SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 242

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

RIN 3235-AJ28

Regulation B

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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

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

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

Electronic comments:

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

Paper comments:

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

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

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

SUPPLEMENTARY INFORMATION:

Table of Contents

1. Introduction and Background
    
1. Statutory Background — The Gramm-Leach-Bliley Act
    
2. Regulatory and Procedural Background — The Interim Final Rules, Public Comment, and the Temporary Exemptions
    
2. Discussion of Proposed Regulation B
    
3. Discussion of Comments on the "Broker" Rules and Proposed Amendments
    
1. 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"
    
1. Meaning of "Nominal"
    
2. Meaning of "One-Time"
    
3. Meaning of "Cash Fee"
    
4. 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"
    
2. Trust and Fiduciary Activities Exception
    
1. Chiefly Compensated
    
1. Statutory Requirements and Existing Rules
    
2. Comments on "Chiefly Compensated" Requirement
    
3. Proposed Changes in Response to Comments
    
4. Proposed Line-of-Business Exemption
    
1. Description of Existing Rule
    
2. Description of Proposed Line-of-Business Exemption
    
5. Proposed New Living, Testamentary, and Charitable Trust Account Exemption
    
6. New Conditional Safe Harbor
    
7. New Proposed Account-by-Account Exemption
    
1. Proposed Account-by-Account Exemption
    
2. New Safe Harbor for Account-Specific Exemption
    
8. Other Provisions
    
1. "Chiefly Compensated" and Related Definitions
    
2. Formulas to Allocate Sales Compensation to Individual Accounts
    
1. 12b-1 Fees
    
2. Other Fees
    
3. 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"
    
3. Sweep Accounts Exception
    
1. Comments on Definition of "No-Load" and Proposed Amendments
    
2. Interpretation of "Program"
    
3. Definition of "Money Market Fund"
    
4. Affiliate Transactions Exception
    
5. 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
    
1. 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
    
1. Bank Asset Size Limit
    
2. Annual Sales Compensation Limit
    
3. Other Conditions
    
1. Solicitation
    
2. Securities Networking
    
3. Employee Staffing Restrictions
    
4. Employee Compensation Restriction
    
5. Investment Company Shares for Tax-Deferred Accounts
    
4. Trust and Fiduciary Activity Accounts
    
5. Availability of Exemption to Non-Depository Trust Companies
    
6. Request for Comments
    
6. 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
    
1. Networking
    
2. Sweep Accounts
    
3. Investment, Trustee, and Fiduciary Transactions
    
4. Scope of Credit Union Exemption
    
5. Additional Exemptions for Credit Unions
    
6. Exemption for the Way in Which Banks Effect Transactions in Investment Company Securities
    
7. Temporary Exemptions
    
1. Extension of Time and Transition Period
    
2. Temporary Exemption for Contracts Entered into by Banks from Being Considered Void or Voidable
    
8. Amendment to Exchange Act Rule 15a-6
    
4. Administrative Law Matters
    
1. General Request for Comments
    
2. Paperwork Reduction Act Analysis
    
3. Consideration of Benefits and Costs
    
4. Consideration of Burden on Competition, and on Promotion of Efficiency, Competition, and Capital Formation
    
5. Consideration of Impact on the Economy
    
6. Regulatory Flexibility Analysis
    
5. Statutory Authority
    
6. 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

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 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

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

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

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

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.

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 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

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

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

II. Discussion of Proposed Regulation B

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

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

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

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

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

Regulation B: Securities Activities of Banks and Other Financial Institutions

Subpart A-Networking Exception: Defined Terms

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

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

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

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

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

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

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

Subpart C-[Reserved]

Subpart D-Sweep Accounts Exception: Defined Terms

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

Subpart E-Affiliate Transactions Exception: Defined Terms

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

Subpart F-Safekeeping and Custody Activities Exception: Exemptions

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

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

Subpart G-Special Purpose Exemptions

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

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

242.772: [Reserved]^34a

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).

242.776: Exemption for banks effecting transactions for certain investors in money market funds (proposed new rule).

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 employees³⁶ 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

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 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.

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

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

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

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

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.

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 addition, the definition would specify $25 (without an adjustment for inflation) as an alternative measure of nominal value.⁵⁴

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

As discussed above, some commenters criticized the definition of "nominal one-time cash fee of a fixed dollar amount" in the Interim Rules⁵⁶ 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.

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.

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

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

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.

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.

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

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.

We request comment on the proposed interpretation of the exception's "cash fee" requirement. In particular, commenters are invited to discuss whether the limitations in this provision would be sufficient to assure that unregistered bank employees are not given incentives to promote a broker-dealer's brokerage business by engaging in more than the limited activities permitted under the exception. We are also soliciting comment on what additional guidance, if any, commenters would find useful with respect to such programs.

d. Meaning of "Fixed Dollar Amount"

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

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

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

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

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

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.

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 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.

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

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

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 Act⁸⁸ 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

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

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

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

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 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

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

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

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.

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

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.

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

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

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

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

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?"

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

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

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

In particular, we solicit comment on what compensation items, in addition to "sales compensation" and "relationship compensation," would be included in a bank's total compensation for qualifying fiduciary activities and the quantitative impact of including these compensation items on the line-of-business proposal. In addition, what impact, if any, would such a change in the calculation have on the number of banks that could meet the trust and fiduciary activities exception? Moreover, what would be the cost savings to banks in complying with the "chiefly compensated" condition if we were to permit banks to compare "sales compensation" to total compensation rather than to "relationship compensation?" We would like to know the types of compensation that banks would include in total compensation from qualifying fiduciary activities. To evaluate the recommendation that we permit banks to compare "sales compensation" to total compensation for trust and fiduciary activities, we are soliciting quantitative information from banks that would illustrate how such a bank would fare under each of the tests.¹¹⁸ What other changes, if any, do commenters believe should be made to the "chiefly compensated" calculation?

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.

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.

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.

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

This new safe harbor should supplement the rule's general exemption in addressing banks' concerns that if they inadvertently exceed the exemption's "sales compensation" percentage in one year, they would immediately need to conduct an account-by-account analysis to determine whether they are in compliance with the "chiefly compensated" condition. We understand that banks relying on proposed Exchange Act Rule 721 may not have compliance procedures in place to do account-by-account monitoring. Banks could rely on the proposed new safe harbor for one year while taking steps to ensure that they will meet the terms of the general exemption before the end of that year.¹²⁴

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.

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.

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

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

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

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.

One commenter urged the Commission to amend the definition of "flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers" in current Exchange Act Rule 3b-17(b) to allow banks to include the cost of shared resources as opposed to the "exclusively dedicated" standard in the Interim Rules.¹³² In response, we propose to amend the definition to include the direct marginal cost of any resources of the bank that are used for transaction execution, comparison, or settlement for trust and fiduciary activity accounts if the bank makes a precise and verifiable allocation of these resources according to their use. We believe this proposed change is consistent with the statutory requirement of cost recovery. We also propose to amend the definition to clarify that the account, rather than the bank, pays the fee. We request comment on the proposed amendments to the definition of "flat or capped per order processing fee equal to not more than the cost incurred by the bank in connection with executing securities transactions for trustee and fiduciary customers" in proposed Exchange Act Rule 724(b).

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

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

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

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.

iii. Indenture Trustee Exemption

Exchange Act Rule 3a4-3 currently provides a limited exemption from broker registration for a bank that serves as an indenture trustee in a no-load money market fund, provided that it meets certain conditions. Comments we received on this rule criticized its utility in part based on the definition of "indenture trustee," which is currently codified in Exchange Act Rule 3b-17.¹³⁹ For example, two commenters recommended that we expand the "indenture trustee" definition to include trustees appointed pursuant to pooling and servicing agreements, trust agreements, bond resolutions, and mortgages, given that, according to these commenters, documents appointing trustees generally are not limited to indentures.¹⁴⁰

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.

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

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.

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 "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.

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.

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

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.

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 disclosure to the customer of all material facts relating to conflicts of interest.¹⁶⁶

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

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

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

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

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.

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 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

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.

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

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