letter; BSA letter; CSBS letter; FirstMerit 
letter; Fleet letter; Frost letter; Harris Trust letter; ICBA 
letter; KeyBank letter; Ledyard letter; Mellon letter; National City 
letter; NYCH letter; PNC letter; Shaw Pittman letter; Roundtable 
letter; UMB Bank letter; and Wells Fargo letter.
    \255\ See IIB letter.
    \256\ See BONY letter.
---------------------------------------------------------------------------

    Another commenter expressed concerns that a bank may not receive 
transaction-based compensation for placing orders for its customers and 
still rely on this exemption.\257\ It viewed this condition as 
requiring banks to provide certain custodial services at a loss.
---------------------------------------------------------------------------

    \257\ See Mellon letter.
---------------------------------------------------------------------------

    Other commenters indicated that Exchange Act Rule 3a4-5 could be 
misinterpreted to prohibit a bank from receiving certain fees that 
these commenters believed should be permissible under the exemption 
(e.g., settlement fees, securities movement fees, or similar processing 
fees that do not depend on whether the bank placed an order for its 
customer).\258\
---------------------------------------------------------------------------

    \258\ See, e.g., NYCH letter and BONY letter.
---------------------------------------------------------------------------

    One commenter urged the Commission to expand the exemption so that 
banks may continue to be compensated for effecting securities 
transactions in custodial accounts where the compensation consists of 
Rule 12b-1 fees, shareholder servicing fees, mutual fund advisory fees, 
or other revenue sharing arrangements.\259\
---------------------------------------------------------------------------

    \259\ See NYCH letter.
---------------------------------------------------------------------------

    Some commenters complained about the solicitation restrictions in 
Exchange Act Rule 3a4-5(a)(5), arguing, among other things, that they 
would prohibit banks from engaging in advertising activities that are 
expressly permitted by the Exchange Act.\260\
---------------------------------------------------------------------------

    \260\ See, e.g., Banking Agencies letter and UMB Bank letter.
---------------------------------------------------------------------------

    Some commenters stated that banks offering proprietary funds should 
not (as the rule requires) be required also to offer competitors' funds 
because their operational costs would increase as the number of 
investment options offered increased.\261\
---------------------------------------------------------------------------

    \261\ See, e.g., BONY letter; Frost letter; Harris Trust letter; 
Mellon letter; NYCH letter; PNC letter; and Roundtable letter.

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[[Page 39709]]

    Several commenters objected to the employee compensation provisions 
in the rule because they believe that banks should be able to reward 
their employees for securing new custody business.\262\ Some commenters 
asserted that the rule's prohibition on using dually licensed employees 
to accept orders is contrary to the Commission's view that registration 
provides important investor protections.\263\
---------------------------------------------------------------------------

    \262\ See, e.g., ABA/ABASA letters; Harris Trust letter; Mellon 
letter; and NYCH letter.
    \263\ See, e.g., Fleet letter; BONY letter; Meredith Village 
Savings Bank letter; National City letter; NYCH letter; PNC letter; 
and Roundtable letter.
---------------------------------------------------------------------------

    One commenter complained about a provision in the rule requiring 
that a bank employee taking customers' securities orders primarily 
perform duties for the bank other than effecting transactions in 
securities for customers.\264\ This commenter contended that this 
provision restricts a bank's ability to staff custody accounts in a 
manner that it deems most appropriate without enhancing customer 
protection.
---------------------------------------------------------------------------

    \264\ See PNC letter referencing Exchange Act Rule 3a4-
5(a)(2)(ii).
---------------------------------------------------------------------------

a. Modifications to General Bank Custody Exemption

1. Bank Compensation

    In response to comments, and based on the Commission staff's 
discussions with representatives of banks, bank trade groups, and staff 
of the Banking Agencies, we propose to amend the general custody 
exemption to clarify that a bank that accepts orders for securities 
could be compensated for effecting a securities transaction for a 
person with an existing custody account or for a ``qualified investor'' 
so long as the compensation that the bank receives for its custody 
services (e.g., securities movement fees, annual fees, asset based 
fees, and processing fees) does not directly or indirectly vary based 
on whether the bank accepts an order to purchase or sell a 
security.\265\
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    \265\ See proposed Exchange Act Rule 760. The term ``qualified 
investor'' is defined in Exchange Act Section 3(a)(54). Banks 
advised the Commission that banks provide custody services to a 
broad range of institutional customers, including corporations, 
endowments, market professionals (such as mutual funds, hedge funds, 
and investment advisers), employer pension plans, state, local, and 
foreign governmental entities, other not-for-profit organizations, 
welfare benefit plans, union plans, Indian Tribal Nations, and 
partnerships and limited liability companies. Bank custodians also 
act as custodians for individuals, such as private banking clients, 
trust clients, or IRA owners. Most of these customers did not use 
bank custodians to execute securities transactions.
---------------------------------------------------------------------------

    Accordingly, the proposed amendment would conditionally permit a 
custodian bank to be compensated for the movement of funds and 
securities for ``grandfathered'' custody accounts or accounts of 
``qualified investors'' when that movement results from the bank's 
acceptance of a securities order. We propose to limit this exemption on 
a going forward basis to ``qualified investors'' because their custody 
accounts have not typically been used extensively for execution 
purposes.\266\ Customers that do not already have a custody 
relationship, other than ``qualified investors,'' would not obtain 
securities (other than securities covered by other exceptions or 
exemptions) through their bank custodian. We solicit comment on 
limiting this exemption to ``qualified investors'' on a going-forward 
basis. In particular, we solicit comment on whether there are other 
institutional entities that have custodial, rather than trust accounts, 
with banks and that have a special need for banks to take their 
securities orders. We request that commenters, particularly those that 
are custody customers, set forth the specific reasons why banks would 
need to have other entities included within the terms of this 
exemption. Please include the special circumstances that apply to these 
entities and why these entities do not require the comprehensive 
protections of the federal securities laws.
---------------------------------------------------------------------------

    \266\ See Banking Agencies letter (``Based on our supervisory 
experience, banks customarily conduct accommodation trades for 
custodial accounts only upon the order of the customer and on an 
incidental and infrequent basis.'').
---------------------------------------------------------------------------

    The proposed amendment articulates more clearly the accommodative 
and historical nature of the limited securities business that banks 
have customarily performed through their custody departments. The 
proposed amendment also would remove limitations in the Interim Final 
Rules that prohibited custody department employees from being 
compensated for securities-related custody activities, including 
gathering assets and moving funds and securities, if the bank accepts 
customer orders. While we see no difference between a bank that effects 
transactions in securities as a custodian and a broker-dealer,\267\ we 
believe an exemption would be appropriate where a bank's sales efforts 
and sales incentives are limited. While the proposal would be more 
accommodative than the current exemption, it would not permit a bank to 
operate as an ``introducing broker'' in the custody department, which 
we do not believe would be consistent with Exchange Act investor 
protection principles.\268\
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    \267\ When brokerage is conducted through a custody account, the 
investor protections associated with order entry through a 
registered broker-dealer are not available. However, the protections 
associated with order execution are available because orders are 
forwarded to a registered broker-dealer for execution.
    \268\ An ``introducing broker'' arranges securities transactions 
for a customer but uses a ``clearing broker'' to execute the 
transactions and maintain securities and funds on that customer's 
behalf.
---------------------------------------------------------------------------

    Under the proposal, banks that accept securities orders would not 
be permitted to adjust their compensation to reflect the additional 
cost of forwarding orders on behalf of customers. These costs could not 
be recouped in any other aspect of their customer relationships to 
account for the acceptance of customers' orders pursuant to this 
exemption.\269\ To give legal certainty to banks regarding the 
compensation condition, the proposed amendment would specify that a 
bank could demonstrate that it does not receive additional compensation 
for effecting securities transactions by utilizing fee schedules that 
specify charges for the movement of funds securities and identifying 
similarly situated customers who pay the same price for such movements 
and who do not utilize the bank or its affiliates to effect securities 
transactions.
---------------------------------------------------------------------------

    \269\ One bank trade group informed the staff that custody fee 
arrangements may reflect other products or services for which the 
customer uses the bank. Similarly, to ensure that the whole 
relationship with a customer is profitable, clearing brokers do not 
necessarily charge uniform fees to securities customers. For 
example, clearing firms may charge low custody fees and split 
securities lending income with the customer to offset other charges. 
In this example, a bank could engage in securities lending pursuant 
to the safekeeping and custody exception or the exemption for 
securities lending transactions in Exchange Act Rule 15a-11. A 
bank's compensation from securities lending transactions involving a 
custody customer's securities could not, however, be used to offset 
or credit fees for that custody customer's securities transactions 
pursuant to this exemption.
    A non-exhaustive list of examples of indirect compensation for 
order-taking may include:
    (1) The bank custody department varies the fees received based 
on securities transaction volume;
    (2) The bank custody department only charges certain custody 
customers for purchasing securities;
    (3) The bank varies the order acceptance fee for customers who 
purchase another product or service, such as by giving high net 
worth bank customers a certain number of free trades annually or by 
requiring a custody customer to purchase another product or service 
to qualify for a particular custody fee that includes order-taking 
services; and
    (4) The bank receives payments of sales compensation from other 
persons related to the sale of mutual funds to custody customers, 
other than payments expressly permitted pursuant to this exemption.
---------------------------------------------------------------------------

    In addition, we propose to amend the general custody exemption to 
permit banks to be compensated for accepting securities orders through 
Rule 12b-1 or shareholder servicing fees for accounts that were opened 
before the date of this proposing release or for ``qualified 
investors.'' While Rule 12b-1 fees create the types of conflicts of 
interest that broker-dealer regulation is designed to address, we 
propose to grandfather

[[Page 39710]]

existing custody accounts to avoid any unnecessary disruption of this 
business.
    In keeping with the accommodative nature of banks' custody business 
and partially to address the conflicts associated with Rule 12b-1 fees, 
we propose to condition the receipt of Rule 12b-1 and shareholder 
servicing fees on the bank making available any class or series of a 
registered investment company's securities that can be reasonably 
obtained by the bank for purchase or sale by customers. This condition 
is designed to ensure that investors have a full range of choices 
available when they consider whether to pay custody costs directly or 
to offset some of these custody costs with Rule 12b-1 fees. By making 
different classes of shares available, including classes that do not 
pay 12b-1 fees (e.g., institutional class), banks will not effectively 
require a customer to pay Rule 12b-1 fees to obtain execution services.
    We believe that the additional conditions that we propose, however, 
will limit banks to the type of accommodation role that commenters 
represent banks act in when effecting transactions in securities as 
custodians. We do not propose to amend the exemption to permit banks to 
be compensated for accepting securities orders through revenue sharing 
arrangements because of the conflicts that these payments create.\270\ 
We solicit comment on these proposed amendments, including specific 
comments on whether we have adequately protected the interests of these 
current bank customers through the conditions we propose. We request 
comment on whether it is appropriate to grandfather existing custody 
customers by allowing banks to take securities orders from these 
customers and collect 12b-1 fees from their accounts. We request 
comment on whether this proposed exemption creates an unreasonable 
level of competitive issues for other banks or broker-dealers that 
should be considered by us further. If commenters think that these 
customers should have additional investor protections that we have not 
provided through these proposed conditions, please tell us what 
additional investor protections we should require.
---------------------------------------------------------------------------

    \270\ The NYCH advised the Commission staff that banks acting as 
custodians may enter into revenue sharing arrangements with 
investment advisers. As the Commission noted, the development of 
fund ``supermarkets'' sponsored by broker-dealers has led to related 
arrangements in which a fund or its affiliates compensates broker-
dealers in ways that are not generally disclosed to investors. See 
69 FR 6438 at 6443.
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2. Solicitation Restrictions
    In general, we propose to tighten the solicitation conditions in 
the proposed amendments. Consistent with commenters' assertions that 
banks effect transactions purely as an accommodation to their 
customers, we propose to remove a provision from the current custody 
exemption that permits banks to solicit investors through investment 
company advertising and other sales material. We propose to modify the 
current custody exemption to permit banks to respond to investor 
inquiries by delivering sales literature that is prepared by an 
investment company that is not an affiliated person.\271\ We propose to 
remove the condition in the current exemption that permits banks to 
solicit their existing customers for securities transactions in 
connection with solicitation of their other custody activities.
---------------------------------------------------------------------------

    \271\ See proposed Exchange Act Rule 760(a)(3)(B).
---------------------------------------------------------------------------

    In response to a request from one commenter to limit the 
solicitation condition to custodian accounts,\272\ we propose to 
clarify that the solicitation restrictions in the general bank custody 
exemption apply only to solicitations of securities transactions 
pursuant to the proposed amended exemption covering accounts for which 
the bank acts as a custodian. Therefore, a bank could solicit a custody 
business, including securities transactions that are permissible under 
the safekeeping and custody exception in Exchange Act Section 
3(a)(4)(B)(viii) and the stock lending exemption in Exchange Act Rule 
15a-11. A bank could not, however, directly or indirectly solicit 
securities transactions in reliance on this proposed exemption, except 
as permitted pursuant to the terms of this exemption. For example, a 
bank making referral payments to another person for the solicitation of 
securities transactions for the bank operating pursuant to this 
proposed exemption would exceed the solicitation limits in this 
proposed exemption.
---------------------------------------------------------------------------

    \272\ See NYCH letter.
---------------------------------------------------------------------------

    Banks advised the Commission staff that departments of a bank other 
than the custody department may provide lists of recommended 
securities, watch lists, research reports, or other publications 
highlighting particular securities or groups of securities, and may 
provide investment advice. These activities exceed the securities 
solicitation limits of Exchange Act Rule 3a4-5 and the proposed 
exemption.\273\ Except as expressly permitted, the solicitation 
conditions would not permit a bank to solicit through another bank 
department securities activities in its custody department. We solicit 
comment on each of these proposed changes to the solicitation 
restrictions. We specifically invite comment on whether these 
restrictions are too lax or too strict. We also invite comment on 
whether we should impose any other or different restrictions.
---------------------------------------------------------------------------

    \273\ As we explained in Exchange Act Release No. 27017, supra 
note 86, 54 FR at 30017-18:
    [T]he Commission generally views ``solicitation,'' in the 
context of broker-dealer regulation, as including any affirmative 
effort by a broker or dealer intended to induce transactional 
business for the broker-dealer or its affiliates. Solicitation 
includes efforts to induce a single transaction or to develop an 
ongoing securities business relationship. Conduct deemed to be 
solicitation includes telephone calls from a broker-dealer to a 
customer encouraging use of the broker-dealer to effect 
transactions, as well as advertising one's function as a broker or a 
market maker in newspapers or periodicals of general circulation in 
the United States or on any radio or television station whose 
broadcasting is directed into the United States. Similarly, 
conducting investment seminars for U.S. investors, whether or not 
the seminars are hosted by a registered U.S. broker-dealer, would 
constitute solicitation. A broker-dealer also would solicit 
customers by, among other things, recommending the purchase or sale 
of particular securities, with the anticipation that the customer 
will execute the recommended trade through the broker-dealer.
    This release explains that providing research reports may be a 
form of solicitation. Providing an asset allocation model to a 
custody customer is another example of an affirmative effort to 
induce transactional business.
---------------------------------------------------------------------------

3. Employee Activities and Compensation
    As suggested by commenters, we propose to eliminate a provision in 
current Exchange Act Rule 3a4-5(a)(2)(i) that prohibits the use of 
dually licensed employees to effect transactions pursuant to the 
general custody exemption. We also propose to eliminate the requirement 
that a bank employee must primarily perform duties for the bank other 
than effecting transactions in securities.\274\ Commenters explained 
that eliminating these prohibitions would enhance operational 
efficiencies and would allow them to use the most skilled persons for 
processing securities transactions.
---------------------------------------------------------------------------

    \274\ See Exchange Act Rule 3a4-5(a)(2)(ii).
---------------------------------------------------------------------------

    We also propose to eliminate the restriction in current Exchange 
Act Rule 3a4-5 (a)(2)(iii)(B) that custody employees may not receive 
incentive compensation for the amount of securities-related assets 
gathered or the size or value of any customer's securities account. 
This will permit compensation for a custody employee that brings assets 
into the bank.
    We request comment on the elimination of both of these 
restrictions. We invite commenters to tell us if other or more tailored 
conditions would be

[[Page 39711]]

more likely to enhance investor protections.
4. Trustee and Fiduciary Activity Accounts
    We propose to add a new provision to the general custody exemption 
designed to ensure that a bank would use that exemption only for those 
custody accounts in which it does not act in a trustee or fiduciary 
capacity.\275\ Transactions for trust and fiduciary activity accounts 
would need to be effected in compliance with the trust and fiduciary 
exception in Exchange Act Section 3(a)(4)(B)(ii). Congress enacted the 
conditions that apply to that exception in recognition of certain 
fiduciary obligations that banks have to their trust customers. In 
contrast, a custody account is created through a contractual 
relationship that does not provide the customer with any fiduciary 
protections. We solicit comment on the appropriateness of this proposed 
new provision of the general custody exemption. We also request comment 
on whether activities covered by any other exceptions or exemptions 
should be specifically carved out of this custody exemption. We also 
invite comment on whether any other restrictions would offer better 
protection to investors.
---------------------------------------------------------------------------

    \275\ See proposed Exchange Act Rule 760(a)(4).
---------------------------------------------------------------------------

5. Employee Benefit Plans
    In light of the proposed new exemption for banks effecting 
transactions for employee benefit plans, we propose to add a new 
provision to the general bank custody exemption to clarify that the 
custody exemption would not be available for banks to effect 
transactions in securities for an employee benefit plan account 
described in proposed Rule 770. We invite comment on this proposed 
provision and whether any other restrictions should be imposed for the 
protection of investors.
6. Small Bank Exemption
    In light of the expanded availability of the small bank custody 
exemption, we propose to add a new provision to the general custody 
exemption that would limit the availability of the general bank custody 
exemption to banks that do not simultaneously use the small bank 
custody exemption. Banks that qualify for both exemptions could choose 
which custody exemption to use. We invite comment on whether it is 
appropriate to limit the use of these exemptions in this way.
7. Custody Account Definition
    We propose to define an ``account for which the bank acts as a 
custodian'' to mean an account established by a written agreement 
between the bank and the customer, which, at a minimum, provides for 
the terms that will govern the fees payable, rights, and obligations of 
the bank regarding the safekeeping of securities, settling of trades, 
investing cash balances as directed, collecting of income, processing 
of corporate actions, pricing securities positions, and providing of 
recordkeeping and reporting services.\276\ We based this definition on 
our understanding of what custodians do. In addition, to provide legal 
certainty to bank custodians accepting orders for IRAs, we specifically 
added such accounts to this definition of custody account. We invite 
comment on the extent to which custodians provide the services outlined 
in the proposed definition and whether there are additional services 
that custodians perform that should be included in this definition. We 
also invite comment on whether there are any other conditions or 
disclosure requirements that we should consider to protect investors.
---------------------------------------------------------------------------

    \276\ Proposed Exchange Act Rule 762(a).
---------------------------------------------------------------------------

8. Request for Comments
    We request comment on these proposed modifications to the general 
custody exemption. In responding to this request for comments, please 
describe whether this exemption would cover most categories of custody 
customers from whom banks accept orders for the purchase or sale of 
securities. For bank commenters, with respect to each type of custody 
customer, please list: (1) The percentage of any type of order for the 
movement of funds or securities that includes an order for the purchase 
or sale of a security; (2) the types of securities the bank purchases 
or sells for these customers; (3) how the bank offers particular 
classes or series of mutual funds to these custody customers; (4) all 
of the types of compensation the bank receives in connection with its 
custody activities related to different types of custody customers; and 
(5) how the bank solicits these custody customers. We solicit comment 
regarding whether we should adopt disclosure requirements similar to 
the proposed general disclosure requirements in proposed Exchange Act 
Rule 776.
    We request comment on whether the proposed definition of ``account 
for which the bank acts as a custodian'' in Rule 762(a) reflects the 
types of services that bank custodians typically provide. If not, 
please explain which of these services bank custodians typically 
provide. In addition, does the custody definition reflect the services 
that banks typically provide for investors who purchase or sell 
securities within individual retirement accounts?
9. Carrying Broker Definition
    The Exchange Act generally \277\ disqualifies banks that act as 
carrying brokers from utilizing the safekeeping and custody exception 
and the networking exception.\278\ The applicable statutory condition 
defines the term ``carrying broker'' by reference to Exchange Act 
Section 15(c)(3) and the rules thereunder.\279\ In adopting the Interim 
Rules, the Commission explained:
---------------------------------------------------------------------------

    \277\ Exchange Act Section 3(a)(4)(B)(viii)(II) does not 
prohibit a bank from using the safekeeping and custody exception if 
the bank only acts as a carrying broker for government securities.
    \278\ Exchange Act Sections 3(a)(4)(B)(i)(VIII) and 
3(a)(4)(B)(viii)(II). 15 U.S.C. 78c(a)(4)(B)(i)(VIII) and 15 U.S.C. 
78c(a)(4)(B)(viii)(II).
    \279\ The legislative history indicates that the GLBA uses the 
terms ``carrying broker'' and ``clearing broker'' synonymously. See 
H.R. Rep. No. 106-74, pt. 3, at 169 (1999). (``The exception also 
will not apply to a bank that acts as a clearing broker in 
connection with securities transactions, except if the bank is 
acting in the U.S. as a clearing broker with respect to government 
securities.''). As the legislative history indicates:
    ``To ensure that an investor has SIPC protection for the 
securities that he or she purchases--protection that applies to the 
broker-dealer but not a bank--the broker-dealer that is part of a 
networking arrangement must carry the investor's account.'' H.R. 
Rep. No. 106-74, pt. 3, at 164.
    There is a technical difference between a ``carrying broker'' 
and a ``clearing broker.'' A carrying firm knows the customer and is 
responsible for the underlying customer assets. A customer may clear 
elsewhere. As the Commission has explained, an introducing broker-
dealer is one that has a contractual arrangement with another firm, 
known as the carrying or clearing firm, under which the carrying 
firm agrees to perform certain services for the introducing firm. 
Usually, the introducing firm submits its customer accounts and 
customer orders to the carrying firm, which executes the orders and 
carries the account. The carrying firm's duties include the proper 
disposition of the customer funds and securities after trade date, 
the custody of customer securities and funds, and the recordkeeping 
associated with carrying customer accounts. Exchange Act Release No. 
31511 (Nov. 24, 1992), 57 FR 56973, 56978 (Dec. 2, 1992). See also 
NASD Rule 3230 regarding clearing arrangements (discussing the 
contractual requirements for all ``clearing or carrying agreements 
entered into by a member''); NYSE Rule 382 and American Stock 
Exchange Rule 400. As noted above, however, Congress used these 
terms interchangeably.

    A bank acting as a carrying broker facilitates the transfer of 
funds and securities associated with the clearance and settlement of 
securities and related margin lending on behalf of a broker-dealer 
and executes trades for itself and its customers. A carrying broker 
relationship is distinguished from a custody relationship by the 
fact that the bank is

[[Page 39712]]

selected and its systems are utilized primarily by the broker-dealer 
rather than primarily by the customer. In a situation where the 
broker-dealer arranges for a substantial majority of its customers 
to use bank custody or deposit services of a bank, a carrying broker 
relationship may be established particularly if the bank performs 
clearance and settlement functions that the broker-dealer cannot 
perform economically or efficiently. In contrast, a bank would not 
be a carrying broker when it acts as custodian for a customer of a 
broker-dealer and responds to customer directions to deliver 
securities against payment or cash against receipt of 
---------------------------------------------------------------------------
securities.\280\

    \280\ Exchange Act Release No. 44291, supra note 13, 66 FR at 
27780, n. 174.
---------------------------------------------------------------------------

    One commenter stated that the distinction between permissible 
clearing and settlement functions within the custody and safekeeping 
exception and impermissible ``carrying broker'' activities was not 
clear.\281\ This commenter expressed concern about a bank's status when 
multiple customers may have bank accounts for which the bank provides 
investment management and custody services, as well as accounts with 
the bank's affiliated broker-dealer for which the bank is a custodian. 
In this commenter's view, a bank in this situation may inadvertently 
act as a carrying broker merely by having a large number of accounts, 
even if the accounts were originated primarily because of the bank's 
relationship with customers.\282\
---------------------------------------------------------------------------

    \281\ See PNC letter.
    \282\ Id.
---------------------------------------------------------------------------

    A brokerage relationship can involve an introducing broker-dealer 
that accepts customer orders, a clearing or carrying broker-dealer that 
settles the customer orders,\283\ and a custodian that holds the funds 
and securities on behalf of the carrying or clearing broker-dealer. The 
prohibition on banks acting as carrying brokers for registered broker-
dealers predates the GLBA.\284\ Only registered broker-dealers have 
been permitted to act as carrying or clearing brokers.\285\ The 
statutes and rules governing securities transactions generally use the 
terms, ``carrying broker'' and ``clearing broker'' 
interchangeably.\286\ Under these earlier provisions, and consistent 
with the Exchange Act condition on the networking and safekeeping and 
custody exceptions, banks are only permitted to act as carrying brokers 
with respect to government securities.\287\ Thus the question arises as 
to what a carrying broker is and when would a bank be engaged in 
prohibited conduct.
---------------------------------------------------------------------------

    \283\ If a broker-dealer effects securities transactions for a 
customer, Exchange Act Rule 15c3-1(a)(2)(i) requires a broker-dealer 
to hold the customer assets and settle the securities transactions. 
See also 15 U.S.C. 78o(c)(3)(A).
    \284\ See Decision of the Comptroller of the Currency on the 
Application by Zions First National Bank, to Commence New Activities 
in an Operating Subsidiary, December 11, 1997, at n. 74. The 
Comptroller references a Commission comment letter on the Zions' 
application in this footnote, and states that the subsidiary has 
committed to comply with all applicable federal securities laws and 
regulations, including the Commission's financial responsibility 
regulations. In more detail than was repeated in the OCC's order, 
the Commission's letter stated,''[b]ecause the bank is not a broker-
dealer, the Operating Subsidiary would be required to introduce to a 
registered broker-dealer its customers' transactions in Revenue 
Bonds, or to carry and clear those accounts itself in compliance 
with the Commission's financial responsibility regulations, 
including Rules 15c3-1 and 15c3-3 under the Securities Exchange Act 
of 1934.'' See letter from Jonathan G. Katz, Secretary, Commission, 
to Office of the Comptroller of the Currency at page 2 (Nov. 21, 
1997).
    \285\ See 15 U.S.C. 78o(c)(3)(A), Exchange Act Rule 15c3-
1(a)(2)(i), NASD Rule 3230, Clearing Agreements and NYSE Rule 382.
    \286\ Id.
    \287\ 15 U.S.C. 78c(a)(4)(B)(viii)(II).
---------------------------------------------------------------------------

    Under the securities laws and rules, a carrying or clearing broker 
has higher minimum net capital requirements than a broker-dealer that 
does not handle customer funds and securities.\288\ In addition, a 
carrying or clearing broker often provides securities recordkeeping, 
trade execution, and settlement services. A carrying or clearing broker 
relationship must be documented and, at a minimum, must specify the 
responsibilities of the introducing broker and the carrying or clearing 
broker.\289\ Because the responsibilities of the carrying or clearing 
broker and the introducing broker are clearly set forth, securities 
customers are protected and the legal obligations of the parties can be 
determined in the event of a dispute.\290\
---------------------------------------------------------------------------

    \288\ See Exchange Act Rule 15c3-1(a)(2)(i).
    \289\ See NASD Rule 3230, Clearing Agreements and NYSE Rule 382, 
which set forth the following requirements to specify the 
responsibility of the introducing broker and the carrying or 
clearing broker: (1) opening, approving and monitoring customer 
accounts; (2) extension of credit; (3) maintenance of books and 
records; (4) receipt and delivery of funds and securities; (5) 
safeguarding of funds and securities; (6) confirmations and 
statements; and (7) acceptance of orders and execution of 
transactions. For purposes of the financial responsibility rules and 
SIPC, customers are customers of the clearing broker. Furthermore, 
each customer whose account is introduced on a fully disclosed basis 
must be notified in writing upon the opening of the account or the 
existence of the agreement and the relationship between the 
introducing and the carrying broker.
    One way to divide the responsibilities of an introducing and a 
clearing broker-dealer is to list the front office activities 
conducted by an introducing broker-dealer (items one and seven 
above) as compared to the back office activities conducted by a 
clearing broker-dealer (items two through six above).
    \290\ For example, if either party were to become insolvent, the 
rights and obligations of the solvent party, the Securities Investor 
Protection Corporation, and the customers could be determined under 
the terms of the written agreement. Without this kind of clear 
documentation, a carrying or clearing broker relationship could 
result in chaos if one of the parties were to become insolvent, or 
in the event of any dispute over their respective responsibilities 
and obligations. This kind of dispute or insolvency may 
unnecessarily harm customers, or the Securities Protection Investors 
Corporation.
---------------------------------------------------------------------------

    When a bank performs the back office functions of a broker-dealer, 
the bank is often acting as a carrying broker for the broker-dealer. A 
bank may be acting as a carrying broker if it also executes customers' 
securities transactions through a broker-dealer whose primary purpose 
is to support the bank, and whose back office functions reside in the 
bank.\291\ For example, a bank could be a carrying broker by acting as 
a custodian, performing many back office functions for a broker-dealer, 
and entering into a networking arrangement on an omnibus basis with the 
broker-dealer.\292\ In this situation, the business of the two entities 
would be so inextricably intertwined, and the bank would be providing 
so many different functions to the broker-dealer, that the bank could 
be said to be ``carrying'' the broker-dealer's accounts.
---------------------------------------------------------------------------

    \291\ See supra note 289 for an explanation of ``front office'' 
versus ``back office'' functions.
    \292\ This would be especially true if that broker-dealer does 
not engage in business other than executing securities transactions 
for the bank. Exchange Act Section 3(a)(4)(B)(vii) permits banks to 
enter into networking arrangements with broker-dealers on the basis 
that all customers that receive the services are fully disclosed to 
the broker-dealer. A bank relying on the networking exception may 
not, however, act as a carrying broker.
    Broker-dealers could, of course, continue to use banks to 
fulfill their customer segregation requirements as provided in 
Exchange Act Rules 15c3-3(c)(5), 15c3-3(e)(1), and 15c3-3(k)(2)(i).
---------------------------------------------------------------------------

    One bank trade group advised the Commission staff that bank custody 
departments typically do not open accounts with large numbers of 
broker-dealers. Instead, when a large bank opens an account with a 
broker-dealer, the broker-dealer frequently is a bank affiliate. A bank 
could be acting as a carrying broker if it uses an affiliated broker-
dealer whose main purpose is to execute the securities transactions of 
the bank and the bank assumes other functions, such as clearing 
transactions with a clearing agency, that properly belong within the 
broker-dealer. The carrying broker question arises when a bank assumes 
more broker-dealer functions, and the broker-dealer is dependent upon 
the specific relationship established between the bank and the broker-
dealer. Of course, a bank would not be acting as a carrying broker when 
a customer chooses the bank to act as custodian and the bank then uses 
a variety of broker-dealers to execute and clear the subsequent

[[Page 39713]]

securities transactions as permitted by the safekeeping and custody 
exception.\293\
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    \293\ This interpretation does not affect the ability of a bank 
to act as a good ``control location'' of fully-paid and excess 
margin securities of customers pursuant to Exchange Act Rule 15c3-
3(c). A broker-dealer is deemed to have control of securities under 
Rule 15c3-3(c)(5), if the securities:
    are in the custody or control of a bank as defined in Section 
3(a)(6) of the Act, the delivery of which securities to the broker 
or dealer does not require the payment of money or value and the 
bank having acknowledged in writing that the securities in its 
custody or control are not subject to any right, charge, security 
interest, lien or claim of any kind in favor of a bank or any person 
claiming through the bank * * * .
    Under Exchange Act Rule 15c3-3(c), only a broker-dealer may have 
access to the securities held at a bank that is a good ``control 
location.''
---------------------------------------------------------------------------

    We solicit comment on whether we should adopt a rule setting forth 
specific factors to clarify the distinction between a bank acting as a 
carrying broker and a bank acting as a custodian. Some of the factors 
we would consider including in a rule as indications of whether a bank 
is acting as a carrying broker are: (1) A bank having opening, 
approving and monitoring control over the broker-dealer's customer 
accounts; (2) a bank extending credit to the broker-dealer's customers; 
(3) a bank maintaining the broker-dealer's books and records; (4) the 
bank receiving and delivering the broker-dealer's funds and securities; 
(5) the bank safeguarding the funds and securities of the broker-
dealer's customers; (6) the bank preparing and issuing the broker-
dealer's confirmations and statements; (7) the bank accepting the 
customer's orders; and (8) the bank arranging for the execution of the 
customer's transactions. We invite comment on whether there are any 
other factors that should be considered in determining whether a bank 
is acting as a carrying broker.
4. Comments on and Proposed Amendments to the Small Bank Custody 
Exemption
    The Exchange Act exceptions from the definition of ``broker'' apply 
equally to all banks. To help alleviate possible administrative burdens 
imposed on small banks by the GLBA, current Exchange Act Rule 3a4-4 
provides a limited exemption from the definition of ``broker'' under 
Exchange Act Section 3(a)(4) to permit small banks to receive 
transaction-based compensation for effecting transactions in investment 
company securities held in tax-deferred custodial securities accounts, 
such as custody IRAs.\294\
---------------------------------------------------------------------------

    \294\ 17 CFR 240.3a4-4.
---------------------------------------------------------------------------

    Exchange Act Rule 3a4-4 is available to banks with less than $100 
million in assets and that are not part of bank holding companies with 
consolidated assets of more than $1 billion.\295\ Compensation from 
securities transactions effected under this exemption may constitute up 
to three percent of a small bank's annual revenue. The exemption is 
only available to small banks offering custody accounts that do not 
have affiliated broker-dealers or networking arrangements with 
registered broker-dealers. The exemption is also subject to 
restrictions on solicitation, staffing, and employee incentive 
compensation.
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    \295\ The Interim Rules use the $1 billion limit for small bank 
holding companies because the Federal Reserve Board has categorized 
these companies as ``small, noncomplex bank holding companies'' for 
the purposes of determining the type of supervisory review that they 
receive. See Exchange Act Release No. 44291, supra note 13, 66 FR at 
27782 (citing the 1999 Federal Reserve Annual Report at 122). See 
also 2003 Federal Reserve Annual Report at 87.
---------------------------------------------------------------------------

    We received several comments regarding the small bank custody 
exemption. Commenters criticized many aspects of the exemption 
asserting, among other things, that its conditions limit the 
exemption's usefulness.\296\ In particular, commenters contended that 
the $100 million asset limit is too low. Some commenters recommended 
increasing the asset limit to $250 million, noting that the Banking 
Agencies, for purposes of the Community Reinvestment Act, define a 
small bank as one with less than $250 million in assets.\297\ In later 
discussions with Commission staff, the ICBA recommended increasing the 
asset limit to $500 million. Some commenters asserted that the three 
percent limit on annual revenue would severely constrain small banks 
from receiving compensation for order taking services.\298\ Commenters 
also objected to the restriction on utilizing networking arrangements 
with registered broker-dealers to effect securities transactions for a 
bank's customers in conjunction with the exemption.\299\
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    \296\ See ABA/ABASA letters; ICBA letter; IIB letter, Compass 
letter; and Trust Financial Services Division of the Texas Bankers 
Association letter.
    \297\ See ICBA letter and ABA/ABASA letters. See also Virginia 
Bankers Association letter (asserting the $100 million dollar asset 
limit is ``too narrow'').
    \298\ See ABA/ABASA letters; Banking Agencies letter; and ICBA 
letter.
    \299\ See, e.g., Banking Agencies letter and ICBA letter.
---------------------------------------------------------------------------

    In response to comments, we propose to amend Exchange Act Rule 3a4-
4, which would be redesignated as Exchange Act Rule 761, to expand the 
exemption's usefulness to small banks while minimizing their potential 
compliance costs. In particular, as discussed in detail below, we 
propose to raise the eligibility limit from banks with $100 million in 
assets to banks with $500 million in assets. In addition, we propose to 
eliminate the exemption's staffing restrictions. We propose to retain, 
however, the requirement that a bank may not be affiliated with a bank 
holding company that has more than $1 billion in assets. We also 
propose to limit the availability of the exemption to banks that have 
less than $100,000 in annual ``sales compensation'' and that do not 
have affiliated broker-dealers. This proposed exemption would be 
available for transactions in any type of security held in an account 
for which the bank acts as a custodian.
    The small bank exemption, with the proposal modifications, reflects 
a balance between making it available to more banks while also assuring 
that these banks' securities activities are largely effected through 
registered broker-dealers, consistent with the functional regulation 
mandate in the GLBA. The conditions are designed to permit small banks 
to use a limited securities sales channel without meeting the 
licensing, sales practices, and other requirements that apply to 
registered broker-dealers.
    In proposing these amendments, we have evaluated the benefits to 
small banks against the risk to investors of not receiving protections 
under the Exchange Act and SRO rules. We have also considered whether 
the proposed conditions could tilt the level playing field between 
securities market participants that Congress sought to establish with 
functional regulation. In particular, we have considered the 
competitive effect the scope of this proposed exemption may have on 
small broker-dealers. Commenters are invited to discuss whether this 
proposal strikes the right balance.

a. Bank Asset Size Limit

    We propose to increase significantly the number of banks that 
potentially could utilize the small bank custody exemption by amending 
the definition of ``small bank'' to mean a bank with less than $500 
million in assets.\300\ We

[[Page 39714]]

propose, however, to retain the requirement that such a bank may not be 
an affiliate of a bank holding company or a savings and loan holding 
company with more than $1 billion in consolidated assets in the two 
prior calendar years.\301\
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    \300\ The Banking Agencies have recently proposed to raise the 
small institution asset limit of the Community Reinvestment Act from 
$250 million to $500 million, without reference to holding company 
assets. See 69 FR 5729 (Feb. 6, 2004). We do not consider this 
proposal relevant for purposes of setting the asset limit for this 
exemption because of the very different legislative purposes of the 
Community Reinvestment Act and the Exchange Act. The asset limit 
increase recently proposed by the Banking Agencies addresses a 
bank's responsibilities under the Community Reinvestment Act, while 
the asset limit increase we propose addresses whether a small bank 
must register as a broker-dealer to effect securities transactions 
for its custody customers.
    The Interim Rules incorporate the definition of ``small bank'' 
used by the Small Business Administration (``SBA'') because it was a 
definition determined by an independent third agency. One option 
would be to raise the asset limit for this exemption to $150 million 
because the SBA raised its size standards for small banks from $100 
million to $150 million since the Interim Rules were adopted. See 13 
CFR 121.201. See also Small Business Size Standards, Inflation 
Adjustments to Size Standards, 67 FR 3041 (Jan. 23, 2002). 
Increasing the asset threshold to $150 million would expand the 
availability of this exemption to approximately 63 percent of all 
banks and thrifts insured by the FDIC.
    However, the ABA and the ICBA have advised the Commission staff 
that few banks with assets of less than $150 million actually hold 
custody of customers' securities. They have indicated that a $500 
million standard would be more useful. Because we believe that this 
exemption should be one that small banks having custody of 
securities can use, we have adopted the suggestion of the ABA and 
the ICBA and propose to increase the asset threshold for the 
proposed Exchange Act Rule 761 to $500 million.
    \301\ The requirement of two prior calendar years is a condition 
of current Exchange Act Rule 3a4-4. We received no comments on this 
requirement. It is intended to preclude short-term business changes 
from affecting a bank's reliance on this provision.
    We propose a technical amendment to add savings and loan holding 
companies to bank holding companies. Because a new bank, bank 
holding company, or a savings and loan holding company would have no 
assets in either one or both of the two prior calendar years, a bank 
would qualify for the exemption for at least the period of time in 
which it had no assets.
---------------------------------------------------------------------------

    A $500 million asset limit would greatly expand the availability of 
this exemption, increasing the number of potentially eligible banks and 
thrifts from 4,359 (or approximately 48 percent of all banks and 
thrifts insured by the FDIC) to 8,021 (or approximately 88 percent of 
all FDIC insured banks and thrifts).\302\ We solicit comment on the 
proposed amendment to the definition of small bank. We also solicit 
comment regarding whether an eligibility test based on deposits rather 
than assets would be better suited for an exemption targeted to small 
banks. Should the $500 million asset limit be adjusted for inflation? 
If so, what measure of inflation should be used?
---------------------------------------------------------------------------

    \302\ A smaller percentage than 88 percent of banks and thrifts 
would be able to use this proposed exemption because other 
conditions of this proposed exemption require that these banks 
cannot be affiliated with a bank holding company or a savings and 
loan holding company with consolidated assets of more than $1 
billion and cannot be affiliated with a registered broker-dealer.
---------------------------------------------------------------------------

b. Annual Sales Compensation Limit

    We propose to replace the current three percent annual revenue 
limit with an annual ``sales compensation'' limit of $100,000 for 
effecting securities transactions in reliance on this exemption. Sales 
compensation would include compensation that a bank receives for a 
securities offering that the bank does not receive directly from a 
customer, beneficiary, or the assets of the trust or fiduciary account, 
such as Rule 12b-1 fees.\303\ We anticipate that most sales 
compensation would be composed of Rule 12b-1 fees. Sales compensation 
could also include revenue sharing arrangements with mutual funds or 
commissions for securities trades that include a profit. Sales 
compensation, however, would not include fees for holding custody of a 
customer's funds and securities that do not vary based on whether 
orders for securities are accepted by the broker. In addition, the 
proposed rule provides that this $100,000 annual limit on ``sales 
compensation'' that the bank receives pursuant to this exemption would 
be adjusted for inflation so that this exemption remains useful to 
small banks in years to come.\304\
---------------------------------------------------------------------------

    \303\ See section III.B. supra.
    \304\ As of December 1, 2003, three percent of the annual 
revenue of an average bank with $500 million in assets was $183,570; 
for an average bank with $250 million in assets it was $131,010; and 
for an average bank with $150 million in assets it was $97,770. The 
proposed revenue limitation is necessary because some banks that 
would qualify for the proposed exemption have extremely high 
revenues in relation to total assets. For example, the Commission 
staff reviewed Schedule RC (``Consolidated Report of Condition'') 
and Schedule RC-I (``Consolidated Report of Income'') (Form FFIEC 
041) of a bank that has assets of approximately $354 million but 
revenue of approximately $493 million. Some banks with $500 million 
or less in assets appear to be almost exclusively in the securities 
business, and these banks could potentially operate a large 
introducing broker-dealer within the bank without an overall revenue 
limitation such as the one we are proposing.
---------------------------------------------------------------------------

    The $100,000 annual ``sales compensation'' limit should provide 
those banks that occasionally effect transactions in securities as an 
accommodation in their custody relationships with sufficient 
flexibility to continue to serve the needs of their customers without 
requiring the banks to register as brokers.\305\ We solicit comment on 
the proposed $100,000 ``sales compensation'' limitation.
---------------------------------------------------------------------------

    \305\ The $100,000 limit was selected based on information the 
Commission staff received from a bank trade association. This 
information indicated that the proposed limit should accommodate 
small banks' existing business.
---------------------------------------------------------------------------

    Commenters are invited to share information about how small banks 
assess custody fees. With respect to each type of customer with a 
custody relationship with a small bank, small banks are invited to 
discuss: (1) The types of securities that the bank purchases or sells 
for these customers; (2) all of the types of compensation that the bank 
receives in connection with its custody activities related to different 
types of such customers; (3) whether custody fees vary depending on 
whether small banks sell non-custody products and services to 
customers; and (4) whether small banks are compensated in other ways 
for custody accounts or relationships.
    In particular, we seek comment regarding the amount of ``sales 
compensation'' that small banks receive for effecting transactions in 
securities for customers with whom they have a custody relationship. We 
seek comment regarding the percentage of custody revenue that small 
banks obtain from Rule 12b-1 fees. Commenters are invited to discuss 
whether small banks receive significant sales compensation outside of 
Rule 12b-1 fees, such as from revenue sharing arrangements for mutual 
funds held for custody customers or through commissions for securities 
trades that include a profit. Commenters should note if their answer 
varies depending on whether the custody accounts are for: (1) 
Companies; (2) market professionals; (3) individual private banking 
clients; or (4) clients holding IRAs. We seek comment on whether small 
banks would find it difficult to calculate the total amount of Rule 
12b-1 fees they would receive on an annual basis in connection with 
this exemption.
    We invite comment on whether the sales compensation limit should be 
set at a different level. Would a different limit on sales compensation 
such as $50,000 be more appropriate for an exemption designed to be 
used only by small banks? Should the limit be higher? Commenters that 
believe that this limit on sales compensation should be more than 
$100,000 should provide empirical data supporting this assertion. We 
request comment about the inflation-adjusted aspect of this condition. 
Is linking it to the Consumer Price Index All Urban Consumers published 
by the Department of Labor appropriate or should another measure of 
inflation be used? \306\ The Commission is also interested in 
information regarding the types of securities transactions that a bank 
likely would effect at these different revenue levels.
---------------------------------------------------------------------------

    \306\ See proposed Exchange Act Rule 761(c).
---------------------------------------------------------------------------

    We invite comment on whether particular types or sources of 
revenues should be excluded, temporarily or permanently, from the 
$100,000 sales compensation limit. For example, should Rule 12b-1 fees 
that small banks

[[Page 39715]]

receive as a result of mutual fund sales that took place before the 
date of this proposal be excluded from the $100,000 sales compensation 
limit? If yes, please explain why. Should there be any limitations on 
such excluded revenue? Should revenues received from the sale of other 
types of securities be excluded from the $100,000 limit? If so, why?

c. Other Conditions

1. Solicitation

    We propose to simplify the solicitation restrictions in current 
Exchange Act Rule 3a4-4 to permit small banks effecting securities 
transactions pursuant to this exemption to publicly solicit brokerage 
business as permitted by the trust and fiduciary activities 
exception.\307\ The trust and fiduciary exception permits small banks 
to solicit brokerage business by advertising that they effect 
transactions in securities in conjunction with advertising their other 
trust activities.\308\ This restriction on solicitation of securities 
transactions for custody accounts would not apply to securities 
transactions that are not effected pursuant to this proposed exemption.
---------------------------------------------------------------------------

    \307\ The Commission interprets solicitation broadly in the 
context of securities transactions. See Exchange Act Release No. 
27017, supra note 86, 54 FR 30013.
    \308\ See Exchange Act Section 3(a)(4)(B)(ii)(II).
---------------------------------------------------------------------------

    We request comment on this proposed amendment to the small bank 
custody exemption. We are particularly interested in comments regarding 
how small banks market custody services to potential clients. We also 
request comment on the extent to which small banks inform those 
customers with whom they have custody relationship about securities. 
For example, do small banks provide these customers with recommended 
lists, watch lists, research reports, or other publications 
highlighting securities or groups of securities? Do small banks offer 
asset allocation advice, and, if so, do they suggest possible 
investments to achieve asset allocation goals? Do small banks recommend 
specific securities--or classes of securities--to such customers? Do 
small banks recommend specific trading strategies to these customers? 
Do small banks provide investment advice to such customers? How do 
small banks offer particular classes or series of mutual funds to their 
customers with whom they maintain a custody relationship? Finally, we 
solicit comment regarding whether we should adopt disclosure 
requirements similar to the proposed general disclosure requirements in 
proposed Exchange Act Rule 776.

2. Securities Networking

    Commenters criticized the provision in Exchange Act Rule 3a4-4 that 
excluded banks that had a networking relationship with a broker. They 
argued that permitting small banks to have networking arrangements with 
third-party broker-dealers would allow banks to offer the services of a 
broker to their customers (the networking arrangement), while still 
allowing banks to conduct some transactions in-house.\309\ We propose 
to replace that restriction with one that restricts a small bank from 
affiliating with a broker-dealer. Permitting banks to have networking 
arrangements with registered broker-dealers will greatly increase the 
utility of this exemption to small banks. Banks with a registered 
broker-dealer affiliate, however, have demonstrated their ability to 
put in place the infrastructure of a regulated broker-dealer to serve 
their customers, which can be used for other securities activities of 
bank customers. Small banks that have networking arrangements with 
broker-dealers are particularly invited to discuss whether this 
provision would be workable for them, and to suggest alternative 
provisions that might be more workable. We request comment on the 
proposal to replace the networking restriction in current Exchange Act 
Rule 3a4-4 with a restriction on having an affiliated broker-dealer. We 
also solicit comment on the number of small banks that have an 
affiliated broker-dealer.
---------------------------------------------------------------------------

    \309\ See, e.g., ICBA letter and Banking Agencies letter.
---------------------------------------------------------------------------

3. Employee Staffing Restrictions

    Commenters criticized the provision in the Interim Rules that 
prohibits bank employees from also being employees of a broker-dealer, 
asserting that having such dual employees allows banks to better serve 
the investment needs of retail customers with whom bank employees come 
into contact while performing their banking custodial 
responsibilities.\310\ In response to this comment, we propose to 
permit small banks to use dual employees with broker-dealers.
---------------------------------------------------------------------------

    \310\ See ABA/ABASA letters.
---------------------------------------------------------------------------

    Commenters also criticized the requirement that any bank employee 
must primarily have duties other than conducting securities 
transactions, arguing that this requirement is contrary to proper 
internal controls.\311\ This requirement was designed to prevent banks 
from developing dedicated securities sales forces outside of the 
safeguards of the sales practice rules applicable to broker-dealers. We 
understand, however, that it would ease small banks' compliance burdens 
if specialized employees could be used to effect securities 
transactions for bank customers in the context of this exemption. We 
also understand that specialized employees may improve operational 
economies. Therefore, we propose to permit banks to use a dedicated 
bank sales force to effect transactions in securities under this 
exemption. This dedicated sales force may consist of either 
unregistered personnel or registered representatives employed by both a 
broker-dealer and the small bank seeking to qualify for the exemption.
---------------------------------------------------------------------------

    \311\ See ICBA letter and Frost letter.
---------------------------------------------------------------------------

    We solicit comment with regard to these proposed amendments to the 
employee staffing restrictions for the small bank custody exemption. 
Commenters are particularly invited to discuss how small banks utilize 
personnel to effect securities transactions.

4. Employee Compensation Restriction

    Some commenters expressed concern regarding the rule's restriction 
on payment of incentive compensation to bank employees for the sale of 
securities.\312\ We propose to retain this restriction but to clarify 
that small banks may pay their employees incentive compensation 
pursuant to a networking arrangement that meets the conditions of 
Exchange Act Section 3(a)(4)(B)(i).\313\ This condition encompasses 
payment of incentive compensation both to unregistered employees and to 
employees who are registered representatives.\314\
---------------------------------------------------------------------------

    \312\ See ICBA letter and BSA letter.
    \313\ See proposed Exchange Act Rule 761(e).
    \314\ See section III.B. supra.
---------------------------------------------------------------------------

    We request comment on this proposed amendment to the small bank 
custody exemption. Commenters are invited to discuss how small bank 
employees are compensated. For example, how much incentive compensation 
would a typical small bank employee receive in a year from making 
referrals to a broker-dealer via a networking arrangement? How much 
could a small bank employee earn in a year from this activity if he or 
she made so many referrals as to be in the top one percent of employees 
referring customers to broker-dealers?

5. Investment Company Shares for Tax-Deferred Accounts

    Commenters also criticized the small bank custody exemption because 
it only applies to transactions in investment company shares for the 
benefit of tax-

[[Page 39716]]

deferred accounts.\315\ One commenter suggested that the exemption 
should not be limited to providing order taking services for clients 
seeking to purchase mutual funds, but should be expanded to include 
tax-deferred accounts holding corporate debt and equity 
securities.\316\ Other commenters suggested that the Commission 
eliminate the requirement that banks offering proprietary mutual funds 
also offer nonproprietary mutual funds.\317\ To provide small banks and 
their customers more flexibility, we propose to expand the scope of 
this exemption to allow small banks to effect transactions in all 
securities, not just shares of investment companies. In addition, we 
are proposing to expand this exemption to apply to custodial accounts 
in general by eliminating the requirement that transactions pursuant to 
this exemption must be for tax-deferred accounts. Finally, we propose 
to permit small banks to offer proprietary mutual funds without the 
requirement that banks also offer nonproprietary mutual funds.
---------------------------------------------------------------------------

    \315\ See ICBA letter and ABA/ABASA letters.
    \316\ See ABA/ABASA letters.
    \317\ See Compass letter and Frost letters.
---------------------------------------------------------------------------

    We solicit comment regarding how small banks select the mutual 
funds they offer to their custody customers, and the extent to which 
they limit offerings to proprietary funds. We also invite comment 
regarding the effect on investor protections of this proposed expansion 
of the securities transactions permitted under the exemption. Moreover, 
we are also interested in receiving comment on this exemption for small 
banks in light of the proposed ERISA exemption available to all banks. 
Do commenters believe that exempting bank trustees and non-fiduciary 
administrators that effect transactions in securities of open-end 
companies for participants in employee benefit plans from the 
definition of broker eliminates the need for the amendments being 
proposed to the small bank custody exemption? \318\ In other words, do 
commenters believe that the small bank custody exemption will be used 
for securities transactions in securities other than investment company 
securities or for accounts other than IRA custody accounts?
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    \318\ See section III.F.2 supra (proposed ERISA exemption).
---------------------------------------------------------------------------

d. Trustee and Fiduciary Activity Accounts

    A small bank that has trust and fiduciary activity accounts may use 
the small bank custody exemption provided that it does not rely on any 
other of the trust and fiduciary exemptions in the Rules.\319\ In other 
words, banks could elect to effect transactions for trust and fiduciary 
activity accounts under this exemption. The sales compensation that a 
bank would receive from these transactions would count towards the 
$100,000 annual limit. If small banks elect to utilize this exemption 
to effect securities transactions for trust and fiduciary activity 
accounts, they would avoid all calculation and other requirements of 
the trust and fiduciary exemptions--except in particular accounts where 
they elect to rely on the statutory test without utilizing any safe 
harbors. We understand that up to 85 percent of small banks may be able 
to avoid any other ``chiefly compensated'' comparison by using this 
proposed exemption.
---------------------------------------------------------------------------

    \319\ See proposed Exchange Act Rule 761(d).
---------------------------------------------------------------------------

e. Availability of Exemption to Non-Depository Trust Companies

    An industry group representing non-depository trust companies 
complained that the small bank custody exemption is not workable for 
its members.\320\ According to this commenter, because trust companies 
do not earn revenue from loan payments, the three percent annual 
revenue limit would not permit them to continue to effect transactions 
in securities.\321\ While we do not propose specific amendments to 
address non-depository trust companies, the proposal to amend Exchange 
Act Rule 3a4-4 to replace the three percent limit on ``annual 
compensation'' with an annual sales compensation limit of $100,000 
should address this comment. We seek comment on whether replacing the 
three percent annual revenue limit with the $100,000 annual limit on 
sales compensation addresses any competitive disadvantages that non-
depository trusts might have with regard to small banks as a result of 
the small bank custody exemption.\322\
---------------------------------------------------------------------------

    \320\ See Association of Independent Trust Companies letter.
    \321\ This commenter stated that its trust company members 
typically have assets under management of between $50 million and 
$500 million and may, in some cases, have in excess of $1 billion in 
assets under management. See id.
    \322\ One commenter asked that we extend current Exchange Act 
Rule 3a4-4 to include small insurance agencies and insurance 
brokerage, arguing that these entities will be at a competitive 
disadvantage in the financial services marketplace if they do not 
also receive an exemption. See letter dated September 4, 2001 from 
Scott Sinder and Douglas S. Kantor, Counsel to the Council of 
Insurance Agents & Brokers. We are not proposing to extend this 
exemption to include these entities because, in contrast to banks, 
insurance agencies and insurance brokerages historically have not 
held customer assets, in connection with securities transactions or 
accepted customer orders as an accommodation to custer without using 
registered broker-dealers.
---------------------------------------------------------------------------

f. Request for Comments

    We solicit comment on the small bank exemption in proposed Exchange 
Act Rule 761. In particular, we are soliciting comments on the 
Commission's proposal to raise the eligibility limit from $100 million 
to $500 million in assets. What would the impact of such a change have 
on the percentage of banks that could qualify for the exception? Should 
the threshold be higher or lower than $500 million? Commenters should 
provide a detailed discussion, including data, if available, to support 
a higher or lower standard. We also solicit comment on whether banks 
anticipate effecting transactions in securities as custodians for 
health savings accounts and whether this proposed exemption would 
accommodate this business.
    In addition, we are soliciting comment on whether the proposed 
exemption would place small broker-dealers at a competitive 
disadvantage vis-a-vis small banks.

F. General and Special Purpose Exemptions

1. General Exemption
    In response to requests by some commenters that the Commission 
provide banks with greater flexibility to provide cash management 
services to their customers, we are proposing a general exemption, not 
tied to any of the GLBA exceptions, that would, subject to certain 
conditions, allow banks to buy and sell money market securities for 
bank customers who are ``qualified investors,'' \323\ a person who 
directs the purchase of securities from any cash flows that relate to 
an asset-backed security that has a minimum original asset amount of 
$25,000,000, and for other customers for whom banks act in a trustee or 
fiduciary capacity, or in an escrow agent, collateral agent, depository 
agent, or paying agent capacity.
---------------------------------------------------------------------------

    \323\ ``Qualified investor'' is defined in Exchange Act Section 
3(a)(54). 15 U.S.C. 78c(a)(54).
---------------------------------------------------------------------------

    The new exemption, which would be contained in proposed Exchange 
Act Rule 776, is based in part on requests from some commenters on the 
Interim Rules that the Commission provide more flexibility with respect 
to the services banks could offer to their customers for whom they act 
in capacities such as indenture trustee, escrow agent, or paying 
agent.\324\ Similarly, commenters and other industry representatives 
have indicated to Commission staff that banks desire

[[Page 39717]]

more flexibility to offer clients with particular cash management needs 
shares in money market funds that may pay more than 25 basis points in 
12b-1 fees.
---------------------------------------------------------------------------

    \324\ See, e.g., ABA/ABASA letters and Federated letters.
---------------------------------------------------------------------------

    The Commission is sensitive to commenters' requests that banks be 
given greater flexibility in offering some of their customers a wider 
range of cash management services that include investing in money 
market funds that may include investing in money market fund shares 
that do not qualify as ``no-load.'' We believe that this enhanced 
flexibility could be granted to banks and would also be consistent with 
the Exchange Act investor protection principles with respect to these 
limited securities transactions that this proposed exemption 
contemplates.
    Accordingly, the exemption in proposed Exchange Act Rule 776 would 
permit banks to make available money market funds for cash management 
purposes to customers that have particular cash management needs and 
that prefer to compensate banks for these or other services through 
Rule 12b-1 fees, or through a combination of Rule 12b-1 fees and other 
fees. For example, banks would be able to continue to provide these 
cash management services when the bank is acting as an indenture 
trustee for a municipality that needs to invest bond proceeds on a 
short-term basis or as escrow agent for corporations that need to 
invest funds pending the consummation of a corporate transaction.
    We would limit the availability of the proposed exemption to 
certain investors. For purposes of the proposed exemption, a 
``qualified investor'' would be identified as a qualified investor 
within the meaning of Exchange Act Section 3(a)(54). We include 
qualified investors because Congress already determined that investors 
in this category were able to engage in some transactions directly with 
banks that would not generally be available to other investors.\325\ We 
would also permit a bank to use the exemption with respect to a person 
who directs the purchase of securities from any cash flows that relate 
to an asset-backed security that has a minimum original asset amount of 
$25,000,000. We selected a minimum $25,000,000 in original asset amount 
for qualifying for this exemption because we believe that it is 
consistent with minimum of $25,000,000 in investments found in many of 
the categories of qualified investor. We elected to make this 
$25,000,000 requirement applicable only to the original asset amount, 
so that the bank would not have to monitor the size of the remaining 
asset pool every time it entered into a sweep transaction with a person 
who directs the purchase of securities from any cash flows that relate 
to an asset-backed security. We believe that this description of the 
second category of persons should be broad enough to accommodate asset-
backed securities issuers, such as certain small state and local 
governmental entities that use these kinds of sweep investments. Bank 
representatives suggested to Commission staff that these types of 
issuers of asset-backed securities be included under an exemption, such 
as the one found in proposed Exchange Act Rule 776, although many of 
these issuers may not meet the definition of qualified investors under 
Exchange Act Section 3(a)(54). We request comment on whether the 
proposed exemption is appropriate in its coverage, including the 
selected minimum $25,000,000 in original asset amount. If commenters 
believe that minimum qualifying amount should be changed, we request 
that commenters provide us with specific information on what the amount 
should be and why. We also request comment on whether the proposed 
exemption should be expanded to cover additional types of investors, 
such as commercial depositors that may not be qualified investors under 
Exchange Act Section 3(a)(54).
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    \325\ For example, the asset-backed transactions exception from 
the definition of dealer only permits a bank to issue and sell 
securities through a grantor trust or other separate entity to 
qualified investors. See Exchange Act Section 3(a)(5)(C)(iii). 15 
U.S.C. 78c(a)(5)(C)(iii).
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    The exemption would be limited to certain, specified securities. 
The money market fund shares in which a bank could effect transactions 
in reliance on the exemption would have to belong to a ``no-load'' 
class or series of the fund's shares, or, alternatively, the bank would 
not be permitted to characterize or refer to the shares as ``no-load.'' 
A bank relying on the exemption to effect transactions in money market 
fund shares that do not qualify as ``no-load'' for customers (other 
than ``qualified investors'' and persons who direct the purchase of 
securities from any cash flows that relate to an asset-backed security 
that has a minimum original asset amount of $25,000,000) also would 
have to provide to these customers a fund prospectus and a clear and 
conspicuous notice disclosing payments the bank may receive in 
connection with the transactions from the fund's fund complex.\326\ 
This notice would also be required to refer the customers to the fund 
prospectus for additional information regarding expenses. These 
conditions are designed to assure that a customer of a bank relying on 
the exemption would have sufficient information upon which to make an 
informed decision. We request comment on whether the proposed exemption 
should be conditioned on additional disclosures, and invite any 
commenters who believe the exemption should be expanded to cover 
transactions for additional types of investors to comment on whether 
such transactions should be conditioned on enhanced disclosures. In 
particular, we invite comment on whether the conditions under which 
banks may rely on the exemption should include disclosure obligations 
with respect to fees banks charge directly to their customers, such as 
rate spreads or retained yield fees. We also request comment on whether 
it is appropriate not to require that the additional disclosures for 
``qualified investors'' and persons who direct the purchase of 
securities from any cash flows that relate to an asset-backed security 
that has a minimum original asset amount of $25,000,000.
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    \326\ The term ``no-load'' is defined in proposed Exchange Act 
Rule 740(c), which amends the definition of the term in current 
Exchange Act Rule 3b-17(f). Under the proposed definition, with 
certain exceptions, a class or series of a fund's securities would 
be considered no-load if it is not subject to a sales load or a 
deferred sales load and charges against net assets for sales or 
sales promotion expenses, for personal service, or for the 
maintenance of shareholder accounts do not exceed 25 basis points. 
The notice that would have to be provided to investors, other than 
qualified investors, in load money market fund shares under the 
proposed exemption would have to identify separately any payments to 
the bank that are a ``sales load'' or a ``deferred sales load,'' as 
those terms are defined in proposed Exchange Act Rule 740, or a fee 
paid pursuant to a plan under Rule 12b-1 under the Investment 
Company Act (17 CFR 270.12b-1).
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    We considered whether to extend the proposed exemption to cover 
transactions for additional types of bank customers. Most such 
customers, however, do not have the same specific cash management needs 
as the customers that we have identified. Moreover, we remain concerned 
that additional types of customers may be more vulnerable than the 
types of customers identified in the proposed exemption to being misled 
regarding the costs of their investments.\327\ As a

[[Page 39718]]

result, the proposed exemption would apply only to ``qualified 
investors'' and certain other customers who already use a bank for 
trust or fiduciary services, or for the agency services identified in 
proposed Exchange Act Rule 776.
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    \327\ The services covered by the proposed exemption would 
involve fee-related issues similar to those raised by sweep accounts 
offered to retail investors. Sweep account fees can represent 
significant costs for retail investors, and sweep account customers 
have sued banks over excessive fees. However, cases in which 
investors unsuccessfully sued banks over excessive sweep fees 
indicate that retail investors do not have a private right of action 
for excessive sweep account fees under the federal banking laws. 
See, e.g., In re Fidelity Bank Trust Fee Litigation, 839 F. Supp. 
318 (E.D. Penn. 1993). In addition, some courts have considered the 
anti-fraud protections of the federal securities laws inapplicable 
to excessive sweep account fees due to the extensive regulation of 
deposit accounts under the federal banking laws. See, e.g., Simpson 
v. Mellon Bank, 1993 U.S. Dist. LEXIS 17994 (E.D. Penn. Dec. 17, 
1993).
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    Bank representatives have told Commission staff that some banks 
have existing business practices that include investments in a broader 
range of securities. We request comment on whether the proposed 
exemption should be extended to cover funds that are not money market 
funds and whether extending the exemption to these other funds would 
accommodate existing bank practices that would not otherwise be covered 
by one of the proposed exemptions or exceptions. It would be 
particularly helpful if any such comments identified and described 
mutual funds, other than money market funds, that banks would be unable 
to continue using for customers under the other exceptions or 
exemptions, as well as how much the banks currently invest in these 
other funds on behalf of customers that would qualify for this 
exemption. We also ask commenters to provide us with information on 
whether the 12b-1 fees generated by those funds are currently offset 
against bank fees. Would a custodial exemption that required that fees 
be offset, such as that proposed for ERISA activities, be appropriate?
    Finally, we request comment generally on the exemption contained in 
proposed Exchange Act Rule 776. Commenters are specifically invited to 
discuss whether the proposed exemption should be limited to particular 
types of money market funds or to specific types of investors within 
the categories described in the proposed exemption, and, if so, under 
what conditions. Commenters that believe the proposed exemption should 
be expanded should also explain why any proposed expansion of the 
proposed exemption would be consistent with the protection of 
investors.
2. Employee Benefit Plan Exemption
    The Exchange Act does not specifically exclude from broker-dealer 
registration banks that administer employer-sponsored retirement 
plans.\328\ While banks do not typically charge plan participants 
directly for the cost of plan administration, banks may be compensated 
through Rule 12b-1 fees and other fees that meet the ``sales 
compensation'' definition in current Exchange Act Rule 3b-17. Because 
of this compensation arrangement, banks that administer these 
retirement accounts often cannot meet the requirement in the trust and 
fiduciary activities exception to be ``chiefly compensated'' through 
relationship fees.\329\
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    \328\ As of 2003, these plans accounted for $2.1 trillion in 
mutual fund assets. They, therefore, are an important vehicle 
through which ordinary Americans invest in securities. Investment 
Company Institute, 2003 Mutual Fund Fact Book at 47.
    \329\ For example, banks administering small plans advised the 
Commission staff that they often bundle their fees by offering Class 
C shares with one percent Rule 12b-1 fees. Banks that offer Class C 
shares to smaller plans do so in part to compete with insurance 
companies that are more prevalent in the small plan market and 
bundle their fees. Class B shares often carry relatively high 12b-1 
fees, but may automatically convert into Class A shares (which 
generally carry lower 12b-1 fees) several years after purchase. 
Class C shares also generally carry relatively high 12b-1 fees, and 
usually do not automatically convert to a class of shares with lower 
12b-1 fees. Because Class C shares do not automatically convert to a 
share class associated with lower 12b-1 fees, post-first year 
compensation for selling Class C shares may be particularly 
significant. See, e.g., Release Nos. 33-8358, 34-49148, IC-26341 
(Jan. 29, 2004) supra note 130, 69 FR 6438 at 6453, n. 97 and 101 
(Feb. 10, 2004).
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    We propose conditionally to exempt from the definition of broker 
bank trustees and non-fiduciary administrators that effect transactions 
in securities of open-end companies for participants in employee 
benefit plans. A bank relying on this proposed exemption would be 
required to offset or credit any compensation it received from a fund 
complex related to securities in which plan assets are invested against 
fees and expenses that the plan owes to the bank. While ERISA permits 
banks to receive Rule 12b-1 compensation from mutual funds that they 
offer to plan sponsors, banks have advised the Commission staff that 
they offset or credit any compensation received from mutual funds 
against plan expenses.\330\ A dollar-for-dollar offset or credit would 
address the conflict of interest that banks would otherwise have when 
choosing particular funds to offer to plan sponsors.
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    \330\ Banks advised the Commission staff that they do a dollar-
for-dollar offset, or credit, of the compensation they receive from 
the funds that they offer to plans against the fees imposed on the 
plans themselves. In this way, the bank avoids having a conflict of 
interest in selecting the funds in which plan participants invest.
    This dollar-for-dollar offset practice is consistent with 
guidance issued by the Department of Labor (``DOL''). See ERISA 
Advisory Opinion 97-15A (available at: http://www.dol.gov/ebsa/programs/ori/advisory97/97-15a.htm). In that opinion, a bank acting 
as a directed trustee that reserved the right to add, delete, or 
substitute individual mutual funds or fund families within the 
investment menu that it made available to plans and applied the 
mutual fund fees received for the benefit of the plans. Because this 
bank applied the mutual fund fees for the benefit of the plans, 
either as a dollar-for-dollar offset against the fees that the plans 
paid for trustee and recordkeeping services, or as amounts credited 
to the plans, the DOL viewed the bank as not engaging in self 
dealing under 29 U.S.C. 406(b)(1) or (b)(3). At all times, the terms 
of the bank's fee arrangements with the mutual fund companies was 
fully disclosed to the plans. Although DOL also issued ERISA 
advisory opinion 97-16A (available at: http://www.dol.gov/ebsa/programs/ori/advisory97/97-16a.htm), no bank has advised the 
Commission staff that it does not apply mutual fund fees for the 
benefit of the plans.
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    In addition, the exemption in proposed Exchange Act Rule 770 would 
require the bank to disclose clearly and conspicuously to the plan 
sponsor or its designated fiduciary, if any, all fees and expenses 
assessed for services provided to the plan and all compensation 
received or to be received from a fund complex.\331\ The disclosures 
would need to be made in a manner that permits the plan sponsor or its 
designated fiduciary to determine that the bank has offset or credited 
any fees or expenses received from a fund complex related to securities 
in which plan assets are invested against the fees and expenses that 
the plan owes to the bank.
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    \331\ The term ``fund complex'' would be defined in proposed 
Exchange Act Rule 770(b)(1).
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    These disclosure requirements are intended to ensure that banks 
relying on the exemption provide their customers with information on 
their compensation and offsets that makes the disclosure of fees 
charged more transparent and easier to compare for plan sponsors or 
their designated fiduciaries.\332\ As we have discussed before, 
investors need to know about the fees associated with these investments 
because these fees directly affect the amount of their returns.\333\ 
This information should be transparent to purchasers of ERISA plans so 
that they can make ``apples to apples'' comparisons.\334\
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    \332\ This requirement is consistent with our proposal to 
increase transparency regarding mutual fund fees and expenses. See, 
e.g., Exchange Act Release No. 49148, supra note 130.
    \333\ Id.
    \334\ It is very difficult for a plan sponsor to compare fees 
across plans because plan vendors have 80 different ways of charging 
plan fees. See Economic Systems, Inc, Study of 401(k) Plan Fees and 
Expenses (April 13, 1998) (study sponsored by the Office of Policy 
and Research of the Department of Labor's Pension and Welfare 
Benefits Administration). This may lead to fee disparities of up to 
100 basis points for similar plans. A 100 basis point charge reduces 
the return to investors by 18 percent over 20 years. See, e.g., 
Exchange Act Release No. 47023 (Dec.18, 2002), 68 FR 160 (Jan. 2, 
2003).

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[[Page 39719]]

    Some plans allow plan participants to invest through their 
retirement plans in securities and funds beyond those offered in the 
plan menu. This is often referred to as a participant-directed 
brokerage account or a ``brokerage window.''\335\ Bank representatives 
advised the Commission staff that when they offer brokerage windows to 
plan participants, they establish separate brokerage accounts for each 
participant with a broker-dealer. The proposed rule would codify this 
practice by requiring banks that offer brokerage windows to plan 
participants to continue to do so through a registered broker-dealer.
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    \335\ See description of ``participant-directed brokerage 
account'' in Schedule H of the 2003 Instructions for Form 5500 
(combined Internal Revenue Service, Department of Labor and Pension 
Benefit Guaranty Corporation Annual Report of Employee Benefit 
Plan).
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    Finally, proposed Exchange Act Rule 770 would prohibit a bank that 
administers employee benefit plans from paying unregistered employees 
incentive compensation that differs based on the value of a security or 
the type of security purchased or sold by a plan participant. The 
payment of incentive compensation for securities transactions creates 
the type of salesman's stake the federal securities laws are designed 
to regulate. Banks could, of course, pay these employees nominal 
referral fees consistent with the terms of the networking exception for 
referring accounts to a broker-dealer. Banks could also register these 
employees as associated persons of broker-dealers for the purpose of 
receiving incentive compensation from the broker-dealers.
    We solicit comment on all aspects of this exemption. In responding 
to comments, please specify the typical size of the employee benefit 
plan. We solicit comment regarding whether we have adequately captured 
the types of employee benefit plans for which banks act as pension plan 
administrators. If we have not listed all the types of employee benefit 
plans that a bank administers, please list the additional types of 
employee benefit plans that are not included in the proposed rule.
    Please answer the following questions for employee benefit plans 
that are listed in the proposed rule, as well as for any additional 
types of employee benefit plans that a commenter believes should be 
added to the list. We seek bank-specific empirical data with respect to 
each question. In other words, a bank should answer these questions 
with respect to its own business and customers.
    Does a bank typically act as a trustee or as a non-fiduciary 
recordkeeper? How does a bank determine in which capacity to act? What 
services does a bank provide in each different capacity in which it 
acts?
    How does a bank's compensation differ depending on the capacity in 
which it acts? How does a bank's compensation differ depending on the 
type of compensation that it offers to plan participants? What 
transactional or asset-based charges does a bank earn when it acts in 
each different capacity? If a bank offers unaffiliated mutual funds, 
how is the bank compensated by these funds? If a bank is acting in a 
trustee or fiduciary capacity, can the bank meet the ``chiefly 
compensated'' comparison requirement, including the related exemptions?
    Does a bank offset or credit any compensation that it receives from 
a fund complex related to securities in which plan assets are invested 
against fees and expenses that the plan owes to the bank? How does a 
bank disclose the total compensation that it receives for acting as 
trustee or non-fiduciary recordkeeper? How does it disclose any offsets 
or credits?
3. Regulation S Transactions with Non-U.S. Persons
    Persons that conduct a broker or dealer business while located in 
the United States must register as broker-dealers (absent an 
exemption), even if they direct all of their selling efforts 
offshore.\336\ A bank industry group has requested an exemption from 
the broker-dealer registration requirements to permit banks to continue 
to sell securities that are covered by the safe harbor from U.S. 
registration pursuant to Regulation S to non-U.S. persons, both as 
agent and on a riskless principal basis.\337\ The group also requested 
that the exemption extend to resale of Regulation S securities held by 
non-U.S. persons to other non-U.S. persons in transactions pursuant to 
Regulation S. While the group indicated that banks need this exemption 
primarily to sell proprietary products, such as mutual funds, to non-
U.S. persons,\338\ they would like the flexibility to sell other 
Regulation S securities to non-U.S. persons as well.\339\
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    \336\ As the Commission stated when it adopted Exchange Act Rule 
15a-6:
    As a policy matter, the Commission now uses a territorial 
approach in applying the broker-dealer registration requirements to 
the international operations of broker-dealers.
    Under this approach, all broker-dealers physically operating 
within the United States that effect, induce, or attempt to induce 
any securities transactions would be required to register as broker-
dealers with the Commission, even if these activities were directed 
only to foreign investors outside the United States.
    Exchange Act Release No. 27017, supra note 86, 54 FR at 30016 
(footnotes omitted).
    \337\ See letter dated May 27, 2004, from Lawrence R. Uhlick, 
Executive Director & General Counsel, Institute of International 
Bankers to Catherine McGuire, Chief Counsel, Division of Market 
Regulation, Commission. Regulation S [17 CFR 230.901, et seq.] 
specifies the requirements for an offer or sale of securities to be 
deemed to occur outside the United States and therefore not subject 
to the registration requirements of Section 5 of the Securities Act. 
Regulation S permits the sale of newly issued off-shore securities 
and re-sales of off-shore securities from a non-U.S. person to a 
non-U.S. person.
    \338\ These mutual funds are usually specifically designed for 
sale offshore to avoid implicating U.S. tax laws for nonresident 
non-U.S. persons.
    \339\ Banks indicated to the Commission staff that although 
these products will vary depending on customer preferences and 
needs, among the most important products for banks are proprietary 
and non-proprietary offshore mutual funds structured (particularly 
for tax purposes) for non-U.S. investors, Euro bonds, and emerging 
market debt (especially debt sold to customers in the local 
jurisdiction--e.g., Argentine debt sold to Argentine investors). To 
a lesser extent, banks indicated they may also sell European equity 
securities and emerging market equity securities (again, especially 
for investors in the local jurisdiction) to investors. Banks also 
noted they may sell tailored investment products, such as structured 
notes or deposits (e.g., equity-or credit-linked notes), which often 
are customized to the individual needs of an investor and may be 
issued by a bank affiliate or an entity (e.g., a special purpose 
vehicle) controlled by a bank affiliate. Banks may sell other 
products as well, such as offshore ``hedge funds,'' to certain 
investors.
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    In explaining the need for an exemption, the industry group 
expressed the view to the Commission staff that non-U.S. persons expect 
to deal with one private banker and that these customers would not 
choose to deal with a registered broker-dealer to conduct securities 
transactions in Regulation S securities, but would instead look to 
foreign banks to effect these transactions.
    In response to this request, we are proposing Exchange Act Rule 
771, which would provide banks with a conditional exemption to effect 
transactions pursuant to Regulation S with non-U.S. persons.\340\ This 
exemption would not permit banks to effect transactions involving U.S. 
persons, other than U.S. registered broker-dealers. This exemption 
would permit banks to effect transactions involving offshore, non-U.S. 
persons on an agency or riskless principal basis. The exemption defines 
riskless principal for the purposes of the exemption. A bank could also 
resell any eligible Regulation S securities after their initial 
issuance by or on behalf of a non-U.S. person or to a non-U.S. person 
as long as the bank continues to

[[Page 39720]]

comply with the requirements of Regulation S.\341\ After the 
requirements of Regulation S cease to apply to an issuance, then the 
bank could resell the securities to another non-U.S. person or a 
broker-dealer without meeting the terms of Regulation S.
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    \340\ 17 CFR 242.771. Nothing in this proposed rule would affect 
the necessity of complying with Regulation S or any other 
requirements of or exemptions from the Securities Act of 1933.
    \341\ Rule 904 of Regulation S (17 CFR 230.904).
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    We are proposing this exemption with these limited conditions 
because we believe that non-U.S. persons will not be relying on the 
protections of the U.S. securities laws when purchasing Regulation S 
securities from U.S. banks.\342\ While generally we believe that U.S. 
broker-dealers should be subject to the broker-dealer standards of 
conduct when dealing with non-U.S. persons, we feel that this principle 
is less compelling when the foreign person has chosen to deal with a 
U.S. bank with respect to Regulation S securities. We also understand 
that non-U.S. persons can purchase the same securities from banks 
located outside of the U.S. and would not have the protections of the 
U.S. law when purchasing these securities offshore. We invite comment 
on whether U.S. broker-dealer registration should be required with 
respect to transactions with these non-U.S. persons who are purchasing 
new offering securities offshore, or may be selling or purchasing 
seasoned securities.
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    \342\ While no rules have been adopted, the exemption provided 
by Exchange Act Section 30(b), pertaining to foreign securities, has 
been held unavailable if the United States is used as a base for 
securities fraud perpetrated on foreigners, Arthur Lipper Corp. v. 
SEC, 547 F.2d 171 (2d Cir. 1976), reh. denied, 551 F.2d 915 (2d Cir. 
1977), cert. denied 434 U.S. 1009. See also Exchange Act Release No. 
27017, supra note 86, 54 FR at 30016.
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    We propose to define two other terms used in the exemption. We 
propose to define the term ``eligible security'' to include a 
requirement that the security is not being sold from the inventory of 
the bank or an affiliate of the bank. We request comment on whether 
this condition would be an appropriate safeguard against banks' 
financial conflicts that may disadvantage foreign investors. Within the 
definition of eligible security, we are also proposing to exclude from 
the exemption situations when the bank or an affiliate of the bank is 
underwriting a new issue security on a firm-commitment basis. In that 
instance, the bank could still sell the security using the exemption if 
the security is acquired from an unaffiliated ``distributor,'' that has 
not purchased the securities from the bank or a bank affiliate.\343\ 
This condition is intended to prevent banks from soliciting investors, 
who do not have the protections of the U.S. securities laws, to 
purchase securities in which banks or their affiliates have an 
overriding financial interest as underwriters or selling group members. 
We understand, however, that there may be instances when a customer 
wants to purchase a security that is being underwritten by a bank or 
its affiliate. To facilitate these customer requests, a bank could sell 
the securities in reliance on this exemption if it obtained the 
securities from another distribution participant, other than an 
affiliate of the bank, as long as the other distribution participant 
did not directly or indirectly obtain the securities from the bank or 
its affiliate. We request comment on whether this condition would be an 
appropriate safeguard against banks' financial conflicts that may 
disadvantage foreign investors.
---------------------------------------------------------------------------

    \343\ The term ``distributor'' is defined in 17 CFR 230.902(d).
---------------------------------------------------------------------------

    We also propose to define the term ``purchaser'' to mean a person 
that purchases a security and that is a non-U.S. person under Rule 
902(k) of Regulation S.\344\
---------------------------------------------------------------------------

    \344\ 17 CFR 230.902(k).
---------------------------------------------------------------------------

    We request comment on this proposed exemption, as well as the other 
proposed definitions, including the definition of riskless principal 
that is consistent with the definition we have used previously in the 
bank dealer rules. We particularly request comment from non-U.S. 
investors on whether this exemption is necessary to serve their needs, 
or whether they would prefer to purchase Regulation S securities 
subject to the full investor protections of the U.S. federal securities 
laws. We also invite comment on the possible competitive effects this 
proposed exemption may have.
4. Redesignation and Revision of Exemptions for Savings Associations 
and Savings Banks
    We propose to redesignate the current exemption for savings 
associations and savings banks found in Exchange Act Rule 15a-9 \345\ 
as Exchange Act Rule 773.\346\ As is true under the current rule, the 
savings associations and savings banks would be subject to all of the 
same conditions and definitions as are applicable to banks that utilize 
the exceptions from the definitions of ``broker'' and ``dealer.'' \347\ 
We propose to extend to savings associations and savings banks the 
proposed money market exemption in Exchange Act Rule 776,\348\ the 
proposed exemptions in Exchange Act Rules 720-723 \349\ relating to the 
bank trust and fiduciary activities exception, the proposed small bank 
custody exemption in Exchange Act Rule 761,\350\ the proposed expanded 
exemption for the way in which banks effect transactions in investment 
company securities in Exchange Act Rule 775,\351\ and the current 
exemption for securities lending transactions in Exchange Act Rule 15a-
11,\352\ which we are proposing to redesignate as Exchange Act Rule 
772.\353\
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    \345\ 17 CFR 240.15a-9.
    \346\ 17 CFR 242.773.
    \347\ Nevertheless, savings associations and savings banks that 
are municipal securities dealers must register and be regulated as 
municipal securities dealers pursuant to Exchange Act Section 15B. 
Banks must also register pursuant to Exchange Act Section 15B. 
Exchange Act Section 3(a)(34)(A) provides that the ``appropriate 
regulatory agency'' of a municipal securities dealer that is a bank 
regulated by the OCC, the Federal Reserve, or the FDIC is the agency 
that already regulates the bank. Exchange Act Section 
3(a)(34)(A)(iv) designates the Commission as the appropriate 
regulatory agency in the case of all other municipal securities 
dealers, which includes savings associations and savings banks that 
are municipal securities dealers.
    \348\ 17 CFR 242.776.
    \349\ 17 CFR 242.720 through 723.
    \350\ 17 CFR 242.761.
    \351\ 17 CFR 242.775.
    \352\ 17 CFR 15a-11.
    \353\ 17 CFR 242.772.
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    We are not proposing to extend to thrifts the proposed general 
custody exemption in Exchange Act Rule 760,\354\ the proposed new ERISA 
exemption in Exchange Act Rule 770,\355\ or the proposed Regulation S 
exemption in Exchange Act Rule 771, however, because we were unable to 
obtain sufficient information to determine whether thrifts directly 
engage in the types of securities activities covered by these proposed 
exemptions.\356\ We solicit comment on whether thrifts engage in 
securities activities or transactions that would be covered by the 
excluded exemptions. We invite commenters to provide specific 
information about their current business models that would require them 
to utilize these proposed exemptions. For example, do thrifts have 
income that does not qualify as ``relationship compensation'' for 
employee benefit plan accounts and that cannot be accommodated by the 
small bank custody exemption? With respect to those securities 
activities or transactions that are not covered by the excluded 
exemptions, we seek empirical data from individual thrifts regarding 
the type and amount of compensation received for each of these 
securities activities. Thrift commenters are invited to answer the 
specific request for comments in each of the exemptions.
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    \354\ 17 CFR 242.760.
    \355\ 17 CFR 242.770.
    \356\ 17 CFR 242.771.

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[[Page 39721]]

5. Credit Unions
    Because credit unions are not ``banks'' under the Exchange 
Act,\357\ they cannot utilize the bank exceptions from the definitions 
of broker and dealer. While nine commenters indicated that some, or 
all, of the exceptions should be extended to credit unions, the 
commenters generally conceded that credit unions do not currently 
engage in many of the securities activities authorized for banks under 
the Exchange Act exceptions from the definitions of ``broker'' and 
``dealer.'' \358\
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    \357\ The term ``bank'' is defined in Exchange Act Section 
3(a)(6).
    \358\ See ACCU letter; CUNA letter; NACUSO letter; NASCUS 
letter; NCUA letter; NAFCU letter; Navy Federal letter; Ohio Credit 
Union League letter; and U.S. Central Credit Union letter.
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    Based on the Commission staff's discussions with credit union 
representatives, we understand that credit unions are engaged in a very 
limited securities business today.\359\ We do not propose extending all 
of the transaction-based bank exceptions in Exchange Act Section 
3(a)(4) to credit unions for their potential future securities 
activities. We do, however, propose to extend three of the bank 
exceptions to provide a limited accommodation for credit unions. As is 
true under the rule for the savings associations and savings banks, 
credit unions utilizing this proposed exemption would be subject to all 
of the same conditions and definitions as are applicable to banks that 
utilize the exceptions from the definitions of ``broker'' and 
``dealer.''
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    \359\ This reflects the fact that credit unions, unlike banks, 
never had a blanket exception from broker-dealer registration. 
Therefore, credit unions that wanted to conduct a securities 
business always had to do so through a registered broker-dealer.
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a. Networking

    Credit unions currently may enter into networking arrangements with 
broker-dealers under the conditions set forth in the Chubb letter.\360\ 
However, banks, savings banks, and savings and loan associations can 
network with broker-dealers under the terms of the Exchange Act Section 
3(a)(4)(B)(i) exception for third-party brokerage arrangements.\361\ 
This bifurcated system makes compliance more complicated for broker-
dealers that have networking arrangements with a variety of financial 
institutions. It also creates an unequal playing field among financial 
institutions offering the same services.
---------------------------------------------------------------------------

    \360\ See Chubb Letter, a staff no-action letter, supra note 37. 
The staff no-action letter sets forth the terms under which 
financial institutions (federal and state chartered banks, savings 
and loan associations, savings banks, and credit unions) may 
participate in the networking arrangement.
    \361\ As discussed throughout this release, banks, savings banks 
and savings associations continue to have a temporary exemption from 
the Exchange Act definition of ``broker.'' The networking exception 
in Exchange Act Section 3(a)(4)(B)(i) and proposed Exchange Act Rule 
710 set forth the terms that banks and savings associations will 
follow when the Exchange Act's bank broker exceptions and rules are 
fully implemented.
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    We, therefore, propose Exchange Act Rule 774 \362\ to address these 
issues by simplifying the terms under which credit unions may enter 
into networking arrangements by exempting them from the definition of 
broker under the terms of the bank networking exception in Exchange Act 
Section 3(a)(4)(B)(i),\363\ including any related interpretive and 
exemptive rules for banks' networking activities that the Commission 
may adopt. The proposed rule would subject credit unions to the same 
uniform networking rules that apply to banks and savings associations. 
This should simplify compliance for credit unions as well as for the 
broker-dealers that enter into networking arrangements with different 
types of retail depository institutions. If the Commission adopts this 
proposal as a final rule, the rule would supercede the staff no-action 
letter. We request comment on whether this is appropriate. We also 
request comment on whether any additional conditions or limitations 
should be imposed on credit unions that enter into networking 
arrangements with broker-dealers.
---------------------------------------------------------------------------

    \362\ 17 CFR 242.774.
    \363\ 15 U.S.C. 78c(a)(4)(B)(i).
---------------------------------------------------------------------------

b. Sweep Accounts

    The sweep accounts exception is a limited transactional exception 
that permits banks to sweep deposit funds into no-load, open-end money 
market funds.\364\ One credit union requested a Commission exemption to 
engage in this activity. The Commission published this request along 
with a request for comment in June 2002.\365\ After reviewing the 
credit unions' comments, we are proposing Exchange Act Rule 774 to 
provide an exemption for credit unions to provide sweep account 
services. In particular, proposed Exchange Act Rule 774 would permit 
credit unions to sweep deposit accounts into no-load money market funds 
under the terms of the bank exception in Exchange Act Section 
3(a)(4)(B)(v).\366\ Because the statutory exception is limited, any 
incentives for abuse are also limited. Thus, we believe extending this 
exception to credit unions would not raise investor protection 
concerns. Moreover, it should place financial institutions offering 
similar services on a more level playing field.
---------------------------------------------------------------------------

    \364\ Exchange Act Section 3(a)(4)(B)(v). 15 U.S.C. 
78c(a)(4)(B)(v).
    \365\ See Notice of Application of Evangelical Christian Credit 
Union for Exemptive Relief Under Sections 15 and 36 of the Exchange 
Act and Request for Comment, Exchange Act Release No. 46069 (June 
12, 2002), 67 FR 41545 (June 18, 2002) (available at http://www.sec.gov/rules/other/).
    \366\ 15 U.S.C. 78c(a)(4)(B)(v).
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c. Investment, Trustee, and Fiduciary Transactions

    The investment transactions exception in Exchange Act Section 
3(a)(5)(ii) permits a bank to buy or sell securities ``for investment 
purposes'' for its own account or for the accounts for which it acts as 
a trustee or fiduciary.\367\ We propose to include in Exchange Act Rule 
774 an exemption for credit unions from the definition of dealer to 
permit credit unions to buy and sell securities for investment purposes 
for themselves, or for accounts for which they act as trustee or 
fiduciary under the terms of the bank exception in Exchange Act Section 
3(a)(5)(C)(ii).\368\ While credit unions may rely on the dealer-trader 
distinction \369\ for their proprietary trading, extending this 
exemption to credit unions should provide them with legal certainty. 
With respect to transactions for trust and fiduciary account customers, 
we would expect credit unions' fiduciary obligations to provide these 
customers with sufficient protections.
---------------------------------------------------------------------------

    \367\ As we noted in footnote 83 of the release in which we 
adopted final ``dealer'' rules for banks, [Exchange Act Release No. 
47364, 68 FR 8686 (Feb. 24, 2003)], the ``dealer'' exception for 
trustee and fiduciary transactions only applies when the bank buys 
or sells securities for investment purposes for the bank, or for 
accounts for which the bank acts as a trustee or fiduciary. 
Furthermore, in giving meaning to the term ``fiduciary'' in Exchange 
Act Section 3(a)(5)(C)(ii), we look to the legislative history. The 
legislative history states that Exchange Act Section 3(a)(5) 
``excepts a bank from the definition of `dealer' when it buys and 
sells securities for investment purposes for the bank, or for 
accounts for which the bank acts as trustee or fiduciary. This 
mirrors existing law distinguishing between investors and dealers, 
and is limited to the portfolio trading of the bank and the accounts 
for which it makes investment decisions.'' H.R. Rep. No. 106-74, pt. 
3, at 170-171 (1999).
    \368\ 15 U.S.C. 78c(a)(5)(C)(ii).
    \369\ See Section IV of the Dealer Release for a discussion of 
the Dealer/Trader distinction. Exchange Act Release. No. 47364 (Feb. 
14, 2003).
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d. Scope of Credit Union Exemption

    We propose to permit all credit unions to utilize the proposed 
Exchange Act Rule 774 exemptions. This would include federal- and 
state-chartered credit unions, as well as federally insured and 
privately insured credit unions. We are preliminarily of the view that 
these transactions should be handled in the same way under one uniform 
set of rules for all credit unions, as well as for all banks and 
savings

[[Page 39722]]

associations. The proposed exemption would grant credit unions these 
three statutory exceptions but this exemption would not automatically 
give them any associated exemptions we may grant to banks in the 
future.
    The Commission requests comment on proposed Exchange Act Rule 
774.\370\ In addition, the Commission specifically requests comment on 
whether state-charted, privately insured credit unions (which do not 
have a federal regulator) should be included within the scope of the 
exemption.\371\ Commenters are requested to discuss the scope of the 
supervision of state-chartered, privately insured credit unions and the 
legal framework applicable to these entities.
---------------------------------------------------------------------------

    \370\ We also request comment on whether there are other issues 
or restrictions that we should consider in connection with this 
exemption for these three securities activities.
    \371\ In contrast to credit unions, all banks and savings 
associations have a federal regulator.
---------------------------------------------------------------------------

e. Additional Exemptions for Credit Unions

    Exchange Act Section 3(a)(4)(B)(viii) provides banks with an 
exception from the definition of broker for certain safekeeping and 
custody activities.\372\ Under this exception, a bank is not considered 
a ``broker'' if, as part of its customary bank activities, it engages 
in certain specified types of safekeeping and custody services with 
respect to securities on behalf of its customers. The exception 
generally permits banks to hold securities, pledge securities, lend 
securities held in custody, and reinvest collateral.\373\
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    \372\ 15 U.S.C. 78c(a)(4)(B)(viii).
    \373\ Exchange Act Section 3(a)(4)(B)(viii)(aa-ee). This 
exception is discussed in greater detail in Section III.E. supra.
---------------------------------------------------------------------------

    The National Credit Union Administration (``NCUA'') has indicated 
to the Commission staff that credit unions are authorized to hold 
custody of customer funds and securities in connection with securities 
transactions. However, the Commission staff has no evidence that credit 
unions engage in the activities included in the safekeeping and custody 
activities exception. For this reason, we are not proposing to give 
credit unions a custody exemption.
    We invite comment on the extent to which credit unions utilize 
their authority to hold custody of customer funds and securities, and 
whether credit unions engage in any of the types of transactions 
enumerated in the bank safekeeping and custody exception. Do credit 
unions hold custody of customer funds and securities in connection with 
transactions other than the networking, sweep accounts, or investment 
transactions described above? Credit union commenters are invited to 
discuss any legal authority on which they currently rely to engage in 
any of these additional activities.\374\
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    \374\ As part of transactions covered by the proposed exemptions 
for networking, sweep accounts, and investment, trustee and 
fiduciary transactions, a credit union would be permitted to hold 
customer funds and securities in connection with the securities 
transactions that fall within the exemptions.
---------------------------------------------------------------------------

    Because we have no evidence that credit unions require additional 
exemptions for the safekeeping and custody of customer funds and 
securities in connection with securities transactions, we are not 
proposing additional exemptions at this time. Commenters that believe 
additional exemptions are warranted should explain why an exemption is 
needed and discuss how such an exemption would be in the public 
interest, and whether any additional conditions should be added to 
protect investors. In addition, we specifically invite comment on how 
any credit unions that need additional exemptions are regulated, both 
under state and federal law.
6. Exemption for the Way in Which Banks Effect Transactions in 
Investment Company Securities
    Exchange Act Section 3(a)(4)(C) requires a bank to execute through 
a registered broker-dealer (or internally cross) transactions executed 
in the United States in securities that are publicly traded in the 
United States that are effected pursuant to either the trust and 
fiduciary activities exception, the safekeeping and custody exception, 
or certain stock purchase plans exception.\375\ Current Exchange Act 
Rule 3a4-6, however, exempts from this requirement banks that process 
transactions in shares of investment company securities through the 
National Securities Clearing Corporation's (``NSCC'') Mutual Fund 
Services,\376\ including Fund/SERV.\377\
---------------------------------------------------------------------------

    \375\ 15 U.S.C. 78c(a)(4)(B)(ii), (iv), and (viii).
    \376\ NSCC is a clearing agency registered pursuant to Exchange 
Act Section 17A. 15 U.S.C. 78q-1. A ``clearing agency'' is a person 
that acts as an intermediary in making payments or deliveries (or 
both) in connection with transactions in securities, or that 
provides facilities for comparing data with respect to the terms of 
securities transactions to reduce the number of settlements or the 
allocation of securities settlement responsibilities. See 15 U.S.C. 
78c(a)(23)(A). A clearing agency is an SRO, and its rules of 
operation are subject to approval by the appropriate federal 
regulatory agency. See 15 U.S.C. 78c(a)(26), 78s(b). See also 
Investment Company Act Release No. 26288 (Dec. 11, 2003), 68 FR 
70388, 70395 at n. 11 (Dec. 17, 2003).
    \377\ NSCC's Mutual Fund Services provide an automated system to 
participants to process transactions in investment company 
securities. Fund/SERV centralizes order entry, confirmation, 
registration, and settlement of purchases and redemptions of 
investment company securities. NSCC's Mutual Fund Services are 
available to investment companies, broker-dealers, banks, trust 
companies, and other financial institutions that have been accepted 
for membership in the NSCC.
---------------------------------------------------------------------------

    Banks that use NSCC's Mutual Fund Services to execute transactions 
in investment company securities advised us that they may not use a 
registered broker-dealer to execute these transactions, depending on 
whether NSCC's arrangement is with the principal underwriter or a 
transfer agent that acts as agent for the investment company. 
Therefore, some industry representatives indicated informally to the 
staff that banks needed an exemption from the trade execution 
requirements of Exchange Act Section 3(a)(4)(C) to continue to use the 
NSCC's Mutual Fund Services, while complying with exceptions and 
exemptions from the definition of broker. Exchange Act Rule 3a4-6 was 
designed to allow banks to continue to execute transactions in shares 
of open-end investment companies through NSCC's Mutual Fund Services 
because NSCC's Mutual Fund Services simplify and automate the process 
for purchasing and redeeming investment company securities.\378\ This 
exemption is a limited one and is only available to banks that process 
orders through a service of a registered clearing agency subject to the 
supervision and regulation of the Commission.
---------------------------------------------------------------------------

    \378\ In light of the recent scandals involving the market 
timing of shares issued by certain registered open-end investment 
companies, this exemption could potentially allow further abuses to 
go undetected. Current Exchange Act Rule 3a4-6 is not an exemption 
from other provisions of the federal securities laws such as 
sections 206(1) and 206(2) of the Investment Advisers Act (15 U.S.C. 
80b-6(1) and (2)) or Section 34(b) of the Investment Company Act (15 
U.S.C. 80a-33(b)).
---------------------------------------------------------------------------

    Commenters generally supported this exemption. However, some urged 
the Commission to expand the exemption to include mutual fund purchases 
and redemptions directed to the fund's transfer agent.\379\ These 
commenters indicated that such an exemption would reflect banks' 
current practices.\380\
---------------------------------------------------------------------------

    \379\ See ABA/ABASA letters; Mellon Bank letter; BONY letter; 
Wilmington Trust letter; NYCH letter; PNC Bank letter; Northern 
Trust letter; Shaw Pittman letter; and Wells Fargo letter.
    \380\ In 2002, Fund/SERV processed approximately 83 million fund 
transactions, half of all such transactions processed that year. 
Transfer agents processed the others. See Investment Company Act 
Release No. 26288, supra note 376 at n. 64.
---------------------------------------------------------------------------

    We, therefore, propose to expand this exemption to permit banks to 
process purchases and redemptions of shares of open-end investment 
companies directly with transfer agents that act as agents for these 
investment companies, provided that the transfer agents do not

[[Page 39723]]

accept compensation paid for the distribution of the securities, 
including any compensation paid pursuant to any revenue-sharing 
arrangement or pursuant to Rule 12b-1 of the Investment Company 
Act.\381\ The proposed exemption would only be available for securities 
that are distributed by registered broker-dealers or otherwise sold for 
sales loads that do not exceed the NASD limits for broker-distributed 
funds. This condition is intended to ensure that mutual fund investors 
will not incur higher loads for the same funds if they choose to 
purchase through banks, rather than through registered broker-dealers.
---------------------------------------------------------------------------

    \381\ See 17 CFR 270.12b-1. Transfer agents that are not 
registered as broker-dealers need to consider whether the securities 
activities that they are undertaking are brokerage activities that 
require them to register as broker-dealers. Exchange Act Section 
3(a)(4) defines a ``broker'' as a person engaged in the business of 
effecting transactions in securities for the account of others. It 
includes several exceptions for certain bank activities. See 15 
U.S.C. 78c(a)(4). Exchange Act Section 15 essentially makes it 
unlawful for a broker or dealer ``to effect any transactions in, or 
induce or attempt to induce the purchase or sale of, any security 
(other than an exempted security or commercial paper, bankers' 
acceptances, or commercial bills)'' unless the broker or dealer is 
registered with the Commission. See 15 U.S.C. 78o(a)(1). See also 
Investment Company Act Release No. 26288, supra note 376 at n. 7.
---------------------------------------------------------------------------

    We propose to limit this exemption to transactions in securities of 
open-end investment companies that are not traded on a national 
securities exchange, through the facilities of a national securities 
association, or through an interdealer quotation system.\382\ This 
exemption would not be necessary with regard to these securities 
because investors purchase or sell such shares through broker-dealers 
at market prices throughout the day.
---------------------------------------------------------------------------

    \382\ For example, this exemption from executing trades through 
a registered broker-dealer would not be available for exchange-
traded funds, which are investment companies that are registered 
under the Investment Company Act as open-end funds or unit 
investment trusts. Section 5(a)(1) of that Act defines an open-end 
fund as an investment company that is a management company, which 
offers, or has outstanding, any redeemable security of which it is 
the issuer. 15 U.S.C. 80a-5(a)(1). Section 4(2) of the Investment 
Company Act defines a unit investment trust as an investment company 
that is organized under a trust indenture or similar instrument, 
that does not have a board of directors, and that issues only 
redeemable securities, each of which represents an undivided 
interest in a unit of specified securities. 15 U.S.C. 80a-4(2). See 
Investment Company Act Release No. 25258 (Nov. 8, 2001).
---------------------------------------------------------------------------

    We solicit comment on the proposed amendments to this exemption. We 
invite comment with regard to the use of omnibus accounts in the 
context of this proposal. In particular, we request comment about the 
issues raised, especially those arising from conflicts of interest 
associated with 12b-1 fees, and how they are disclosed by banks to 
custody account customers. We also seek comment regarding the number 
and percentage of fund share orders submitted directly to designated 
transfer agents.
    While not specifically addressing Exchange Act Rule 3a4-6, one 
commenter requested guidance on the meaning of the term ``publicly 
traded security [in the United States]'' within the context of Exchange 
Act Section 3(a)(4)(C).\383\ Exchange Act Section 3(a)(4)(C)(i) 
requires a bank to direct trades in publicly traded securities in the 
United States to a registered broker-dealer for execution. However, a 
U.S. registered broker-dealer would not necessarily provide the most 
liquid markets and the best prices for foreign securities, because the 
primary trading markets for foreign securities are located outside of 
the United States. Thus, if a bank customer requests a security listed 
or traded primarily outside of the United States, Exchange Act Section 
3(a)(4)(C) gives banks the flexibility to seek the best markets for 
that security. In other words, Exchange Act Section 3(a)(4)(C) 
encourages banks to obtain best execution for securities by directing 
them to registered broker-dealers for U.S. transactions, but not for 
foreign transactions.
---------------------------------------------------------------------------

    \383\ See Compass letter. In that letter, the commenter asked 
the Commission to clarify that shares of open-end investment 
companies are not ``publicly traded securities'' within the meaning 
of Exchange Act Section 3(a)(4)(C) unless the shares are, in fact, 
traded on a recognized exchange.
---------------------------------------------------------------------------

    Publicly traded securities \384\ include all securities in which at 
least two registered broker-dealers have indicated a willingness to 
quote a price, securities that are registered under Exchange Act 
Section 12,\385\ or those from an investment company that is required 
to file reports under Exchange Act Section 15(d).\386\ The term 
includes equity securities, regardless of whether they are traded 
through a national securities exchange, an automated quotation system 
sponsored by a registered national securities association, an 
alternative trading system, an electronic communications network, 
Nasdaq's Over-the Counter Bulletin Board service, or an interdealer 
quotation system such as the one operated by Pink Sheets LLC.\387\ The 
term also includes debt securities and hybrid securities.\388\ We 
solicit comment about whether the term ``publicly traded securities'' 
should be defined by rule.
---------------------------------------------------------------------------

    \384\ While the term ``publicly traded security'' is used in 
other sections of the Exchange Act for specific purposes, see, e.g, 
15 U.S.C. 78m(h) and 78u-3(c)(3)(A)(i), the term is commonly 
understood to encompass a broader range of securities than these 
other particular uses would indicate.
    \385\ 15 U.S.C. 78l.
    \386\ 15 U.S.C. 78o(d).
    \387\ Pink Sheets LLC is a privately owned company that provides 
pricing and financial information for equity securities that are not 
listed on a national securities exchange or quoted on Nasdaq.
    \388\ Hybrid securities are securities with features common to 
both equity and debt securities.
---------------------------------------------------------------------------

G. Temporary Exemptions

1. Extension of Time and Transition Period
    Commenters have indicated that banks may need as much as a year to 
develop compliance systems to adapt to the more limited Exchange Act 
bank exceptions from the definition of broker. The Commission has also 
stated that it does not expect banks to develop compliance systems for 
the broker exceptions until the Commission has adopted any amendments 
to the Interim Rules.
    We recognize that when the bank broker exceptions are fully 
effective, some banks may need a transition period as they move toward 
statutory compliance.\389\ Exchange Act Rule 15a-7 provides such a 
transition period, and we propose to amend that rule, which would be 
redesignated as Exchange Act Rule 781, to extend the transition period 
to one year after any amended rules are adopted. We expect banks to use 
this time to develop compliance systems.\390\
---------------------------------------------------------------------------

    \389\ 17 CFR 240.15a-7.
    \390\ For example, if the bank broker rules were adopted by 
year-end 2004, then the bank broker exceptions would apply one year 
later, beginning January 1, 2006. Thus, banks would not have to be 
in compliance with the terms of the exception or exemption during 
2005, but should develop compliance systems to be used beginning in 
2006.
    With respect to the ``chiefly compensated'' requirements, banks 
would need to be in compliance with the terms of the account-by-
account calculation, or one of the exemptions by the end of 2006. 
Demonstrated compliance during 2006 would exempt a bank from risk of 
noncompliance with these requirements during 2007. See proposed 
Exchange Act Rule 722(a)(2).
---------------------------------------------------------------------------

    We request comment on the proposed amendment to this temporary 
exemption, and, in particular, on whether banks would need a full year 
to develop compliance systems. We also request comment on whether the 
transition period should cease at the end of a calendar year.
2. Temporary Exemption for Contracts Entered Into by Banks From Being 
Considered Void or Voidable
    Current Exchange Act Rule 15a-8 recognizes that banks may have 
inadvertent, technical violations as they become accustomed to any new 
regulatory requirements. This exemption mitigates the unique compliance 
problems that banks may

[[Page 39724]]

have by eliminating the possibility that any inadvertent failures by 
banks could trigger rescission under Exchange Act Section 29 during 
this transitional period.\391\ The Commission amended this exemption in 
the rules addressing the exceptions from the definition of ``dealer'' 
under the Exchange Act to provide a transitional period from rescission 
liability under Exchange Act Section 29 on contracts entered into by 
banks in a dealer capacity for a finite period until March 31, 
2005.\392\
---------------------------------------------------------------------------

    \391\ Exchange Act Section 29(b) provides, in pertinent part, 
that every contract made in violation of the Exchange Act or of any 
rule or regulation thereunder shall be void.
    \392\ See Exchange Act Release No. 47364, supra note 34, 68 FR 
8686.
---------------------------------------------------------------------------

    We received a few comments on Exchange Act Rule 15a-8.\393\ All of 
these commenters supported this temporary exemption for banks. One 
commenter said that liability for any violation of the broker-dealer 
registration requirements should be limited to customers or groups of 
customers that received the services or were parties to the 
transactions.\394\
---------------------------------------------------------------------------

    \393\ See ABA/ABASA letters; Banking Agencies letter; NYCH 
letter; NASAA letter; and Regions letter.
    \394\ See NYCH letter.
---------------------------------------------------------------------------

    Once we adopt any final rules, or amendments to the bank broker 
rules, we anticipate extending the compliance date for the broker 
statutory exceptions and rules to provide banks with an appropriate 
transition period. We therefore propose to extend the exemption from 
rescission liability under Exchange Act Section 29 to contracts entered 
into by banks acting in a broker capacity until 18 months after the 
delayed effective date of the broker rules.
    This proposed exemption, which would be codified in proposed 
Exchange Act Rule 780, would be limited to bank contracts being 
considered void or voidable by reason of Exchange Act Section 29 
because a bank that is a party to the contract violated the 
registration requirements of Section 15(a) of the Exchange Act or any 
applicable provision of this Act and the rules and regulations 
thereunder, based solely on a bank's status as a broker or dealer when 
the contract was created.
    We note that this proposed exemption would not relieve banks of the 
obligation to register as a broker or dealer if their securities 
activities do not fit within a specific functional exception or 
exemption. We also note that banks' securities activities continue to 
be subject to the antifraud provisions of the federal securities laws, 
irrespective of the bank's lack of registration or failure to comply 
with the provisions of the Exchange Act and the related rules that 
otherwise apply to banks based on their status as broker-dealers. We 
request comment on extending the temporary exemption from Exchange Act 
Section 29(b).

H. Amendment to Exchange Act Rule 15a-6

    Exchange Act Rule 15a-6 provides a conditional exemption from U.S. 
broker-dealer registration for certain foreign broker-dealers.\395\ 
Exchange Act Rule 15a-6 (a)(4)(i) allows a foreign broker-dealer, 
without registering in the United States, to effect transactions in 
securities with or for a U.S.-registered broker-dealer or bank acting 
``in a broker-dealer capacity as permitted by U.S. law.'' \396\ Thus, 
in transactions between a U.S. bank and its foreign broker-dealer 
affiliate, acting as principal, the U.S. bank could rely on the 
affiliate transactions exception in the GLBA,\397\ and the foreign 
affiliate could rely on Rule 15a-6(a)(4)(i). As discussed in the 
release adopting the Interim Rules, Exchange Act Rule 15a-6(a)(4)(i), 
however, does not permit a foreign broker-dealer or bank to have direct 
contact with customers of the U.S. bank.\398\ Moreover, the affiliate 
transactions exception would not permit the U.S. bank to effect 
transactions with its foreign affiliate's customers.\399\ We received 
no comments on our discussion of the interplay between Exchange Act 
Rule 15a-6 and the affiliate transactions exemption and we are not 
proposing to change that analysis in the current proposal.
---------------------------------------------------------------------------

    \395\ 17 CFR 240.15a-6. Even when the GLBA permits a bank to 
engage in securities-related activities without itself registering 
as a broker-dealer, a broker-dealer engaged in the business of 
effecting transactions for such bank still must register--absent an 
exemption or other exclusion from the broker-dealer registration 
requirements of the Exchange Act. For instance, a foreign broker-
dealer that executes trades for a bank under Exchange Act Section 
3(a)(4)(C) would need to register as a U.S. broker-dealer if it does 
not meet the conditions of Exchange Act Rule 15a-6, or it does not 
otherwise qualify for an exemption from registration. Foreign banks 
cannot rely on the GLBA bank exceptions because they do not fall 
within the definition of ``bank'' in Exchange Act Section 3(a)(6). 
Cf. U.S. branches and agencies of foreign banks can rely on the bank 
exceptions to the extent described in 54 FR 30013 at 30015, n. 16.
    \396\ 17 CFR 240.15a-6(a)(4)(i).
    \397\ Exchange Act Section 3(a)(4)(B)(vi).
    \398\ 66 FR at 27783.
    \399\ Id. A bank would, however, be permitted to sell Regulation 
S securities to non-U.S. persons, including customers of a foreign 
affiliate, as provided in the Regulation S exemption discussed at 
section III.F.3, supra.
---------------------------------------------------------------------------

    We do, however, propose a technical amendment to Exchange Act Rule 
15a-6 in light of the amended definitions of ``broker'' and ``dealer.'' 
Currently, Exchange Act Rule 15a-6(a)(4)(i) refers to ``a bank acting 
in a broker or dealer capacity as permitted by U.S. law.'' As amended, 
however, the definitions of ``broker'' and ``dealer'' in Exchange Act 
Section 3(a)(4) and 3(a)(5) respectively, provide that banks engaging 
in the conditional exceptions in those definitions ``shall not be 
considered to be'' brokers or dealers. To reflect this change, we 
propose to amend Exchange Act Rule 15a-6(a)(4)(i) by replacing the 
phrase ``in a broker or dealer capacity as permitted by U.S. law'' with 
the phrase ``pursuant to an exception or exemption from the definition 
of `broker' or `dealer' in Sections 3(a)(4)(B) or 3(a)(5)(C) of the 
Act.'' \400\ We request comment on this proposed amendment to Exchange 
Act Rule 15a-6(a)(4)(i).
---------------------------------------------------------------------------

    \400\ Nothing in this release should be construed as modifying 
the Exchange Act Section 3(a)(6) definition of ``bank'' as it 
applies to foreign banks. Currently, foreign banks generally would 
not meet this definition and would be considered broker-dealers 
under the U.S. securities laws. As such, foreign banks generally 
would be required to register as U.S. broker-dealers unless they 
qualify for an exemption from registration under Exchange Act Rule 
15a-6.
---------------------------------------------------------------------------

IV. Administrative Law Matters

A. General Request for Comments

    We are soliciting comments on all aspects of these proposed new 
rules and rule amendments. We also request comment on the portions of 
the Interim Rules pertaining to banks' broker activities that we are 
not proposing to amend, including Exchange Act Rule15a-9,\401\ which 
provides an exemption from the definitions of ``broker'' and ``dealer'' 
for savings associations and savings banks. In addition, we encourage 
comment on the other provisions of Exchange Act Section 3(a)(4)(B) that 
we did not discuss in connection with these proposals. We plan to 
address issues regarding issuer plans separately.\402\
---------------------------------------------------------------------------

    \401\ 17 CFR 240.15a-9.
    \402\ Exchange Act Section 3(a)(4)(B)(iv)(III).
---------------------------------------------------------------------------

    Commenters should, when possible, provide us with empirical data to 
support their views. Commenters suggesting alternative approaches 
should provide comprehensive proposals, including any conditions or 
limitations they believe should apply. We also specifically request 
comment on when any final rules should become effective. Should 
particular rules be implemented on a more delayed schedule? If so, why? 
With respect to proposed exemptions that contain a grandfather clause, 
have we proposed the most appropriate date for such purposes? If not, 
why not? Commenters suggesting an alternative date should

[[Page 39725]]

provide reasons why they believe the alternative date would be more 
appropriate.
    Finally, individual banks that anticipate the need for additional 
time to implement compliance systems for particular rules or statutory 
provisions are encouraged to explain their specific needs.

B. Paperwork Reduction Act Analysis

    Certain provisions of proposed Exchange Act Rules 776, 722, and 770 
contain ``collection of information'' requirements within the meaning 
of the Paperwork Reduction Act of 1995.\403\ The Commission has 
submitted them to the Office of Management and Budget (``OMB'') for 
review in accordance with 44 U.S.C. 3507(d) and 5 CFR 1320.11. The 
collections of information under proposed Exchange Act Rules 776, 722, 
and 770 are new. The title for the new collection of information under 
proposed Exchange Act Rule 776 is ``Rule 776: Exemption for banks 
effecting transactions for certain investors in money market funds.'' 
The title for the new collection of information under proposed Exchange 
Act Rule 722 is ``Rule 722: Exemption for banks from determining 
whether they are `chiefly compensated' on an account-by-account 
basis.'' The title for the new collection of information under proposed 
Exchange Act Rule 770 is ``Rule 770: Exemption from the definition of 
`broker' for banks that effect transactions in securities in certain 
employee benefit plans.'' OMB has not yet assigned a control number to 
the new collections of information contained in proposed Exchange Act 
Rules 776, 722, and 770. An agency may not conduct or sponsor, and a 
person is not required to respond to, a collection of information 
unless it displays a currently valid control number.\404\
---------------------------------------------------------------------------

    \403\ 44 U.S.C. 3501, et seq.
    \404\ 44 U.S.C. 3512.
---------------------------------------------------------------------------

1. Proposed Exchange Act Rule 776

a. Collection of Information

    Proposed Exchange Act Rule 776(a)(2)(ii)(B) would require a bank 
relying on this proposed exemption to provide customers that are not 
qualified investors or persons that direct the purchase of securities 
from any cash flows relating to asset-backed issues of at least 
$25,000,000 with a prospectus for the securities bought or sold 
pursuant to the proposed exemption and a clear and conspicuous notice 
containing the information required by this proposed rule.\405\
---------------------------------------------------------------------------

    \405\ See proposed Exchange Act Rule 776(a)(2)(ii)(B) which 
would require, among other things, that a bank would have to 
disclose any payments it may receive in connection with transactions 
effected pursuant to the proposed rule from the fund complex to 
which the issuer of the securities belongs.
---------------------------------------------------------------------------

b. Proposed Use of Information

    The purpose of the collection of information in proposed Exchange 
Act Rule 776 is to assure that a customer of a bank relying on the 
exemption would have sufficient information upon which to make an 
informed investment decision and to learn of any potential conflicts of 
interest that the bank may have.

c. Respondents

    The proposed collection of information in Exchange Act Rule 776 
would apply to banks relying on the exemption provided in the proposed 
rule.

d. Reporting and Recordkeeping Burden

    The Commission estimates that approximately 500 banks annually 
would use the exemption in proposed Exchange Act Rule 776 and each bank 
would deliver the prospectus and notice required by the proposed rule 
to approximately 1,000 customers annually. Therefore, the Commission 
estimates that proposed Exchange Act Rule 776 would result in 
approximately 500,000 responses per year. The Commission estimates 
further that a bank would spend approximately .10 hour per response to 
comply with the delivery requirement of proposed Exchange Act Rule 776. 
Thus, the estimated total annual reporting and recordkeeping burden for 
proposed Exchange Act Rule 776 is 50,000 hours. The Commission 
estimates that the initial reporting and recordkeeping burden for this 
proposed rule would be insubstantial, but we solicit comment on this 
point.

e. Collection of Information Is Mandatory

    This collection of information would be mandatory.

f. Confidentiality

    The collection of information delivered pursuant to proposed 
Exchange Act Rule 776 would be provided by banks relying on the 
exemption in this rule to customers that are not ``qualified 
investors,'' as defined in proposed Exchange Act Rule 776(b)(6).

g. Record Retention Period

    Proposed Exchange Act Rule 776 would not include a record retention 
requirement. Banks are subject to record retention requirements 
promulgated by banking regulators.
2. Proposed Exchange Act Rule 722

a. Collection of Information

    Proposed Exchange Act Rule 722(c)(2) would require banks relying on 
the exemption in this rule to document the reason that an account has 
continued not to meet the ``chiefly compensated'' condition and link 
the reason to its exercise of fiduciary responsibility.

b. Proposed Use of Information

    Proposed Exchange Act Rule 722 is intended to provide banks that 
determine compliance with the ``chiefly compensated'' condition through 
an account-by-account calculation with legal certainty for one year 
based on their demonstrated compliance for the previous year. The 
purpose of the collection of information in proposed Exchange Act Rule 
722 is to document the reason a bank has not met the ``chiefly 
compensated'' condition while still being able to rely on the exemption 
provided in paragraph (c) of the rule.

c. Respondents

    The proposed collection of information in proposed Exchange Act 
Rule 722 would apply to banks that wish to utilize the exemption 
provided in this proposed rule.

d. Reporting and Recordkeeping Burden

    Based on information available to the Commission at this time, the 
Commission estimates that approximately ten banks per year would use 
the exemption provided by proposed Exchange Act Rule 722(c) for 
approximately ten accounts per bank for a total of 100 responses 
annually. The Commission estimates that it will take each bank 
approximately .25 hour per response. Thus, the Commission estimates the 
annual reporting and recordkeeping burden for proposed Exchange Act 
Rule 722 to be 25 hours.

e. Collection of Information Is Mandatory

    This collection of information would be mandatory.

f. Confidentiality

    Banks relying on the exemption provided in proposed Exchange Act 
Rule 722(c) would not be required to provide the documentation required 
by the proposed rule to the Commission. Rather, banks would be required 
to make the proper documentation and maintain such documentation in 
compliance with existing recordkeeping requirements of banking 
regulators.

[[Page 39726]]

g. Record Retention Period

    Proposed Exchange Act Rule 722 would not include a record retention 
requirement. Banks are subject to the record retention requirements 
promulgated by banking regulators.
3. Proposed Exchange Act Rule 770

a. Collection of Information

    Proposed Exchange Act Rule 770(a)(2)(ii) would require banks that 
wish to utilize the exemption provided in this proposed rule to 
disclose clearly and conspicuously to plan sponsors or their designated 
fiduciaries all fees and expenses assessed for services provided to the 
plan and all compensation received or to be received from a fund 
complex.

b. Proposed Use of Information

    The purpose of the collection of information in proposed Exchange 
Act Rule 770 is to provide information to plan sponsors or their 
designated fiduciaries to enable them to determine that a bank has 
offset or credited any fees or expenses received from a fund complex 
related to securities in which plan assets are invested against the 
fees and expenses that the plan owes to the bank.

c. Respondents

    The collection of information in proposed Exchange Act Rule 770 
would apply to banks that administer employer-sponsored retirement 
plans that wish to utilize the exemption provided in the proposed rule.

d. Reporting and Recordkeeping Burden

    Based on the information available to the Commission at this time 
regarding which banks might utilize the exemption in proposed Exchange 
Act Rule 770, the Commission estimates that approximately 100 banks 
would rely on proposed Exchange Act Rule 770 annually, and each bank 
would provide the notice required by the proposed rule to approximately 
100 plan sponsors. Thus, the Commission estimates that there would be 
approximately 10,000 annual responses for proposed Exchange Act Rule 
770. Based on discussions between Commission staff and industry 
participants, the Commission believes that disclosure requirements of 
proposed Exchange Act Rule 770 reflect current business practices of 
banks, and as such, banks utilizing the exemption provided in proposed 
Exchange Act Rule 770 would already have in place the systems and 
procedures to make the disclosure required by the proposed Rule. 
Therefore, the Commission believes that the time required for a bank to 
comply with the clear and conspicuous notice requirement of the 
proposed rule would require .10 hour per response. Thus, the Commission 
estimates the total annual reporting and recordkeeping burden imposed 
by proposed Exchange Act Rule 770 would be 1,000 hours.

e. Collection of Information Is Mandatory

    This collection of information would be mandatory.

f. Confidentiality

    The collection of information delivered pursuant to proposed 
Exchange Act Rule 770 would be provided by banks to plan sponsors or 
their designated fiduciaries.

g. Record Retention Period

    Proposed Exchange Act Rule 770 would not include a record retention 
requirement. Banks are subject to the record retention requirements 
promulgated by banking regulators.
4. Request For Comment
    Pursuant to 44 U.S.C. 3506(c)(2)(B), the Commission solicits 
comments to:
    (i) Evaluate whether the proposed collections of information are 
necessary for the proper performance of the functions of the 
Commission, including whether the information would have practical 
utility;
    (ii) Evaluate the accuracy of the Commission's estimates of the 
burden of the proposed collections of information and provide the 
Commission with data on proposed Exchange Act Rules 770, 772, and 776;
    (iii) Enhance the quality, utility, and clarity of the information 
to be collected; and
    (iv) Minimize the burden of the collections of information on those 
required to respond, including through the use of automated collection 
techniques or other forms of information technology.
    In addition to the general solicitation of comments above regarding 
the collections of information contained in the proposed rules, the 
Commission also solicits comments regarding how many banks would rely 
on the exemptions provided in proposed Exchange Act Rules 776, 722, and 
770, and whether banks relying on such exemptions would be able to use 
existing systems, programs, and procedures to comply with the 
collections of information requirements contained in the proposed 
rules. Persons desiring to submit comments on the collection of 
information requirements should direct them to the Office of Management 
and Budget, Attention: Desk Officer for the Securities and Exchange 
Commission, Office of Information and Regulatory Affairs, Washington, 
DC 20503, and should send a copy of their comments to Jonathan G. Katz, 
Secretary, Securities and Exchange Commission, 450 Fifth Street, NW, 
Washington, DC 20549-0609, and refer to File No. S7-26-04. OMB is 
required to make a decision concerning the collection of information 
between 30 and 60 days after publication of this release in the Federal 
Register. Therefore, comments to OMB are best assured of having full 
effect if OMB receives them within 30 days of this publication. 
Requests for materials submitted to OMB by the Commission with regard 
to this collection of information should be in writing, refer to File 
No. S7-26-04, and be submitted to the Securities and Exchange 
Commission, Records Management, Office of Filings and Information 
Services, 450 Fifth Street, NW, Washington, DC 20549.

C. Consideration of Benefits and Costs

1. Introduction
    Prior to enactment of the GLBA, banks were exempted from the 
definitions of ``broker'' and ``dealer'' in Sections 3(a)(4) and 
3(a)(5) of the Exchange Act, respectively. As a result, notwithstanding 
the fact that banks may have conducted activities that would have 
brought them within the scope of the broker or dealer definitions, they 
were not required by the Exchange Act to register as such.\406\ The 
GLBA replaced banks' historic exemption from the definitions of 
``broker'' and ``dealer'' with fifteen functional exceptions. Eleven of 
these exceptions apply to broker activities and are the subject of this 
release.\407\
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    \406\ Exchange Act Release No. 44291, supra note 13, 66 FR at 
27761.
    \407\ See Exchange Act Section 3(a)(4)(B)(i) `` (xi).
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    In May 2001, when the Commission adopted the Interim Rules, it 
analyzed their costs and benefits and noted:

[w]hile these rules may affect how the banks' restructuring occurs, 
we believe that most of the restructuring will stem from the statute 
and not from the rules themselves. Moreover, the extent to which 
banks need to restructure may be limited by the way they already do 
business. The majority of banks conduct most of their securities 
activities through registered broker-dealers that are already 
regulated by the Commission.\408\

    \408\ 66 FR at 27790.
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    Given that the costs and benefits of the Interim Rules were 
discussed at the time they were adopted, this discussion will focus on 
the costs and benefits that could result from the changes the

[[Page 39727]]

Commission is proposing to make through Regulation B.
2. Discussion of Proposed Regulation B
    Proposed Regulation B responds to commenters' concerns that the 
Interim Rules are overly complex, do not provide banks with sufficient 
flexibility, and would be too costly to implement. The potential 
benefits and costs of the principal amendments the Commission is 
proposing are discussed below.

a. Networking Exception

    Exchange Act Section 3(a)(4)(B)(i) excepts banks from the 
definition of ``broker'' if they enter into a contractual or other 
written arrangement with a registered broker-dealer to share revenue 
when the broker-dealer offers brokerage services to bank customers. 
This ``networking'' exception is subject to several conditions.
    The section also permits banks to motivate unregistered bank 
employees--such as tellers, loan officers, and private bankers--to 
refer bank customers to their broker-dealer networking partners, 
through the payment of nominal referral fees.\409\
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    \409\ Exchange Act Section 3(a)(4)(B)(i)(VI) limits such 
referral fees to a ``nominal one-time cash fee of a fixed dollar 
amount'' and requires that the payment of the fees not be contingent 
on whether the referral results in a transaction.
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    Commenters complained that provisions of the Interim Rules defining 
how these referral fees could be paid would impose unnecessary limits 
on bank networking arrangements and administrative burdens on 
banks.\410\ As a result, the Commission is proposing to amend these 
provisions to allow banks to pay referral fees that do not exceed: (1) 
the referring employee's base hourly rate of pay; (2) $15 plus an 
adjustment for inflation; or (3) $25 without adjustment for inflation. 
Moreover, the Commission is proposing to permit banks to pay their 
employees non-cash referral fees under certain conditions.\411\
---------------------------------------------------------------------------

    \410\ Exchange Act Rule 3b-17(g)(1) defines the term ``nominal 
one-time cash fee of a fixed dollar amount.''
    \411\ See proposed Exchange Act Rule 710(b).
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    The Commission believes that banks will benefit in a number of ways 
from the proposed amendments. For example, establishing a flat fee or 
inflation-adjusted fee could benefit the over 8,000 smaller banks--the 
entities that the Commission anticipates will be most likely to take 
advantage of this exemption--by permitting them to pay their employees 
for referrals in a manner that is easy to understand and requires no 
complicated calculations. In addition, permitting banks to pay referral 
fees based on an employee's base hourly rate of pay will give banks 
objective and easily calculable approaches to paying their employees 
referrals while remaining consistent with the requirements of the GLBA 
that such fees be ``nominal'' in relation to the overall compensation 
of the referring employees.
    The Commission does not anticipate that the proposed changes to the 
networking exception rules will impose any material additional costs to 
banks other than those costs that banks already would incur as a result 
of the GLBA and the Interim Rules. The proposed amendments discussed 
above are designed to provide banks flexibility while being consistent 
with the statutory requirements. We believe that any cost of compliance 
would not be significant.
    We request comments generally on the costs and benefits associated 
with the proposed changes to the networking exception rules. We also 
invite banks to provide us with additional information, including data, 
to assist us in further evaluating the costs and benefits associated 
with the proposed change to the networking exception. We invite banks 
to include estimates of their start-up costs for updating their 
systems, and their annual ongoing costs for complying with the proposed 
changes discussed above. We invite commenters to provide us with data 
to assist the Commission in further evaluating these proposed rules. We 
specifically invite comment regarding the costs associated with 
proposed Exchange Act Rule 710's alternative measures of nominal 
referral fee value based on $15 adjusted for inflation, $25 without an 
adjustment for inflation, and an unregistered employee's hourly rate of 
pay. We also request comment on any other costs banks would likely need 
to incur as a result of the proposal, and ask that commenters provide 
us with data to support their views.

b. Trust and Fiduciary Activities Exception

    Exchange Act Section 3(a)(4)(B)(ii) permits a bank, under certain 
conditions, to effect transactions in a trustee or fiduciary capacity 
in its trust department or other department that is regularly examined 
by bank examiners for fiduciary principles and standards without 
registering as a broker. To qualify for the trust and fiduciary 
activities exception, Exchange Act Section 3(a)(4)(B)(ii) requires that 
the bank be ``chiefly compensated'' for such transactions on the basis 
of the types of fees specified in the GLBA.
    The Commission believes that the proposed amendments to the Interim 
Rules dealing with the trust and fiduciary activities exception should 
provide a number of benefits to banks and their customers without 
imposing significant costs on either group.\412\ Indeed, virtually all 
of the proposed amendments, discussed above, are in response to 
commenters' concerns that certain aspects of the Interim Rules are 
overly costly or burdensome to banks.
---------------------------------------------------------------------------

    \412\ The trust and fiduciary exception is addressed in proposed 
Exchange Act Rules 720-724.
---------------------------------------------------------------------------

    The proposed amendments to the ``chiefly compensated'' test and 
related exemptions should reduce banks' compliance costs and make the 
trust and fiduciary activities exception more useful. For example, the 
proposed line-of-business test should provide banks with a less costly 
approach for determining compliance with the trust and fiduciary 
activities exception. Similarly, the Commission's proposal to 
grandfather living, testamentary, and charitable trust accounts opened 
prior to a certain date should reduce banks' compliance costs by 
allowing them not to analyze these older accounts. In addition, the 
proposed exemptions for money market accounts, employee benefit plan 
accounts, and Regulation S accounts for non-U.S. persons, the benefits 
and costs of which are discussed below, should provide banks with the 
option of excluding from the ``chiefly compensated'' analysis 
compensation a bank receives from these accounts provided the accounts 
are in lines of business that do not contain other accounts not subject 
to an exemption. The proposed safe harbors should provide banks with 
legal certainty with respect to their compliance with the trust and 
fiduciary activities exception. The Commission also is proposing to 
amend the small bank custody exemption so that it can be used by 
qualifying small banks in lieu of complying with the ``chiefly 
compensated'' condition and the other requirements of the trust and 
fiduciary activities exception.
    Moreover, the Commission is proposing to remove a current 
requirement in the Interim Rules that banks provide ``continuous and 
regular'' investment advice to their customers' accounts.\413\ This 
proposed amendment to the definition of ``investment adviser if the 
bank receives a fee for its investment advice'' could make it easier 
for banks to determine that they are acting in a fiduciary capacity 
with respect to those accounts and thereby make it easier for banks to 
rely on the trust and fiduciary activities exception

[[Page 39728]]

in Exchange Act Section 3(a)(4)(B)(ii).\414\ In particular, in the 
absence of the ``continuous and regular'' requirement, banks would not 
be required to monitor the frequency with which their employees provide 
advice to determine whether they are meeting a certain continuity 
standard. In addition, banks would not be required to impose on their 
employees arbitrary requirements that they take steps to demonstrate 
continuity of advice, such as contacting customers, merely to satisfy 
the ``continuous and regular'' standard.\415\
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    \413\ Compare Exchange Act Rule 3b-17(d)(1) with proposed 
Exchange Act Rule 724(d)(2).
    \414\ See Exchange Act Section 3(a)(4)(D) which defines 
``fiduciary capacity'' for purposes of the trust and fiduciary 
exception to mean, among other things, ``as an investment adviser if 
the bank receives a fee for its investment advice.''
    \415\ From the perspective of the banks' customers, the removal 
of the ``continuous and regular'' requirement could reduce the 
number of unwanted contacts they receive from their banks. The 
removal could also decrease the likelihood that bank employees would 
make confusing or unnecessary securities recommendations to the 
banks' customers merely to ensure that the employees are providing 
``continuous and regular'' investment advice.
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    As the Commission noted in the release adopting the Interim Rules, 
banks are likely to incur costs to comply with the GLBA, but ``almost 
all of these costs will be necessary because of the statutory change 
and not because of the interim final rules.'' \416\ The same is true 
with respect to the proposed amendments to the Interim Rules. None of 
the amendments discussed above with respect to the trust and fiduciary 
activities exception imposes additional requirements on banks. Indeed, 
for the most part, the proposed rules would increase the number of 
available exemptions.
---------------------------------------------------------------------------

    \416\ 66 FR at 27793.
---------------------------------------------------------------------------

    Although the proposed exemptions to the ``chiefly compensated'' 
test should reduce banks' costs to comply with the trust and fiduciary 
activities exception, banks will incur costs in complying with the 
statutory ``chiefly compensated'' condition. The costs of compliance 
with the ``chiefly compensated'' condition, however, are already 
established by the GLBA and, to the extent they are not, they are 
established by current Exchange Act Rule 3a4-2. As a result, the 
Commission does not believe that banks would incur additional marginal 
costs to comply with the liberalized exemptions proposed in Exchange 
Act Rules 720 through 724.
    We solicit comment on the costs and benefits banks expect to incur 
in complying with the ``chiefly compensated'' condition in the statute. 
We anticipate that most banks that are subject to the ``chiefly 
compensated'' condition will utilize the proposed line-of-business 
exemption, and other exemptions, such as the proposed money market 
account exemption, if available. To the extent that this is true, we 
ask that commenters attempt to provide us with data associated with 
complying with the ``chiefly compensated'' condition after excluding 
lines of business that are covered by an exemption.
    In determining the costs associated with the ``chiefly 
compensated'' condition, we also seek comment on how banks track 
revenue from their trust and fiduciary business (e.g., on a line-of-
business basis or by type, such as assets under management fees), and 
whether their systems are able to distinguish revenue from various 
lines of business, including lines of business covered by an exemption. 
In addition, we seek comment on how banks track revenue they earn from 
mutual funds, and whether banks can separate 12b-1 fees between 
fiduciary and custody accounts and along lines of business in the 
fiduciary activity accounts.
    We also seek comment on whether the ``chiefly compensated'' 
condition will require banks to track compensation in a manner that 
they have not done before, and if so, we would like information on the 
start-up and annual ongoing costs to update systems to track 
compensation in this manner. We have received preliminary estimates 
indicating that the costs associated with complying with the ``chiefly 
compensated'' condition would range from minimal to $100,000. Those 
banks that estimate the costs to be minimal have indicated that their 
systems currently are able to track compensation consistent with this 
condition. Other banks intend to stop receiving Rule 12b-1 fees. Those 
banks whose cost estimates on the high end of the range contend that 
their current systems would need to be reprogrammed to track 
compensation consistent with this condition. We solicit comment on 
these estimates.

c. Safekeeping and Custody Exception

    The Interim Rules include two exemptions that permit banks to 
accept orders from investors for the purchase and sale of securities 
under limited circumstances in which the bank is acting in a 
safekeeping or custody capacity. These exemptions, which are in current 
Exchange Act Rules 3a4-4 and 3a4-5, supplement the ``safekeeping and 
custody activities'' exception in Exchange Act Section 
3(a)(4)(B)(viii).
    Current Exchange Act Rule 3a4-4 provides that small banks may 
effect transactions in investment company securities in customers' tax-
deferred custody accounts, provided that the bank meets certain 
conditions. Current Exchange Act Rule 3a4-5 provides that banks may 
effect transactions in securities in an account for which the bank acts 
as custodian under Exchange Act Section 3(a)(4)(B)(viii), if, among 
other conditions, the bank does not receive any compensation for 
effecting such transactions.\417\
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    \417\ Exchange Act Rule 3a4-5(a)(1).
---------------------------------------------------------------------------

    Commenters criticized both of these exemptions, arguing that the 
exemptions provide banks with less flexibility to effect securities 
transactions in a safekeeping or custody capacity than is provided 
under the GLBA.\418\ In response, the Commission has decided both to 
simplify and expand the exemption in current Exchange Act Rule 3a4-4 
(proposed to be redesignated as Exchange Act Rule 761) and to clarify 
and simplify current Exchange Act Rule 3a4-5 (proposed to be 
redesignated as Exchange Act Rule 760).
---------------------------------------------------------------------------

    \418\ See, e.g., Banking Agencies letter.
---------------------------------------------------------------------------

    In proposed Exchange Act Rule 761, the Commission is proposing to 
expand the definition of ``small bank'' from the current $100 million 
asset limit to a $500 million asset limit, and replace the current 
three percent annual revenue limit with an annual sales compensation 
limit of $100,000. The proposed rule would also simplify the 
solicitation restrictions to permit small banks effecting securities 
transactions pursuant to this exemption to publicly solicit brokerage 
business as permitted by the trust and fiduciary activities exception. 
In addition, it would replace the broad restriction on networking with 
broker-dealers with a narrower restriction that only prohibits 
affiliation with broker-dealers. The rule would also permit dual 
employees and allow small banks to maintain a dedicated sales force. 
Moreover, the exemption would expand to include all custodial accounts 
not just tax-deferred accounts, and to permit transactions in all 
securities rather than just mutual funds. Finally, the proposed 
amendments would simplify the rule's restriction on payment of 
incentive compensation to permit banks to pay their employees incentive 
compensation pursuant to a networking arrangement that meets the 
conditions of Exchange Act Section 3(a)(4)(B)(i).
    The Commission believes that the proposed amendments to the 
safekeeping and custody exemptions--in particular, the broadening of 
the exemption in current Exchange Act Rule 3a4-4--would benefit 
approximately 4,000 additional small banks and thrifts

[[Page 39729]]

by raising the asset limit for this exemption from $100 million to $500 
million. As a result, many more banks would be able to rely on this 
exemption.
    To help the Commission better assess the costs and benefits of 
these proposed amendments to current Exchange Act Rule 3a4-4, we invite 
comment from small banks. Banks should indicate their the asset size, 
the approximate number of their custody relationships, and the annual 
dollar amount of revenue that the bank receives from effecting 
securities transactions for custodial accounts. Small banks are also 
invited to estimate their start-up costs and annual ongoing costs to 
update their systems to track revenue that the bank receives from 
effecting securities transactions for its custodial accounts.
    The other proposed amendments to this exemption, including 
permitting small banks to enter into networking arrangements with 
broker-dealers, have dual employees, and to expand the types of 
accounts and the types of securities that are covered by the 
exemption--will permit smaller banks to continue to perform many of the 
same securities activities that they perform today. As a result, up to 
85 percent of small banks may not need to make material changes to 
their current operations, which should lower their overall costs of 
compliance with the GLBA. We believe that costs of compliance for 
qualifying small banks will not be significant. We request comment on 
the costs that will be incurred by qualifying small banks to comply 
with this proposed amended rule.
    The Commission believes that the small bank exemption should 
provide a very useful exemption to small banks that is not also 
available to small broker-dealers. This may give small banks a 
competitive advantage over broker-dealers that might compete with those 
banks. That being said, the Commission believes that small banks 
currently provide the services that would be encompassed by proposed 
Exchange Act Rule 761 and, given its limited scope, should not 
materially impact the competitive environment between small banks and 
broker-dealers. Nevertheless, the Commission seeks comment on whether 
the proposed amendments to the small bank custody exemption as set 
forth in proposed Exchange Act Rule 761 place small broker-dealers at a 
competitive disadvantage vis-[agrave]-vis small banks. We note, 
however, that, according to the NASD, there are 5,304 active registered 
broker-dealers and that 1,284 firms, or 24.21 percent, have annual 
revenue of $100,000 or less. The Commission requests comment on whether 
the proposed amendments to the small bank custody exemption would have 
a cost to small broker-dealers. The Commission is particularly 
interested in hearing from those active registered broker-dealers that 
have annual revenue of $100,000 or less and whether the existence of 
any of the proposed bank exemptions will have a negative impact on 
competition. Please provide detailed information on exactly how banks 
and broker-dealers compete and how the particular exemptions would 
impact broker-dealers' business. We are also interested in the relative 
cost structure of these small broker-dealers as compared to banks that 
qualify as ``small'' under the proposed amendments to the small bank 
custody exemption. In these comments, please provide us with specific 
information on any differences in costs between banks that could use 
this exemption and small registered broker-dealers that could have a 
hidden cost that we should consider in our analysis.
    We also request comment from small banks about whether they have 
affiliated broker-dealers or if they are affiliated with a bank holding 
company. Those affiliated with a bank holding company should indicate 
the holding company's approximate consolidated assets. Small banks are 
also invited to discuss whether they have a networking relationship 
with a registered broker-dealer, and if so, whether they have dual 
employees. Those with dual employees should indicate how many.
    The Commission also is proposing to amend the general custody 
exemption, which would be codified in Exchange Act Rule 760, to permit 
a bank to be compensated for effecting a securities transaction for a 
person with an existing custody account or for a ``qualified investor'' 
so long as the compensation that the bank receives for its custody 
services (e.g., securities movement fees, annual fees, asset based 
fees, and processing fees) does not directly or indirectly vary based 
on whether the bank accepts an order to purchase or sell a security. In 
other words, the proposed amendment would conditionally permit a 
custodian bank to be compensated for the movement of funds and 
securities for ``grandfathered'' custody accounts or accounts of 
``qualified investors'' when that movement results from the bank's 
acceptance of a securities order. The proposed exemption also would 
remove limitations in the Interim Rules that prohibited custody 
department employees from being compensated for securities-related 
custody activities, including gathering assets and moving funds and 
securities, if the bank accepts customer orders.
    We solicit comment about the costs and benefits that would be 
imposed by proposed Exchange Act Rule 760. In particular, we invite 
commenters to discuss whether banks charge their custody customers when 
they accept an order to purchase or sell securities, and if so, how. 
Banks should note whether that charge varies when they accept an order 
to move funds or securities without purchasing or selling securities. 
If the charge varies depending on the type of customer, banks should 
also explain the range of charges and the proportion of customers 
within each range.
    We expect these proposed changes to ease the compliance burden on 
those banks that qualify for the exemption because they would permit a 
bank to continue to receive Rule 12b-1 shareholder servicing fees for 
existing custody accounts as well as for new accounts with qualified 
investors. While the proposed amendment to the general custody 
exemption could impose some limited marginal costs on banks to ensure 
that the compensation they receive is consistent with the exemption, we 
believe that, on balance, the benefits of the exemption should justify 
the costs of complying with it. We believe that the costs of compliance 
for individual banks with respect to individual accounts will not be 
significant. We solicit comment on the costs that individual banks will 
incur to comply with this proposed rule on an account basis and we ask 
that banks tell us how many accounts will be affected by these proposed 
amendments to the rule.
    We solicit comment on the percentage of a bank's customers' orders 
to move funds and securities that also include orders to purchase or 
sell a security. We also solicit comment about which segment or type of 
customers' account for these orders, such as custody IRAs. Banks are 
also invited to discuss the percentage of the securities transactions 
they effect for custody accounts that involve the purchase or sale of 
mutual fund shares. In addition, we request comment on whether banks 
wanting to use the modified general bank custody exemption would need 
to code their new accounts (other than those for qualified investors) 
to distinguish them from old accounts and to identify qualified 
investors. If so, we also invite estimates of the costs associated with 
coding new accounts.

d. Other Proposed Changes

    In addition to those exemptions discussed above, the Commission is

[[Page 39730]]

proposing a number of special purpose exemptions. For example, in 
response to commenters' recommendations that the Commission provide 
more flexibility with respect to the services banks could offer to 
customers that utilize money market funds for cash management purposes, 
we are proposing a new exemption that would, subject to certain 
conditions, allow a bank (without registering as a broker-dealer) to 
effect transactions for ``qualified investors,'' trust and fiduciary 
activity accounts and certain agency accounts. These transactions in 
money market funds would not be limited to no-load funds or to 
transactions that are part of a sweeps program.
    The proposal should benefit banks by permitting them to offer a 
cash management service to these customers under an exemption that has 
few conditions. This proposed exemption should give banks additional 
flexibility in structuring their business models and in accommodating 
the needs of their customers when the bank acts as an indenture trustee 
or escrow agent. Moreover, the proposed exemption should benefit the 
customers within the scope of the exemption by allowing them to use 
more financial instruments to meet their cash management needs, 
including money market funds, which are diversified, highly liquid, and 
have low transactions costs.
    We do not expect banks or investors to incur any costs related to 
this proposed exemption. We request comment from banks on whether they 
will incur any costs related to this proposed exemption.
    The Commission also is proposing to permit banks that are relying 
on the trust and fiduciary activities, safekeeping and custody, or 
certain stock purchase plans exceptions under the GLBA to process 
transactions in investment company shares through a mutual fund's 
transfer agent, (in addition to using a broker-dealer or Fund/SERV, 
which the Interim Rules currently permit), provided the banks meet 
certain conditions.\419\ We do not expect banks to incur any costs from 
complying with this proposed exemption. We invite comment from banks on 
whether they will incur any costs related to the proposed amendments to 
this exemption.
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    \419\ Exchange Act Section 3(a)(4)(C) requires a bank to execute 
through a registered broker-dealer (or internally cross) 
transactions executed in the United States in securities that are 
publicly traded in the United States that are effected pursuant to 
either the trust and fiduciary activities exception, the safekeeping 
and custody exception, or certain stock purchase plans exception. 15 
U.S.C. 78c(a)(4)(B)(ii), (iv), and (viii). Current Exchange Act Rule 
3a4-6 exempts from this requirement banks that process transactions 
in investment company securities through NSCC's Mutual Fund 
Services, including Fund/SERV.
---------------------------------------------------------------------------

    The Commission is proposing a new exemption for bank trustees and 
non-fiduciary administrators that effect transactions in securities of 
open-end investment companies for participants in employee benefit 
plans. This proposed exemption would allow a bank to accept 
compensation from a fund complex as long as the bank offsets or credits 
any such compensation against fees and expenses that the plan owes to 
the bank. Since banks have advised the Commission staff that they 
offset or credit any compensation received from mutual funds against 
plan expenses, there should be no cost to banks from utilizing this 
proposed new exemption. We request comment on whether any banks will 
incur any costs as a result of this exemption. We invite any bank that 
believes it will incur costs as a result of this proposed exemption 
specifically to delineate the nature of the costs that the bank will 
incur.
    The Commission also is proposing a new exemption that would permit 
banks to effect transactions pursuant to Regulation S with non-U.S. 
persons. We do not expect banks to incur any significant costs in 
connection with utilizing this proposed exemption. We request comment 
on whether banks will incur any costs related to this proposed 
exemption. The Commission is proposing to extend the cash management 
exemption and the exemptions from the definition of ``chiefly 
compensated'' relating to trust and fiduciary activity accounts to 
savings banks and savings and loan associations, and to extend certain 
GLBA bank exceptions to credit unions.\420\ We do not expect savings 
associations, savings banks, or credit unions to incur any costs as a 
result of the proposed amendments to the exemptions and proposed new 
exemptions. We invite comment on any costs that these entities may 
incur related to these proposed changes. The Commission also is 
proposing to extend the exemption from rescission liability under 
Exchange Act Section 29 to contracts entered into by banks acting in a 
broker capacity until a date that would be 18 months after the 
effective date of the proposed amendments to the Interim Rules.\421\ We 
do not expect banks to incur any costs due to the proposed amendments 
to this exemption. We request comment on any costs banks may incur.
---------------------------------------------------------------------------

    \420\ See proposed Exchange Act Rules 771 and 774, respectively.
    \421\ See proposed Exchange Act Rule 780.
---------------------------------------------------------------------------

    The Commission believes these proposed changes could offer a number 
of benefits to banks, credit unions, and to their respective customers. 
In particular, extending the Fund/SERV exemption to mutual fund 
purchases and redemptions directed to the fund's transfer agent would 
give banks more flexibility in processing their customers' mutual fund 
transactions without losing a broker registration exemption.
    Moreover, the proposed Regulation S exemption could help to ensure 
that U.S. banks that effect transactions in Regulation S securities 
with non-U.S. customers will be more competitive with foreign banks 
that offer those services. In addition, the proposed credit union 
exemptions should help to level the competitive playing field between 
banks, savings banks, savings and loan associations, and credit unions 
while remaining consistent with the principles of the Exchange Act. 
Finally, the proposed extension of the exemption from rescission 
liability under Exchange Act Section 29 should provide banks some legal 
certainty for a reasonable period of time while they become accustomed 
to the proposed amendments to the Interim Rules.
    We estimate that the costs of the proposed exemptions would be 
minimal and would be justified by the benefits. For example, the 
Regulation S exemption could impose certain costs on banks to ensure 
that they remain in compliance with the conditions under the exemption. 
In particular, the proposed exemption would require banks to expend 
certain administrative costs to ensure that the proposed exemption is 
used only for ``eligible securities'' and for a purchaser who is 
outside of the U.S. within the meaning of section 903 of Regulation S. 
Nevertheless, the proposed exemption is an accommodation to banks that 
wish to effect transactions in Regulation S securities and, as a 
result, the compliance costs will only be imposed on those banks that 
believe that it is in their best business interests to take advantage 
of the proposed exemption. The same is true with respect to the 
proposed cash management exemption and the proposed exemption for 
credit unions. Given that Exchange Act Section 29 is rarely used as a 
remedy, the Commission does not anticipate that this proposed exemption 
will impose any costs on the industry or on investors. We request 
comment on whether any bank will incur any costs or will benefit as a 
result of this proposed exemption. Please provide any

[[Page 39731]]

supporting data with respect to such costs or benefits.

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

    Exchange Act Section 3(f) requires the Commission, whenever it 
engages in rulemaking, to consider or determine if an action is 
necessary or appropriate in the public interest, and to consider 
whether the action will promote efficiency, competition, and capital 
formation.\422\ Exchange Act Section 23(a)(2) requires the Commission, 
in adopting rules under that Act, to consider the impact that any such 
rule would have on competition. This section also prohibits the 
Commission from adopting any rule that would impose a burden on 
competition not necessary or appropriate in furtherance of the purposes 
of the Exchange Act.\423\
---------------------------------------------------------------------------

    \422\ 15 U.S.C. 78c(f).
    \423\ 15 U.S.C. 78w(a)(2).
---------------------------------------------------------------------------

    The Commission has considered the proposed amendments to the 
Interim Rules in light of these standards and preliminarily believes 
that they will not impose a burden on competition not necessary or 
appropriate in furtherance of the purposes of the Exchange Act. Indeed, 
the Commission believes that by providing legal certainty to banks that 
conduct securities activities, by clarifying the GLBA requirements, and 
by exempting a number of activities from those requirements, the 
proposed amendments should allow banks to continue to conduct many of 
the securities activities they already conduct consistent with the 
GLBA. As a result, the Commission believes that the proposed amendments 
will permit banks to continue to compete with broker-dealers in 
providing a wide range of securities activities, which should preserve 
competition and help to keep transaction costs low for investors and 
for companies. We note, however, that, according to the NASD, there are 
5,304 active registered broker-dealers and that 1,284 firms, or 24.21 
percent, have annual revenue of $100,000 or less. The Commission 
requests comment on whether the proposed amendments would promote 
efficiency, competition, and capital formation. The Commission is 
particularly interested in hearing from those active registered broker-
dealers that have annual revenue of $100,000 or less and whether the 
existence of any of the proposed bank exemptions will have a negative 
impact on competition. Please provide detailed information and data on 
exactly how banks and broker-dealers compete and how the particular 
exemptions would impact broker-dealers' business.

E. Consideration of Impact on the Economy

    For purposes of the Small Business Regulatory Enforcement Fairness 
Act of 1996, or ``SBREFA,'' \424\ the Commission must advise the Office 
of Management and Budget as to whether the proposed amendments to the 
Interim Rules constitute a ``major'' rule. Under SBREFA, a rule is 
considered ``major'' where, if adopted, it results or is likely to 
result in:
---------------------------------------------------------------------------

    \424\ Pub. L. 104-121, Title II, 110 Stat. 857 (1996) (codified 
in various sections of 5 U.S.C., 15 U.S.C. and as a note to 5 U.S.C. 
601).
---------------------------------------------------------------------------

    An annual effect on the economy of $100 million or more (either in 
the form of an increase or a decrease);
    A major increase in costs or prices for consumers or individual 
industries; or
    A significant adverse effect on competition, investment, or 
innovation.
    If a rule is ``major,'' its effectiveness will generally be delayed 
for 60 days pending Congressional review. We request comment on the 
potential impact of the proposed amendments on the economy on an annual 
basis. Commenters are requested to provide empirical data and other 
factual support for their views to the extent possible.

F. Initial Regulatory Flexibility Analysis

    The Commission has prepared an Initial Regulatory Flexibility 
Analysis (``IRFA''), in accordance with the provisions of the 
Regulatory Flexibility Act (``RFA''),\425\ regarding the proposed 
amendments to the Interim Rules.
---------------------------------------------------------------------------

    \425\ 5 U.S.C. 603.
---------------------------------------------------------------------------

1. Reasons for the Proposed Action
    The Commission is proposing the amendments to the Interim Rules to 
respond to a number of concerns commenters raised about the Interim 
Rules and generally to make the guidance and exemptions provided in 
those rules more useful to the industry while preserving the investor 
protection principles of the GLBA.
2. Objectives
    The proposed amendments are intended to improve the usefulness and 
clarity of the principles addressed by the Interim Rules. The 
Commission intends for the proposed amendments to the Interim Rules to 
provide legal certainty to the industry with respect to the GLBA 
requirements. The Commission also seeks to make the restrictions 
imposed by the GLBA more accommodating of current securities activities 
carried out by banks while preserving investor protection principles.
3. Legal Basis
    Pursuant to the Exchange Act and, particularly, Sections 3, 23(a), 
and 36 thereof, the Commission proposes to adopt amendments to the 
Interim Rules.
4. Small Entities Subject to the Rule
    Congress did not exempt small entity banks from the application of 
the GLBA. Moreover, because the Interim Rules are intended to provide 
guidance to all banks that are subject to the GBLA, the Commission 
determined that it would not be appropriate to exempt small entity 
banks from the operation of those Rules. Therefore, the Interim Rules 
generally applied to banks that would be considered small entities.
    Nevertheless, in adopting the Interim Rules, the Commission 
recognized that small banks' customers often use banks to effect 
transactions in IRAs. To allow small banks to continue to offer this 
service, the Commission adopted Exchange Act Rule 3a4-4 (which we are 
proposing to amend and redesignate as Exchange Act Rule 761), which 
provides a limited exemption from broker-dealer registration for small 
banks that effect transactions in investment company securities in tax-
deferred accounts.\426\
---------------------------------------------------------------------------

    \426\ 66 FR at 27781.
---------------------------------------------------------------------------

    In response to comments that the scope of this exemption is too 
limited to be useful to small banks and their customers, as discussed 
above, the Commission is proposing to expand the small bank exemption. 
A proposed amendment to this rule would raise the limit on this 
exemption from $100 million to $500 million in assets. The proposed 
amount could greatly expand the number of banks that qualify for the 
exemption.\427\ The Commission seeks comment on the number of banks 
that would qualify for the small bank custody exemption.
---------------------------------------------------------------------------

    \427\ A $500 million asset limit could greatly expand the 
availability of this exemption from broker registration, increasing 
the number of eligible entities from over 4,000 FDIC-insured banks 
and thrifts, or approximately 48 percent of all such entities, to 
over 8,000 FDIC-insured banks and thrifts, or almost 88 percent of 
all such entities. Given that some of these entities may be 
affiliated with larger holding companies or may be affiliated with 
registered broker-dealers, however, some of these entities 
presumably would not meet the proposed definition of small bank. See 
proposed Exchange Act Rules 761(a) and 762(h).
---------------------------------------------------------------------------

    Moreover, the proposed amendment would expand the scope of the 
exemption to increase the types of securities that could be bought or 
sold under the exemption and the types of accounts. It would also 
permit a small bank to use a dedicated bank sales force

[[Page 39732]]

to effect transactions in securities that may consist of either 
unregistered personnel or registered representatives employed by both a 
broker-dealer and the small bank seeking to qualify for the exemption.
5. Reporting, Recordkeeping and Other Compliance Requirements
    The proposed amendments would not impose any new reporting, 
recordkeeping, or other compliance requirements on banks that are small 
entities.
6. Duplicative, Overlapping, or Conflicting Federal Rules
    The Commission believes that there are no rules that duplicate, 
overlap, or conflict with the proposed amendments.
7. Significant Alternatives
    Pursuant to Section 3(a) of the RFA,\428\ the Commission must 
consider the following types of alternatives: (a) The establishment of 
differing compliance or reporting requirements or timetables that take 
into account the resources available to small entities; (b) the 
clarification, consolidation, or simplification of compliance and 
reporting requirements under the proposed rule for small entities; (c) 
the use of performance rather than design standards; and (d) an 
exemption from coverage of the proposed rule, or any part thereof, for 
small entities.
---------------------------------------------------------------------------

    \428\ 5 U.S.C. 603(c).
---------------------------------------------------------------------------

    As discussed above, the GLBA does not exempt small banks from the 
Exchange Act broker-dealer registration requirements, and the 
Commission does not believe that an unconditional exemption would be 
consistent with the investor protection principles of the GLBA. 
Moreover, such an exemption could place broker-dealers at a competitive 
disadvantage versus small banks.
    The proposed amendments to the Interim Rules (which would be 
codified in Regulation B) are intended to clarify and simplify 
compliance with the GLBA by expanding exemptions in the Interim Rules 
and by adding additional exemptions. As such, the proposed amendments 
should ease compliance on banks of all sizes, including smaller 
entities.
    The Commission does not believe that it is necessary to consider 
whether small entities should be permitted to use performance rather 
than design standards to comply with the proposed amendments because 
they already propose performance standards and do not dictate for 
entities of any size any particular design standards (e.g., technology) 
that must be employed to achieve the objectives of the proposed 
amendments.
    Nevertheless, as discussed above, the Commission is proposing to 
expand the exemption for small banks in current Exchange Act Rule 3a4-4 
(which we are proposing to redesignate as Exchange Act Rule 761) by 
increasing the asset limit from $100 million to $500 million, as well 
as expanding the types of securities included under the exemption. 
These proposed changes should further ease the compliance burden on 
those small banks that qualify for the exemption.
8. Request for Comments
    The Commission encourages written comments on matters discussed in 
the IRFA. In particular, the Commission requests comments on (a) the 
number of small entities that would be affected by the proposed 
amendments; (b) the nature of any impact the proposed amendments would 
have on small entities and empirical data supporting the extent of the 
impact; and (c) how to quantify the number of small entities that would 
be affected by and/or how to quantify the impact of the proposed 
amendments. Such comments will be considered in the preparation of the 
Final Regulatory Flexibility Analysis, if the proposed rule is adopted, 
and will be placed in the same public file as comments on the proposed 
rule itself. Persons wishing to submit written comments should refer to 
the instructions for submitting comments in the front of this release.

V. Statutory Authority

    Pursuant to authority set forth in the Exchange Act and 
particularly Sections 3(b), 15, 23(a), and 36 thereof (15 U.S.C. 
78c(b), 78o, 78w(a), and 78mm, respectively) the Commission proposes to 
(1) amend current Rules 3a4-2, 3a4-3, 3a4-4, 3a4-5, 3a4-6, 15a-8, and 
15a-9 (Sec. Sec.  240.3a4-2, 240.3a4-3, 240.3a4-4, 240.3a4-5, 240.3a4-
6, 240.15a-8, and 240.15a-9, respectively) and redesignate them as 
Rules 721, 723, 761, 760, 775, 780, and 773 (Sec. Sec.  242.721, 
242.723, 242.761, 242.760, 242.775, 242.780, and 242.773, respectively) 
(2) amend Exchange Act Rule 15a-6 (Sec.  240.15a-6); (3) repeal Rule 
3b-17 (Sec.  240.3b-17); and redesignate Exchange Act Rules 15a-10, and 
15a-11 as 15a-7 (Sec.  240.15a-7), and 772 (Sec.  242.772).

VI. Text of Proposed Rules and Rule Amendments

List of Subjects

17 CFR Part 240

    Broker-dealers, Reporting and recordkeeping requirements, 
Securities.

17 CFR Part 242

    Banks, banking, Brokers, Broker-dealers, Credit unions, Savings 
associations, Securities.
    For the reasons set forth in the preamble, Title 17, Chapter II of 
the Code of Federal Regulations is proposed to be amended as follows:

PART 240--GENERAL RULES AND REGULATIONS, SECURITIES EXCHANGE ACT OF 
1934

    1. The authority citation for Part 240 continues to read, in part, 
as follows:

    Authority: 15 U.S.C. 77c, 77d, 77g, 77j, 77s, 77z-2, 77z-3, 
77eee, 77ggg, 77nnn, 77sss, 77ttt, 78c, 78d, 78e, 78f, 78g, 78i, 
78j, 78j-1, 78k, 78k-1, 78l, 78m, 78n, 78o, 78p, 78q, 78s, 78u-5, 
78w, 78x, 78ll, 78mm, 79q, 79t, 80a-20, 80a-23, 80a-29, 80a-37, 80b-
3, 80b-4, 80b-11, and 7201 et seq.; and 18 U.S.C. 1350, unless 
otherwise noted.
* * * * *


Sec. Sec.  240.3a4-2 through 240.3a4-6  [Removed]

    2. Sections 240.3a4-2 through 240.3a4-6 are removed.
* * * * *


Sec.  240.3b-17  [Removed and Reserved]

    3. Section 240.3b-17 is removed and reserved.
* * * * *
    4. Section 240.15a-6 is amended by revising paragraph (a)(4)(i) to 
read as follows:


Sec.  240.15a-6  Exemption of certain foreign brokers or dealers.

    (a) * * *
    (4) * * *
    (i) A registered broker or dealer, whether the registered broker or 
dealer is acting as principal for its own account or as agent for 
others, or a bank acting pursuant to an exception or exemption from the 
definition of ``broker'' or ``dealer'' in sections 3(a)(4)(B) or 
3(a)(5)(C) of the Act (15 U.S.C. 78c(a)(4)(B) or 15 U.S.C. 
78c(a)(5)(C)).
* * * * *


Sec. Sec.  240.15a-7 through 240.15a-9  [Removed]

    5. Sections 240.15a-7 through 240.15a-9 are removed.


Sec.  240.15a-10  [Redesignated]

    6-7. Section 240.15a-10 is redesignated as Sec.  240.15a-7.

[[Page 39733]]

PART 242--REGULATIONS M, ATS, AC AND B AND CUSTOMER MARGIN 
REQUIREMENTS FOR SECURITY FUTURES

    8. The part heading for part 242 is revised as set forth above.
    9. The authority citation for Part 242 is revised to read as 
follows:

    Authority: 15 U.S.C. 77g, 77q(a), 77s(a), 78b, 78c, 78g(c)(2), 
78i(a), 78j, 78k-1(c), 78l, 78m, 78n, 78o(b), 78o(c), 78o(g), 
78q(a), 78q(b), 78q(h), 78w(a), 78dd-1, 78mm, 80a-23, 80a-29, and 
80a-37.

    10. Part 242 is amended by adding Regulation B, Sec. Sec.  242.710 
through 242.781, to read as follows:

Regulation B--Securities Activities of Banks and Other Financial 
Institutions

Subpart A--Networking Exception: Defined Terms
Sec.
242.710 Defined terms relating to the networking exception from the 
definition of ``broker.''
Subpart B--Trust and Fiduciary Activities Exception: Exemptions and 
Defined Terms
242.720 Exemption from the ``chiefly compensated'' condition for 
banks with existing personal trust accounts.
242.721 Exemption for banks from determining whether they are 
``chiefly compensated'' on a line of business.
242.722 Exemption for banks from determining whether they are 
``chiefly compensated'' on an account-by-account basis.
242.723 Exemption from the definition of ``broker'' for banks 
effecting transactions as an indenture trustee in a no-load money 
market fund.
242.724 Defined terms relating to the trust and fiduciary activities 
exception from the definition of ``broker.''
Subpart C--[Reserved]
Subpart D--Sweep Accounts Exception: Defined Terms
242.740 Defined terms relating to the sweep accounts exception from 
the definition of ``broker.''
Subpart E--Affiliate Transactions Exception: Defined Terms
242.750 Defined terms relating to the affiliate transactions 
exception from the definition of ``broker.''
Subpart F--Safekeeping and Custody Activities Exception: Exemptions
242.760 Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in a custody account.
242.761 Exemption from the definition of ``broker'' for small banks 
effecting securities transactions in a custody account.
242.762 Defined terms relating to the safekeeping and custody 
activities exception from the definition of ``broker.''
Subpart G--Special Purpose Exemptions
242.770 Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in certain employee benefit 
plans.
242.771 Exemption from the definitions of ``broker'' and ``dealer'' 
for banks effecting transactions in securities issued pursuant to 
Regulation S.
242.772 [Reserved]
242.773 Exemption from the definitions of ``broker'' and ``dealer'' 
for savings associations and savings banks.
242.774 Exemption from the definitions of ``broker'' and ``dealer'' 
for credit unions.
242.775 Exemption from the definition of ``broker'' for the way 
banks effect excepted or exempted transactions in investment company 
securities.
242.776 Exemption for banks effecting transactions for certain 
investors in money market funds.
Subpart H--Temporary Exemptions
242.780 Exemption for banks from liability under section 29 of the 
Securities Exchange Act of 1934.
242.781 Exemption from the definition of ``broker'' for banks for a 
limited period of time.

Regulation B--Securities Activities of Banks and Other Financial 
Institutions

Subpart A--Networking Exception: Defined Terms


Sec.  242.710  Defined terms relating to the networking exception from 
the definition of ``broker.''

    When used with respect to the Third Party Brokerage Arrangements 
(``Networking'') Exception from the definition of the term ``broker'' 
in section 3(a)(4)(B)(i) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(4)(B)(i)), the following terms shall have the meaning 
provided:
    (a) Contingent on whether the referral results in a transaction 
means contingent on any factor related to whether the referral results 
in a securities transaction, including whether it is likely to result 
in a transaction, whether it results in a particular type of 
transaction, or whether it results in multiple transactions, provided, 
however, that a referral fee may be contingent on whether a customer:
    (1) Contacts or keeps an appointment with a registered broker or 
dealer as a result of the referral; or
    (2) Has assets, a net worth, or income meeting any minimum 
requirement that the registered broker or dealer, or the bank, may have 
established generally for referrals for securities brokerage accounts.
    (b) Nominal one-time cash fee of a fixed dollar amount means a 
payment:
    (1) Having a value that does not exceed the greater of:
    (i) The employee's base hourly rate of pay;
    (ii) Twenty five dollars; or
    (iii) A dollar amount that does not exceed the whole dollar amount 
nearest to fifteen dollars in 1999 dollars adjusted by the cumulative 
annual percentage change in the Consumer Price Index All Urban 
Consumers--(CPI-U) published by the Department of Labor that was 
reported on June 1 of the preceding year;
    (2) Paid to a bank employee no more than one time for each customer 
referred by that employee;
    (3) That, to the extent any portion of the fee is paid other than 
in cash:
    (i) Is paid in units of value with a readily ascertainable cash 
equivalent;
    (ii) Has, together with any portion of the fee paid in cash, a 
total cash value that meets the conditions of paragraph (b)(1) of this 
section; and
    (iii) Is paid under an incentive program that covers a broad range 
of products and that is designed primarily to reward activities 
unrelated to securities; and
    (4) Having a set value that a particular employee making a referral 
would receive for any referral to a registered broker or dealer, and 
that does not vary based on factors such as the financial status of a 
customer the employee refers, the identity of the registered broker or 
dealer to which the customer is referred, the number of referrals the 
employee makes, or whether the customer expresses an interest in a 
particular type of securities product.
    (c) Referral means the action taken by a bank employee to direct a 
customer of the bank to a registered broker or dealer for the purchase 
or sale of securities for the customer's account.

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


Sec.  242.720  Exemption from the ``chiefly compensated'' condition for 
banks with existing living, testamentary, or charitable trust accounts.

    (a) A bank relying on the exception from the definition of the term 
``broker'' under section 3(a)(4)(B)(ii) of the Securities Exchange Act 
of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)) is exempt from meeting the 
``chiefly compensated'' condition in section 3(a)(4)(B)(ii)(I) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)(I)) to the 
extent that it effects transactions in securities for a living, 
testamentary, or charitable trust account opened, or established before 
July 30, 2004, in a trustee or fiduciary capacity within the scope of 
section 3(a)(4)(D) of the Securities

[[Page 39734]]

Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)), if the bank:
    (1) Meets the other conditions for the exception from the 
definition of the term ``broker'' under sections 3(a)(4)(B)(ii) and 
3(a)(4)(C) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(ii) and 15 U.S.C. 78c(a)(4)(C)); and
    (2) Does not individually negotiate with the accountholder or 
beneficiary of such account to increase the proportion of sales 
compensation as compared to relationship compensation after July 30, 
2004.
    (b) For purposes of this section, a testamentary trust may be 
deemed to be established as of the date of the will that directed that 
the trust be established.


Sec.  242.721  Exemption for banks from determining whether they are 
``chiefly compensated'' on a line of business basis.

    (a) A bank relying on the exception from the definition of the term 
``broker'' under section 3(a)(4)(B)(ii) of the Securities Exchange Act 
of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)) is exempt from meeting the 
``chiefly compensated'' condition in section 3(a)(4)(B)(ii)(I) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)(I)) to the 
extent that it effects transactions in securities for any account in a 
trustee or fiduciary capacity within the scope of section 3(a)(4)(D) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)) in any 
year in which the bank:
    (1) Meets the other conditions for the exception from the 
definition of the term ``broker'' under sections 3(a)(4)(B)(ii) and 
3(a)(4)(C) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(ii) and 15 U.S.C. 78c(a)(4)(C));
    (2) Can demonstrate that during the preceding year its ratio of 
sales compensation to relationship compensation was no more than one to 
nine;
    (3) Maintains procedures reasonably designed to ensure that, before 
opening or establishing an account for which it will act in a trustee 
or fiduciary capacity, the bank reviews the account to ensure that the 
bank is likely to receive more relationship compensation than sales 
compensation with respect to that account; and
    (4) Maintains procedures reasonably designed to ensure that, after 
opening or establishing an account for which it will act in a trustee 
or fiduciary capacity, at such time as the bank individually negotiates 
with the accountholder or beneficiary of that account to increase the 
proportion of sales compensation as compared to relationship 
compensation, the bank reviews the account to ensure that the bank is 
likely to receive more relationship compensation than sales 
compensation with respect to that account.
    (b) A bank that fails to meet the ratio requirement in paragraph 
(a)(2) of this section may nonetheless continue to rely on the 
exemption in paragraph (a) of this section for one year if it:
    (1) Meets the other requirements in paragraph (a) of this section;
    (2) Can demonstrate that during the preceding year its ratio of 
sales compensation to relationship compensation was no more than one to 
seven; and
    (3) Did not rely on the safe harbor in paragraph (b) of this 
section during any of the five preceding years.
    (c) A bank may use this section for all accounts for which the bank 
acts in a trustee or fiduciary capacity on a bank-wide basis, or a bank 
may use this section for one or more individual lines of business 
provided that the sales compensation and relationship compensation from 
all accounts for which the bank acts in a trustee or fiduciary 
capacity, or all accounts established before a single date certain for 
which the bank acts in a trustee or fiduciary capacity, within a 
particular line of business is used to determine whether the bank meets 
the requirement in paragraph (a)(2) or (b)(2) of this section.


Sec.  242.722  Exemption for banks from determining whether they are 
``chiefly compensated'' on an account-by-account basis.

    (a) A bank relying on the exception from the definition of the term 
``broker'' under section 3(a)(4)(B)(ii) of the Securities Exchange Act 
of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)) is exempt from meeting the 
``chiefly compensated'' condition in section 3(a)(4)(B)(ii)(I) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)(I)) to the 
extent that it effects transactions in securities for an account in a 
trustee or fiduciary capacity within the scope of section 3(a)(4)(D) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)) in any 
year in which the bank:
    (1) Meets the other conditions for the exception from the 
definition of the term ``broker'' under sections 3(a)(4)(B)(ii) and 
3(a)(4)(C) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(ii) and 15 U.S.C. 78c(a)(4)(C));
    (2) Can demonstrate that it met the ``chiefly compensated'' 
condition with respect to such account during the preceding year;
    (3) Maintains procedures reasonably designed to ensure that, before 
opening or establishing an account for which it will act in a trustee 
or fiduciary capacity, the bank reviews the account to ensure that the 
bank is likely to receive more relationship compensation than sales 
compensation with respect to that account; and
    (4) Maintains procedures reasonably designed to ensure that, after 
opening or establishing an account for which it will act in a trustee 
or fiduciary capacity, at such time as the bank individually negotiates 
with the accountholder or beneficiary of that account to increase the 
proportion of sales compensation as compared to relationship 
compensation, the bank reviews the account to ensure that the bank is 
likely to receive more relationship compensation than sales 
compensation with respect to that account.
    (b) Except as provided in paragraph (d) of this section, a bank 
that fails to meet the requirement in paragraph (a)(2) of this section 
with respect to an account may nonetheless continue to rely on the 
exemption in paragraph (a) of this section with respect to such account 
for one year if it:
    (1) Meets the other requirements in paragraph (a) of this section; 
and
    (2) Did not rely on the safe harbor in paragraph (b) of this 
section with respect to such account during any of the five preceding 
years.
    (c) Except as provided in paragraph (d) of this section, a bank 
that fails to meet the requirements in paragraphs (a)(2) and (b)(2) of 
this section with respect to an account may nonetheless continue to 
rely on the exemption in paragraph (b) of this section with respect to 
such account if it:
    (1) Meets the other requirements in paragraph (a) of this section;
    (2) Has documented the reason that such account continued not to 
meet the ``chiefly compensated'' condition and linked that reason to 
its exercise of fiduciary responsibility; and
    (3) Has no more than the lesser of 500 or one percent of the total 
number of accounts for which it acts in a trustee or fiduciary capacity 
that did not meet the requirement in paragraph (b)(2) of this section.
    (d) A bank may not rely on the safe harbors in paragraphs (b) and 
(c) of this section if more than ten percent of the total number of 
accounts for which it acts in a trustee or fiduciary capacity did not 
meet the ``chiefly compensated'' condition.


Sec.  242.723  Exemption from the definition of ``broker'' for banks 
effecting transactions as an indenture trustee in a no-load money 
market fund.

    A bank that meets the conditions for the exception from the 
definition of the

[[Page 39735]]

term ``broker'' under section 3(a)(4)(B)(ii) of the Securities Exchange 
Act of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)), except for the ``chiefly 
compensated'' condition in section 3(a)(4)(B)(ii)(I) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(B)(ii)(I)), is exempt from 
the definition of the term ``broker'' under section 3(a)(4) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4)) to the extent 
that it effects transactions as an indenture trustee in a no-load money 
market fund.


Sec.  242.724  Defined terms relating to the trust and fiduciary 
activities exception from the definition of ``broker.''

    For purposes of this subpart and sections 3(a)(4)(B)(ii) and 
3(a)(4)(D) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(ii) and 15 U.S.C. 78c(a)(4)(D)), the following terms shall 
have the meaning provided:
    (a) Chiefly compensated means that during the preceding year, the 
bank received more relationship compensation than sales compensation 
from an account for which the bank acts in a trustee or fiduciary 
capacity within the scope of section 3(a)(4)(D) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)).
    (b) Flat or capped per order processing fee equal to not more than 
the cost incurred by the bank in connection with executing securities 
transactions for trustee and fiduciary customers means a fee that is no 
more than the amount a broker-dealer charged an account for which the 
bank acts in a trustee or fiduciary capacity within the scope of 
section 3(a)(4)(D) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(D)) for executing the transaction, plus the direct marginal 
cost of any resources of the bank that are used for transaction 
execution, comparison, or settlement for accounts for which the bank 
acts in a trustee or fiduciary capacity if the bank makes a precise and 
verifiable allocation of these resources according to their use.
    (c) Indenture trustee means any trustee for an indenture to which 
the definition in section 303 of the Trust Indenture Act of 1939 (15 
U.S.C. 77ccc) applies, and any trustee for an indenture to which the 
definition in section 303 of that Act would apply but for an exemption 
from qualification pursuant to section 304 of that Act.
    (d) Investment adviser if the bank receives a fee for its 
investment advice in section 3(a)(4)(D) of the Securities Exchange Act 
of 1934 (15 U.S.C. 78c(a)(4)(D)) means a bank that has a fiduciary 
relationship with the advised customer in which the bank:
    (1) Owes the customer duty of loyalty, including an affirmative 
duty to make full and fair disclosure of all material facts and 
conflicts of interest; and
    (2) Has an ongoing responsibility to provide investment advice 
based upon the customer's individual needs that includes selecting or 
making recommendations regarding specific securities and, if the 
customer accepts such selections or recommendations, a responsibility 
to direct the purchases or sales to a registered broker or dealer for 
execution.
    (e) Line of business means an identifiable department, unit, or 
division of a bank organized and operated on an ongoing basis for 
business reasons with similar types of accounts and for which the bank 
acts in a similar type of fiduciary capacity as listed in section 
3(a)(4)(D) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(D)).
    (f) Money market fund has the same meaning as in Sec.  242.740.
    (g) No-load has the same meaning as in Sec.  242.740.
    (h) Relationship compensation means any compensation a bank 
receives directly from a customer or beneficiary, or directly from the 
assets of an account for which the bank acts in a trustee or fiduciary 
capacity within the scope of section 3(a)(4)(D) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)), that consists solely of:
    (1) An administration or annual fee (payable on a monthly, 
quarterly, or other basis);
    (2) A fee based on a percentage of assets under management;
    (3) A flat or capped per order processing fee equal to not more 
than the cost incurred by the bank in connection with executing 
securities transactions for trustee and fiduciary customers; or
    (4) Any combination of such fees.
    (i) Sales compensation means any compensation a bank receives in 
connection with activities for which it relies on an exception under 
section 3(a)(4)(B)(ii) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(4)(B)(ii)) that is:
    (1) A fee for effecting a securities transaction that exceeds the 
fee defined in paragraph (b) of this section;
    (2) Compensation that if paid to a broker or dealer would be 
payment for order flow, as defined in 17 CFR 240.10b-10;
    (3) A finders' fee received in connection with a securities 
transaction or account, except a fee received pursuant to section 
3(a)(4)(B)(i) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(i));
    (4) A fee paid for an offering of securities that the bank does not 
receive directly from a customer or beneficiary, or directly from the 
assets of an account for which the bank acts in a trustee or fiduciary 
capacity, which fee may be allocated to each account by dividing the 
number of shares of each class of an investment company's securities 
(or class of a series of an investment company's securities) held in 
each account on the last business day of the preceding year by the 
aggregate number of shares of the same class held by the bank in a 
trustee or fiduciary capacity on the same day, and multiplying the 
resulting number by the aggregate dollar amount of these fees the bank 
received in connection with that class during the preceding year, or by 
using another method of allocation that fairly and consistently 
measures the amount of sales compensation attributable to each account 
during the preceding year;
    (5) A fee paid pursuant to a plan under 17 CFR 270.12b-1, which fee 
may be calculated for each account by multiplying the number of shares 
of each class of a registered investment company's securities (or class 
of a series of an investment company's securities) held in each account 
on the last business day of the preceding year by the net asset value 
per share for that class of securities for such day by the annual Rule 
12b-1 fee rate applicable to that class of securities, or by using 
another method of allocation that fairly and consistently measures the 
amount of sales compensation attributable to each account during the 
preceding year; or
    (6) A fee paid by an investment company, other than pursuant to a 
plan under 17 CFR 270.12b-1, for personal service or the maintenance of 
shareholder accounts, which fee may be allocated to each account by 
dividing the number of shares of each class of an investment company's 
securities (or class of a series of an investment company's securities) 
held in each account on the last business day of the preceding year by 
the aggregate number of shares of the same class held by the bank in a 
trustee or fiduciary capacity on the same day, and multiplying the 
resulting number by the aggregate dollar amount of these fees the bank 
received in connection with that class during the preceding year, or by 
using another method of allocation that fairly and consistently 
measures the amount of sales compensation attributable to each account 
during the preceding year. For purposes of this section, charges for 
the following will not be considered charges for personal service or 
for the maintenance of shareholder accounts:

[[Page 39736]]

    (i) Providing transfer agent or sub-transfer agent services for 
beneficial owners of investment company shares;
    (ii) Aggregating and processing purchase and redemption orders for 
investment company shares;
    (iii) Providing beneficial owners with account statements showing 
their purchases, sales, and positions in the investment company;
    (iv) Processing dividend payments for the investment company;
    (v) Providing sub-accounting services to the investment company for 
shares held beneficially;
    (vi) Forwarding communications from the investment company to the 
beneficial owners, including proxies, shareholder reports, dividend and 
tax notices, and updated prospectuses; or
    (vii) Receiving, tabulating, and transmitting proxies executed by 
beneficial owners of investment company shares.
    (j) Year means a calendar year or other fiscal year consistently 
used by the bank for recordkeeping and reporting purposes.

Subpart C--[Reserved]

Subpart D--Sweep Accounts Exception: Defined Terms


Sec.  242.740  Defined terms relating to the sweep accounts exception 
from the definition of ``broker.''

    For purposes of section 3(a)(4)(B)(v) of the Securities Exchange 
Act of 1934 (15 U.S.C. 78c(a)(4)(B)(v)), the following terms shall have 
the meaning provided:
    (a) Deferred sales load has the same meaning as in 17 CFR 270.6c-
10.
    (b) Money market fund means an open-end company registered under 
the Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) that is 
regulated as a money market fund pursuant to 17 CFR 270.2a-7.
    (c)(1) No-load, in the context of an investment company or the 
securities issued by an investment company, means, for securities of 
the class or series in which a bank effects transactions, that:
    (i) That class or series is not subject to a sales load or a 
deferred sales load; and
    (ii) Total charges against net assets of that class or series of 
the investment company's securities for sales or sales promotion 
expenses, for personal service, or for the maintenance of shareholder 
accounts do not exceed 0.25 of 1% of average net assets annually and 
are disclosed in the investment company's prospectus.
    (2) For purposes of this definition, charges for the following will 
not be considered charges against net assets of a class or series of an 
investment company's securities for sales or sales promotion expenses, 
for personal service, or for the maintenance of shareholder accounts:
    (i) Providing transfer agent or sub-transfer agent services for 
beneficial owners of investment company shares;
    (ii) Aggregating and processing purchase and redemption orders for 
investment company shares;
    (iii) Providing beneficial owners with account statements showing 
their purchases, sales, and positions in the investment company;
    (iv) Processing dividend payments for the investment company;
    (v) Providing sub-accounting services to the investment company for 
shares held beneficially;
    (vi) Forwarding communications from the investment company to the 
beneficial owners, including proxies, shareholder reports, dividend and 
tax notices, and updated prospectuses; or
    (vii) Receiving, tabulating, and transmitting proxies executed by 
beneficial owners of investment company shares.
    (d) Open-end company has the same meaning as in section 5(a)(1) of 
the Investment Company Act of 1940 (15 U.S.C. 80a-5(a)(1)).
    (e) Sales load has the same meaning as in section 2(a)(35) of the 
Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(35)).

Subpart E--Affiliate Transactions Exception: Defined Terms


Sec.  242.750  Defined terms relating to the affiliate transactions 
exception from the definition of ``broker.''

    For purposes of section 3(a)(4)(B)(vi) of the Securities Exchange 
Act of 1934 (15 U.S.C. 78c(a)(4)(B)(vi)), the term effects transactions 
for the account of any affiliate means effecting a securities 
transaction as agent for an affiliate of the bank as defined in section 
2 of the Bank Holding Company Act of 1956 (12 U.S.C. 1841(k)), provided 
that:
    (a) The affiliate is:
    (1) Acting as a principal; or
    (2) Acting as a trustee or fiduciary purchasing or selling for 
investment purposes; and
    (b) The affiliate is not:
    (1) Acting as a riskless principal for another person;
    (2) Registered as a broker or dealer; or
    (3) Engaged in merchant banking as described in section 4(k)(4)(H) 
of the Bank Holding Company Act of 1956 (12 U.S.C. 1843(k)(4)(H)); and
    (c) The bank obtains the security or securities to complete the 
transaction from a registered broker or dealer, from a person that is 
acting in the capacity of a broker or dealer that is not required to 
register as such, or pursuant to another exception or exemption from 
section 3(a)(4)(B) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)).

Subpart F--Safekeeping and Custody Activities Exception: Exemptions


Sec.  242.760  Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in a custody account.

    (a) A bank is exempt from the definition of the term ``broker'' 
under section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)) to the extent that it accepts orders to effect transactions 
in securities in an account for which the bank acts as a custodian 
under section 3(a)(4)(B)(viii) of the Securities Exchange Act of 1934 
(15 U.S.C. 78c(a)(4)(B)(viii) for a person with an account that was 
opened before July 30, 2004, or for a qualified investor if:
    (1) The bank can demonstrate that it does not charge for or receive 
any compensation for effecting such transactions that directly or 
indirectly varies based on whether the bank accepts an order to 
purchase or sell a security other than:
    (i) A fee paid pursuant to a plan under 17 CFR 270.12b-1; or
    (ii) A fee paid by a registered investment company, other than 
pursuant to a plan under 17 CFR 270.12b-1, for personal service or the 
maintenance of shareholder accounts;
    (2) Any bank employee effecting such transactions does not receive 
compensation from the bank, the executing broker or dealer, or any 
other person related to the size, value, or completion of any 
securities transaction effected pursuant to this exemption;
    (3) The bank does not directly or indirectly solicit such 
securities transactions except through responding to inquiries of a 
potential purchaser in a communication initiated by the potential 
purchaser of the security; provided, however, that the content of such 
responses is limited to:
    (A) Information contained in a registration statement for the 
security filed under the Securities Act of 1933 (15 U.S.C. 77a et 
seq.); and
    (B) Sales literature prepared by the principal underwriter that is 
a registered broker or dealer or prepared by a registered investment 
company that is not an affiliated person of the bank;
    (4) The bank does not effect securities transactions in reliance on 
this section for an account for which the bank acts in a trustee or 
fiduciary capacity within

[[Page 39737]]

the scope of section 3(a)(4)(D) of the Securities Exchange Act of 1934 
(15 U.S.C. 78c(a)(4)(D));
    (5) The bank does not effect securities transactions in reliance on 
this section for an account described in Sec.  242.770(a)(1);
    (6) The bank does not effect transactions in reliance on Sec.  
242.761;
    (7) The bank complies with section 3(a)(4)(C) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(C)); and
    (8) If the bank accepts an order to effect transactions in 
securities of a registered investment company for compensation as 
described in paragraph (a)(1)(i) or (a)(1)(ii) of this section, the 
bank does so on the same terms for any class or series of securities of 
such registered investment company that can reasonably be obtained by 
the bank for purchase or sale by bank customers.
    (b) A bank may demonstrate that it does not receive compensation 
for effecting securities transactions that varies based on whether the 
bank accepts an order to purchase or sell a security by:
    (1) Utilizing fee schedules that specify charges for the movement 
of funds and securities; and
    (2) Identifying similarly situated customers who pay the same price 
for such movements and who do not utilize the bank or its affiliates to 
effect securities transactions.
    (c) For purposes of this section, the term qualified investor has 
the same meaning as in section 3(a)(54)(A) of the Securities Exchange 
Act of 1934 (15 U.S.C. 78c(a)(54)(A)).


Sec.  242.761  Exemption from the definition of ``broker'' for small 
banks effecting securities transactions in a custody account.

    A small bank is exempt from the definition of the term ``broker'' 
under section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)) to the extent that it accepts orders to effect transactions 
in securities in an account for which the bank acts as custodian under 
section 3(a)(4)(B)(viii) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(4)(B)(viii)) if:
    (a) The bank is not a person associated with a broker or dealer;
    (b) The bank does not publicly solicit such securities transactions 
except by soliciting brokerage business as permitted under section 
3(a)(4)(B)(ii)(II) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(ii)(II));
    (c) The annual sales compensation the bank receives for effecting 
transactions in securities pursuant to this exemption does not exceed 
$100,000 in 2004 dollars adjusted by the cumulative annual percentage 
change in the Consumer Price Index All Urban Consumers--(CPI-U) 
published by the Department of Labor that was reported on June 1 of the 
preceding year;
    (d) The bank does not effect securities transactions in reliance on 
this section for an account for which the bank acts in a capacity 
described in section 3(a)(4)(D) of the Securities Exchange Act of 1934 
(15 U.S.C. 78c(a)(4)(D)) unless it does not rely on any exemption under 
Sec.  242.720, Sec.  242.721, or Sec.  242.722 in the year following 
the year in which this exemption is utilized in connection with such an 
account;
    (e) The bank does not pay its employees any incentive compensation 
related to any brokerage transaction effected under this section except 
pursuant to a networking arrangement that meets the conditions of 
section 3(a)(4)(B)(i) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(B)(i)); and
    (f) The bank complies with section 3(a)(4)(C) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(C)).


Sec.  242.762  Defined terms relating to the safekeeping and custody 
activities exception from the definition of ``broker.''

    For purposes of this subpart, the following terms shall have the 
meaning provided:
    (a) Account for which the bank acts as a custodian means an account 
established by a written agreement between the bank and the customer, 
which at a minimum provides for the terms that will govern the fees 
payable, rights, and obligations of the bank regarding:
    (1)(i) Safekeeping of securities;
    (ii) Settling trades;
    (iii) Investing cash balances as directed;
    (iv) Collecting income;
    (v) Processing corporate actions;
    (vi) Pricing securities positions; and
    (vii) Providing recordkeeping and reporting services; or
    (2) An individual retirement account for which the bank acts as a 
custodian.
    (b) Affiliate has the same meaning as in the Bank Holding Company 
Act of 1956 (12 U.S.C. 1841 et seq.).
    (c) Affiliated person has the same meaning as in section 2(a)(3) of 
the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(3)).
    (d) Bank holding company has the same meaning as in the Bank 
Holding Company Act of 1956 (12 U.S.C. 1841 et seq.).
    (e) Principal underwriter has the same meaning as in section 
2(a)(29) of the Investment Company Act of 1940 (15 U.S.C. 80a-
2(a)(29)).
    (f) Sales compensation has the same meaning as in Sec.  242.724.
    (g) Savings and loan holding company has the same meaning as in 
section 10(a)(1)(D) of the Home Owners' Loan Act (12 U.S.C. 
1467(a)(1)(D)).
    (h) Small bank means a bank that:
    (1) Had less than $500 million in assets as of December 31 of both 
of the prior two calendar years; and
    (2) Is not, and since December 31 of the third prior calendar year 
has not been, an affiliate of a bank holding company or a savings and 
loan holding company that as of December 31 of both of the prior two 
calendar years had consolidated assets of more than $1 billion.

Subpart G--Special Purpose Exemptions


Sec.  242.770  Exemption from the definition of ``broker'' for banks 
effecting transactions in securities in certain employee benefit plans.

    (a) A bank is exempt from the definition of the term ``broker'' 
under section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)) to the extent that it effects transactions in securities of 
an open-end company in an account for a plan that is qualified under 
section 401(a) of the Internal Revenue Code of 1986 (26 U.S.C. 401(a)) 
or a plan described in sections 403(b) or 457 of the Internal Revenue 
Code of 1986 (26 U.S.C. 403(b) or 26 U.S.C. 457) for which the bank 
acts as a trustee or a custodian; or offers participants a participant-
directed brokerage account, if:
    (1) The bank offsets or credits any compensation that it receives 
from a fund complex related to securities in which plan assets are 
invested against fees and expenses that the plan owes to the bank;
    (2) The bank provides a clear and conspicuous disclosure to the 
plan sponsor or its designated fiduciary, if any, that includes all 
fees and expenses assessed for services provided to the plan and all 
compensation received or to be received from a fund complex in a manner 
that permits the plan sponsor or its designated fiduciary, if any, to 
determine that the bank has offset or credited any compensation 
received from a fund complex related to securities in which plan assets 
are invested or to be invested against the fees and expenses that the 
plan owes to the bank;
    (3) The bank offers the participant-directed brokerage account 
through a registered broker or dealer;
    (4) The bank does not pay any incentive compensation to a natural 
person that is not qualified pursuant to

[[Page 39738]]

the rules of a self-regulatory organization that differs based on the 
value of a security or the type of security purchased or sold by an 
account or a person who exercises control over the assets of such 
account; and
    (5) The bank complies with section 3(a)(4)(C) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(C)).
    (b) Definitions. For purposes of this section:
    (1) Fund complex means the issuer of the security (including the 
sponsor, depositor or trustee), the issuer of any other security that 
holds itself out to investors as a related company for purposes of 
investment or investor services, any agent of such issuer, any 
investment adviser of such issuer, and any affiliated person (as 
defined in section 2(a)(3) of the Investment Company Act of 1940 (15 
U.S.C. 80a-2(a)(3)) of such issuer or any such investment adviser.
    (2) Open-end company has the same meaning as in Sec.  242.740.
    (3) Participant-directed brokerage account means an account that is 
carried by a broker or dealer on a basis in which each participant that 
receives any brokerage services is fully disclosed to the broker or 
dealer.


Sec.  242.771  Exemption from the definitions of ``broker'' and 
``dealer'' for banks effecting transactions in securities issued 
pursuant to Regulation S.

    (a) A bank is exempt from the definitions of the terms ``broker'' 
and ``dealer'' under sections 3(a)(4) and 3(a)(5) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4) and 15 U.S.C. 78c(a)(5)), to 
the extent that, as agent or as a riskless principal, the bank:
    (1) Effects a sale of an eligible security to a purchaser who is 
outside of the United States within the meaning of and in compliance 
with the requirements of 17 CFR 230.903;
    (2) Effects a resale of an eligible security after its initial sale 
within the meaning of and in compliance with the requirements of 17 CFR 
230.903, by or on behalf of a person who is not a U.S. person under 17 
CFR 230.902(k) to a purchaser or a registered broker or dealer, 
provided that if the sale is made prior to the expiration of the 
distribution compliance period specified in 17 CFR 230.903(b)(2) or 
(b)(3), the sale is made in compliance with the requirements of 17 CFR 
230.904; or
    (3) Effects a resale of an eligible security after its initial sale 
within the meaning of and in compliance with the requirements of 17 CFR 
230.903, by or on behalf of a registered broker or dealer to a 
purchaser, provided that if the sale is made prior to the expiration of 
the distribution compliance period specified in 17 CFR 230.903(b)(2) or 
(b)(3), the sale is made in compliance with the requirements of 17 CFR 
230.904.
    (b) Definitions. For purposes of this section:
    (1) Distributor has the same meaning as in 17 CFR 230.902(d).
    (2) Eligible security means a security that:
    (i) Is not being sold from the inventory of the bank or an 
affiliate of the bank; and
    (ii) Is not being underwritten by the bank or an affiliate of the 
bank on a firm-commitment basis, unless the bank acquired the security 
from an unaffiliated distributor that did not purchase the security 
from the bank or an affiliate of the bank.
    (3) Purchaser means a person who purchases an eligible security and 
who is not a U.S. person under 17 CFR 230.902(k).
    (4) Riskless principal transaction means a transaction in which, 
after having received an order to buy from a customer, the bank 
purchased the security from another person to offset a contemporaneous 
sale to such customer or, after having received an order to sell from a 
customer, the bank sold the security to another person to offset a 
contemporaneous purchase from such customer.


Sec.  242.772  [Reserved]


Sec.  242.773  Exemption from the definitions of ``broker'' and 
``dealer'' for savings associations and savings banks.

    (a) Any savings association or savings bank that has deposits 
insured by the Federal Deposit Insurance Corporation under the Federal 
Deposit Insurance Act (12 U.S.C. 1811 et. seq.), and is not operated 
for the purpose of evading the provisions of the Securities Exchange 
Act of 1934 (15 U.S.C. 78a et seq.), is exempt from the definitions of 
the terms ``broker'' and ``dealer'' under sections 3(a)(4) and 3(a)(5) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4) and 15 
U.S.C. 78c(a)(5)), to the extent that the savings association or 
savings bank acts as a broker or dealer on the same terms and under the 
same conditions that banks are excepted, provided that if a savings 
association or savings bank acts as a municipal securities dealer, it 
shall be considered a bank municipal securities dealer for purposes of 
the Securities Exchange Act of 1934 and the rules thereunder, including 
the rules of the Municipal Securities Rulemaking Board.
    (b) Any savings association or savings bank that has deposits 
insured by the Federal Deposit Insurance Corporation under the Federal 
Deposit Insurance Act (12 U.S.C. 1811 et seq.), and is not operated for 
the purpose of evading the provisions of the Securities Exchange Act of 
1934 (15 U.S.C. 78a et seq.), is exempt from the definitions of the 
terms ``broker'' and ``dealer'' under sections 3(a)(4) and 3(a)(5) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(4) and 15 U.S.C. 
78c(a)(5)) to the extent that the savings association or savings bank 
acts as a broker or dealer on the same terms and under the same 
conditions that banks are exempted pursuant to Sec. Sec.  242.720 
through 242.723, Sec.  242.761, Sec.  242.772, Sec.  242.775, Sec.  
242.776, Sec.  242.780 and Sec.  242.781.


Sec.  242.774  Exemption from the definitions of ``broker'' and 
``dealer'' for credit unions.

    Any federal or state-chartered credit union that is not operated 
for the purpose of evading the provisions of the Securities Exchange 
Act of 1934 (15 U.S.C. 78a et seq.) is exempt from the definitions of 
the terms ``broker'' and ``dealer'' under sections 3(a)(4)(B)(i) and 
(v) and 3(a)(5)(C)(ii) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(4)(B)(i) and (v) and 15 U.S.C. 78c(a)(5)(C)(ii)), to the 
extent that the credit union acts as a broker or dealer on the same 
terms and under the same conditions that banks are excepted under those 
sections of the Securities Exchange Act of 1934.


Sec.  242.775  Exemption from the definition of ``broker'' for the way 
banks effect excepted or exempted transactions in investment company 
securities.

    (a) A bank that meets the conditions for an exception or exemption 
from the definition of the term ``broker'' except for the condition in 
section 3(a)(4)(C)(i) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)(C)(i)), is exempt from such condition to the extent that it 
effects transactions in securities issued by an open-end company that 
is neither traded on a national securities exchange nor through the 
facilities of a national securities association or an interdealer 
quotation system, provided that:
    (1) Such transactions are effected through the National Securities 
Clearing Corporation's Mutual Fund Services or directly with a transfer 
agent acting for the open-end company; and
    (2) With respect to such transactions:
    (i) The transfer agent, if any, does not accept compensation paid 
for the distribution of the securities, including any compensation paid 
pursuant to any revenue-sharing arrangement and

[[Page 39739]]

compensation paid pursuant to a plan under 17 CFR 270.12b-1; and
    (ii)(A) The securities are distributed by a registered broker or 
dealer; or
    (B) The sales charge is no more than the amount a registered broker 
or dealer may charge pursuant to the rules of a securities association 
registered under section 15A of the Securities Exchange Act of 1934 (15 
U.S.C. 78o-3) adopted pursuant to section 22(b)(1) of the Investment 
Company Act of 1940 (15 U.S.C. 80a-22(b)(1)).
    (b) Definitions. For purposes of this section:
    (1) Interdealer quotation system has the same meaning as in 17 CFR 
240.15c2-11.
    (2) Open-end company has the same meaning as in Sec.  242.740.


Sec.  242.776  Exemption for banks effecting transactions for certain 
investors in money market funds.

    (a) A bank is exempt from the definition of the term ``broker'' 
under section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)) to the extent that it effects transactions on behalf of a 
customer in securities issued by a money market fund, provided that:
    (1)(i) The customer has obtained from the bank a financial product 
or service not involving securities and is a qualified investor as 
defined in section 3(a)(54)(A) of the Securities Exchange Act of 1934 
(15 U.S.C. 78c(a)(54)(A)), or a person that directs the purchase of 
securities from any cash flows that relate to an asset-backed security 
as defined in proposed 17 CFR 229.1101(c)(1) of Regulation AB, which 
has a minimum original asset amount of $25,000,000;
    (ii) The bank effects the transactions in a trustee or fiduciary 
capacity within the scope of section 3(a)(4)(D) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78c(a)(4)(D)); or
    (iii) The bank effects the transactions as escrow agent, collateral 
agent, depository agent, or paying agent; and
    (2)(i) The class or series of securities is no-load; or
    (ii)(A) The class or series of securities is not no-load, and the 
bank does not characterize or refer to the class or series of 
securities as no-load; and
    (B) If the customer is not a person described in paragraph 
(a)(1)(i) of this section, the bank provides the customer, not later 
than at the time the customer authorizes the bank to effect the 
transactions, a prospectus for the securities and a clear and 
conspicuous notice that:
    (1) Discloses any payments the bank may receive in connection with 
the transactions from the fund complex to which the issuer of the 
securities belongs;
    (2) Separately identifies any such payments that are sales loads, 
deferred sales loads, or fees paid pursuant to a plan under 17 CFR 
270.12b-1; and
    (3) Indicates that the customer should carefully review the 
prospectus for the securities for additional information regarding 
expenses.
    (b) Definitions. For purposes of this section:
    (1) Deferred sales load has the same meaning as in Sec.  242.740.
    (2) Fund complex has the same meaning as in Sec.  242.770.
    (3) Money market fund has the same meaning as in Sec.  242.740.
    (4) No-load has the same meaning as in Sec.  242.740.
    (5) Open-end company has the same meaning as in Sec.  242.740.
    (6) Sales load has the same meaning as in Sec.  242.740.

Subpart H--Temporary Exemptions


Sec.  242.780  Exemption for banks from liability under section 29 of 
the Securities Exchange Act of 1934.

    (a) No contract entered into before January 1, 2003, shall be void 
or considered voidable by reason of section 29 of the Securities 
Exchange Act of 1934 (15 U.S.C. 78cc) because any bank that is a party 
to the contract violated the registration requirements of section 15(a) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78o(a)), any other 
applicable provision of that Act, or the rules and regulations 
thereunder based solely on the bank's status as a broker or dealer when 
the contract was created.
    (b) No contract entered into before March 31, 2005, shall be void 
or considered voidable by reason of section 29 of the Securities 
Exchange Act of 1934 (15 U.S.C. 78cc) because any bank that is a party 
to the contract violated the registration requirements of section 15(a) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78o(a)), any other 
applicable provision of that Act, or the rules and regulations 
thereunder based solely on the bank's status as a dealer when the 
contract was created.
    (c) No contract entered into before [insert date 18 months after 
effective date of the final rule], shall be void or considered voidable 
by reason of section 29 of the Securities Exchange Act of 1934 (15 
U.S.C. 78cc) because any bank that is a party to the contract violated 
the registration requirements of section 15(a) of the Securities 
Exchange Act of 1934 (15 U.S.C. 78o(a)), any other applicable provision 
of that Act, or the rules and regulations thereunder based solely on 
the bank's status as a broker when the contract was created.


Sec.  242.781  Exemption from the definition of ``broker'' for banks 
for a limited period of time.

    A bank is exempt from the definition of the term ``broker'' under 
Section 3(a)(4) of the Securities Exchange Act of 1934 (15 U.S.C. 
78c(a)(4)) until January 1, 2006.

    Dated: June 17, 2004.
    By the Commission.
J. Lynn Taylor,
Assistant Secretary.
[FR Doc. 04-14138 Filed 6-29-04; 8:45 am]
BILLING CODE 8010-01-P