Securities Regulatory Handbook: 2001-2002 (Pricewaterhousecoopers Regulatory Handbooks)

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The

SECURITIES Regulatory Handbook

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The


2001–2002 Edition

M.E.Sharpe Armonk, New York London, England

Copyright © 2001, PricewaterhouseCoopers. PricewaterhouseCoopers refers to the individual member firms of the worldwide PricewaterhouseCoopers Organization.

All rights reserved. No part of this book may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher, M.E. Sharpe, Inc., 80 Business Park Drive, Armonk, New York 10504. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that neither the author nor the publisher is engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought.—From a Declaration of Principles jointly adopted by a Committee of the American Bar Association and a Committee of Publishers.

ISBN: 0-7656-0654-2 ISSN: 1090-252X

Printed in the United States of America

(EB) 10 9 8 7 6 5 4 3 2 1

Nancy

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TABLE OF CONTENTS Introduction ............................................................................................................................. 3 I.

Overview of Bank Securities Laws ......................................................................................... 5

II.

Investment and Treasury Activities ........................................................................................ 13

III.

Overview of Bank Derivatives Activities............................................................................... 33

IV.

Brokerage Activities .............................................................................................................. 49

V.

Underwriting and Dealing ..................................................................................................... 73

VI.

Merchant Banking ............................................................................................................... 113

VII.

Mutual Funds Activities....................................................................................................... 121

VIII.

Overseas Securities Activities .............................................................................................. 133 Index .................................................................................................................................... 145

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The



Introduction

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Introduction This Handbook The Regulatory Advisory Services practice of PricewaterhouseCoopers wrote The Securities Regulatory Handbook to provide the firm and its financial institution clients with a summary of the major federal laws, regulations, and interpretations applicable to the securities activities of financial institutions. The Handbook is one in a series of Regulatory Handbooks prepared by Regulatory Advisory Services, which focus on the regulatory requirements of financial institutions’ activities. The other handbooks in the series cover: Consumer Banking; Commercial Banking; Trust; Regulatory Reporting; and Regulatory Risk Management. A seventh book, The Compliance Link, is a comprehensive cross-reference for the other six. The Securities Regulatory Handbook emphasizes those regulatory requirements that are enforced through the examination process of the federal bank regulatory agencies. Therefore, we have not attempted to address all the rules applicable to broker-dealers that are imposed by organizations such as the SEC, CFTC, NASD, and the various stock and commodity exchanges. Because of the frequency with which these laws and regulations are changed or new ones added, we revise this Handbook annually. The information in this Handbook is current through July 1, 2001. The 90 Percent Solution We have written this Handbook, and others in the series, intending to give readers a plain-language answer to 90 percent of the compliance problems they may encounter. We have specifically avoided trying to answer all possible compliance questions. Thus, we emphasize concepts and regulatory risk management advice over detailed explanations of the law and regulations. Our principal goal is to familiarize the reader with the requirements of a law or regulation. We recognize that someone may want more information on a subject and, therefore, we include in each section a reference to the laws, regulations, and regulatory policies on the subject.

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4 The Securities Regulatory Handbook Caution Readers should be cautioned that, although we have highlighted the key legal requirements of the various laws and regulations, the area remains quite complex, with many technical requirements and frequent new agency interpretations. The Handbook, therefore, should be used as only one resource in addition to reviewing the actual law or regulation or seeking additional counsel or advice. PwC Regulatory Advisory Services The PricewaterhouseCoopers Regulatory Advisory Services practice in Washington, DC, consists of former senior federal bank regulators, attorneys, and bankers who advise their clients on a broad range of U.S. banking regulatory and supervisory issues. The group is prepared to assist any financial institution in developing an effective compliance program or in evaluating its existing compliance program. Regulatory Advisory Services is also prepared to conduct reviews of an institution’s policies and procedures in a particular area as well as on-site examinations to assist the institution in evaluating its level of compliance or in preparing for a regulatory exam. PwC Financial Services Leadership Robert Moritz Donald E. Brooks Tim Ryan Patrick J. Shouvlin Chip Voneiff

U.S. Assurance and Business Advisory Services Financial Services Leader U.S. Assurance and Business Advisory Services Capital Markets Leader U.S. Assurance and Business Advisory Services Banking Leader U.S. Assurance and Business Advisory Services Insurance Leader U.S. Assurance and Business Advisory Services Investment Management Leader

(646) 471-8486 (646) 471-7660 (617) 439-7376 (646) 471-8285 (312) 516-4815

Overview of Bank Securities Laws

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I. Overview of Bank Securities Laws The Gramm-Leach-Bliley Act .............................................................................................................. 6 The Glass-Steagall Act ......................................................................................................................... 7 The Bank Holding Company Act ......................................................................................................... 7 The Federal Deposit Insurance Act ...................................................................................................... 9 The Federal Reserve Act ....................................................................................................................... 9 The Home Owners Loan Act ................................................................................................................ 9 The Government Securities Act ............................................................................................................ 9 The Securities Act of 1933 ................................................................................................................. 10 The Securities Exchange Act of 1934 ................................................................................................. 10 The Investment Company Act of 1940 ............................................................................................... 11 The Investment Advisers Act of 1940................................................................................................. 11 The Securities Acts Amendments of 1975 (“Municipal Securities Laws”) ........................................................................................................... 12 State Securities Laws (“Blue Sky Laws”) .......................................................................................... 12

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6 The Securities Regulatory Handbook The Gramm-LeachBliley Act The Gramm-Leach-Bliley Act (GLBA), enacted in November 1999, is historic financial modernization legislation that repeals statuatory provisions prohibiting full affiliations among banks, securities underwriters and dealers, and insurers. GLBA permits a bank holding company, whose banking subsidiaries meet certain requirements relating to capital, management, and community reinvestment, to elect to become a financial holding company (FHC). An FHC can engage in a broad range of activities deemed to be “financial in nature.” Foreign banks with a U.S. branch or agency may also elect to become FHCs and expand their U.S. activities into other financial fields. Insurance, securities, and other financial firms that do not now control a bank may acquire one, subject to the appropriate bank regulatory approvals. Other provisions of GLBA address: Functional regulation—The FRB becomes the so-called umbrella regulator for an FHC, with responsibility to supervise an FHC’s overall risk management and an FHC’s activities that might pose undue risk to its bank subsidiary. Other regulators such as the Securities and Exchange Commission and state insurance commissioners will continue to exercise their normal oversight of FHC activities falling within their respective jurisdictions. Bank securities activities—As a corollary to functional regulation, banks (and U.S. branches and agencies of foreign banks) must “push out” certain securities activities banks may now conduct directly. These activities must be moved into a broker-dealer or an investment adviser regulated by the SEC. The original compliance date for this requirement was May 2001. The SEC has adopted conditional rules that delay the effectiveness of these requirements until October 1, 2001, or January 1, 2002, based on the applicability of certain exceptions. The impact of GLBA on bank securities activities will be addressed in more detail throughout this Handbook. For additional information about GLBA, its implementation, and expected impact on financial services refer, to An Executive Guide to U.S. Financial Services Modernization prepared by the Regulatory Advisory Services practice of PricewaterhouseCoopers. The guide provides an executive summary of the act, an analysis of the impact of the act on the financial services industry, and strategic planning issues and opportunities for management to consider.


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The Glass-Steagall Act The Glass-Steagall Act, which refers to Sections 16, 20, 21, and 32 of the Banking Act of 1933, limits the securities activities of banks. GLBA repeals Section 20, which prohibits member bank affiliation with firms “engaged principally” in securities underwriting, dealing, or distribution. Likewise, GLBA also repeals Section 32, which prohibits personnel interlocks between member banks and firms “primarily engaged” in securities underwriting, dealing, or distribution. Sections 16 and 21 of Glass-Steagall remain effective. Section 16, codified as 12 U.S.C. 24 (Seventh), prohibits national banks from underwriting and dealing in corporate debt and equity. National banks are authorized to underwrite, deal, and purchase for their own account U.S. government and U.S. and Canadian state and local general obligation securities without limit, and certain other securities subject to specific limitations. They also may purchase for their own account, subject to limitations, “investment securities,” which include marketable debt obligations of investment quality. The Office of the Comptroller of the Currency (OCC) has issued regulations that classify these types of obligations as either Type I, Type II, Type III, Type IV, or Type V securities. These classifications are discussed in Chapter II, “Investment and Treasury Activities.” Section 16 also applies to state member banks. Insured state banks and their subsidiaries are subject to the same underwriting and dealing restrictions as national banks. Section 21 prohibits a firm engaged in the business of issuing, underwriting, distributing, or selling securities (except to the extent permitted by Section 16) from also accepting deposits. The Bank Holding Company Act The Bank Holding Company Act (BHCA) regulates the activities of bank holding companies and their nonbanking subsidiaries and ensures the separation of banking and commerce. As a means of ensuring this separation, Congress restricted bank holding companies and their subsidiaries from engaging in all nonbanking activities except those listed in the BHCA or determined by the FRB to be “closely related banking.”

8 The Securities Regulatory Handbook The provision in the BHCA that has provided bank holding companies with the greatest flexibility in expanding their activities is the “closely related to banking” exception found in Section 4(c)(8) of the act. This exception permits bank holding companies to engage in any activity that is found to be “so closely related to banking . . . as to be a proper incident thereto.” The Federal Reserve Board must find not only that an activity is “closely related to banking” but also that it provides a net public benefit to the community. A list of nonbanking activities that the Federal Reserve Board has determined to be “closely related to banking” appears in Federal Reserve Regulation Y. Some of the securities-related activities that have been approved include: • Engaging in trust company functions; • Providing financial and investment advisory services; • Providing securities brokerage; • Engaging in riskless principal transactions; • Providing private placement services; • Underwriting and dealing in government obligations and money market instruments; • Providing foreign exchange advisory and transactional services; • Acting as a futures commission merchant; • Providing investment advice on derivatives; and • Providing advice on mergers and acquisitions and other corporate finance issues. Section 4(c)(13) permits U.S. bank holding company subsidiaries operating primarily overseas to engage in nonbanking activities consistent with the purposes of the BHCA and in the public interest. In addition, the holding company may engage domestically in activities found by the Federal Reserve Board to be incidental to the overseas activities of the holding company subsidiary. The permissible activities of the foreign subsidiaries of U.S. bank holding companies are codified in Federal Reserve Regulation K. Regulation K also addresses the establishment and activities of foreign branches of U.S. banks and Edge and Agreement Corporations. Regulation K will be discussed in more detail in Chapter VIII, “Overseas Securities Activities.”


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(Note: GLBA freezes domestic permissible nonbanking activities for BHCs that cannot qualify as FHCs to those permissible on the day before GLBA’s enactment.) The Federal Deposit Insurance Act The Federal Deposit Insurance Act (FDIA) designates the Federal Deposit Insurance Corporation (FDIC) as the primary federal regulator of insured state nonmember banks. While state banking laws determine the initial scope of permissible securities activities for state nonmember banks, the FDIC Improvement Act of 1991 gave the FDIC greater power in limiting their activities. The FDIA also limits the securities activities that state savings associations may engage in as principal to those activities that are permissible for federal savings associations under the Home Owners Loan Act. The Federal Reserve Act The Federal Reserve Act (FRA) applies to banks that are members of the Federal Reserve System. The affiliate transaction restrictions of Sections 23A and 23B of the FRA are particularly important as they apply to extensions of credit and the purchase and sale of instruments between an insured depository institution and its nonbank affiliates. The Home Owners Loan Act The Home Owners Loan Act (HOLA) regulates the activities of federal savings associations and savings and loan holding companies. HOLA limits the investments of savings associations and prohibits them from directly engaging in securities brokerage activities. The Government Securities Act Congress passed the Government Securities Act of 1986 (GSA) to address certain improper practices in the largely unregulated government securities market. The stated purpose of the GSA is to enhance the protection of investors in government securities by establishing and enforcing appropriate financial responsibility and custodial standards. The Department of the Treasury has issued regulations implementing the GSA. These regulations are enforced by the three federal bank regulatory agencies for banks and by the SEC for nonbank broker-dealers and nonbank government securities broker-dealers.

10 The Securities Regulatory Handbook The Securities Act of 1933 The Securities Act of 1933 (the 1933 Act) requires that any security that will be offered initially to the public through the use of the mail or any other means of interstate commerce first must be registered with the SEC. The 1933 Act exempts certain securities and securities transactions from the registration requirements. Securities issued by both banks and savings associations are exempted from registration. Bank holding company securities, however, are not exempted. The Securities Exchange Act of 1934 The Securities Exchange Act of 1934 (the 1934 Act) requires that all securities broker-dealers register with the SEC. Banks traditionally were not included in the definitions of broker or dealer and did not have to register. However, GLBA reforms both definitions to now include banks. Bank-affiliated brokerages (including bank broker-dealer subsidiaries) are still required to register as broker-dealers and are subject to the regulations of the SEC, the rules of the National Association of Securities Dealers, and any stock exchanges of which they are members. Savings associations and the affiliates of savings associations are not exempt from broker-dealer registration. All broker-dealers and banks are subject to the 1934 Act’s antifraud provisions. In addition, the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA) amended the 1934 Act, extending insider trading liability to a party that controls the person guilty of illegal insider trading. Therefore, if a bank’s securities subsidiary or affiliate uses inside information in connection with the purchase or sale of a security, the bank may be subject to insider trading liability as a controlling person under ITSFEA. ITSFEA also requires that registered broker-dealers and investment advisers establish policies and procedures to avoid insider trading. The 1934 Act also requires that any securities that are traded on a national exchange and any securities of a company with assets in excess of $1 million and with more than 500 shareholders must be registered with the SEC. Those companies that register securities under the 1934 Act also are subject to the reporting and recordkeeping requirements of the 1934 Act as well as other SEC regulations.


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The Investment Company Act of 1940 The Investment Company Act of 1940 (the 1940 Act) was passed in response to an SEC study of investment companies and investment trusts that revealed serious abuses in the operation of these vehicles. The 1940 Act regulates the establishment of investment companies and imposes restrictions on their activities. The 1940 Act defines an “investment company” as an entity that is engaged primarily in the business of investing, reinvesting, or trading securities and whose own shares are offered and sold to the investing public. Shares of investment companies are considered securities and must be registered under the Securities Act of 1933. Mutual funds are the most commonly recognized investment companies. The 1940 Act requires that all investment companies with 100 or more shareholders register as such with the SEC. Once registered, an investment company is subject to SEC rules regarding safekeeping of assets, capital structure, disclosure, dividends, and investment activities. The 1940 Act also places restrictions on the makeup of the board of directors, the use of investment advisers, and transactions with affiliates. Banks and savings associations are expressly exempted from coverage under the 1940 Act. Bank common trust funds and certain collective pension funds also are exempted from the act’s provisions. Under GLBA, common trust funds are exempt from SEC registration as an investment company only if: • Its sole function is to aid in the administration of trusts, estates, or other accounts created for fiduciary purposes; • It does not advertise or offer for sale to the general public (except in connection with the ordinary advertising of fiduciary services); and • It does not charge fees and expenses in contravention of fiduciary principles under relevant federal and state law. The Investment Advisers Act of 1940 GLBA has ended the long-term exclusion of banks from regulation under the Investment Advisers Act of 1940 (the Advisers Act). GLBA requires banks that act as investment advisers for registered investment companies (i.e., mutual funds and unit investment trust) to register under the Advisers Act.

12 The Securities Regulatory Handbook The Advisers Act regulates and requires the registration of investment advisers. The Advisers Act defines an “investment adviser” as any person who, for compensation, engages in the business of advising others, whether directly or through writings or other publications, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities. It also includes any person who, as a part of a regular business, issues analyses or reports concerning securities. Under GLBA, banks that advise mutual funds will be defined as “investment advisers” under the Advisers Act. A bank can conduct its advisory activity through a “separately identifiable department” (SID) and then only that department will be required to register as an investment adviser. The act defines an SID as a unit under the direct supervision of an officer designated by the bank’s board of directors as responsible for the day-to-day conduct of the bank’s investment advisory activities for one or more mutual funds, including the supervision of all bank employees engaged in the performance of such activities. The effective date of the Adviser Act provision of GLBA is May 12, 2001. The Securities Acts Amendments of 1975 (“Municipal Securities Laws”) The Securities Acts Amendments of 1975 extended a comprehensive network of federal regulation to the municipal securities markets. Municipal securities brokers and dealers are required to register with the SEC. The act also created a separate, self-regulatory body, the Municipal Securities Rulemaking Board (MSRB), to formulate working rules for the regulation of the municipal securities industry. The federal bank regulatory agencies are required to enforce these rules as they apply to banks. State Securities Laws (“Blue Sky Laws”) Every state has state securities laws, also known as “blue sky laws.” Generally, states require a person who buys or sells securities, for their own account or the account of others, within its borders to register with the state and subjects that person to the state’s laws and regulations. Many of the states exempt banks from broker-dealer registration. However, many do not. Therefore, the securities laws of any state in which a bank engages in securities activities will have to be reviewed prior to the bank engaging in any securities-related activities in that state.

Investment and Treasury Activities 13

II. Investment and Treasury Activities Permissible Investments ..................................................................................................................... 14 Repurchase Agreements ..................................................................................................................... 19 Securities Lending .............................................................................................................................. 20 Reporting of Securities Transactions .................................................................................................. 26 Unsuitable Investment Practices ......................................................................................................... 27 Selection of Securities Dealers ........................................................................................................... 30 References .......................................................................................................................................... 31

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14 The Securities Regulatory Handbook Permissible Investments Banks are restricted in the composition of their investment portfolios. National banks are governed in their securities activities by the Comptroller of the Currency’s Investment Securities Regulation (12 CFR 1). The regulation subdivides securities that banks are eligible to underwrite, deal, and invest in according to the nature and composition of the specific security. These subdivisions are labeled Type I, Type II, Type III, Type IV, and Type V securities, and are commonly referred to as bank-eligible securities. Each security type is distinguished further by limitations, if any, on the amount that a bank may hold as a percentage of the bank’s capital and surplus. Generally, a bank’s investment limitations are calculated as of the most recent of the last day of the preceding calendar quarter or the date on which there is a change in the bank’s capital category. In addition to the specific limitations which distinguish the types of securities that national banks may underwrite, deal, and invest in, the regulation reemphasizes the most pervasive banking axiom in providing that a national bank must adhere to safe and sound banking practices when conducting its securities activities. In determining that particular securities-related activities are appropriate for a bank, the bank should consider, as applicable, the following risks associated with the proposed activity: • Interest rate risk; • Credit risk; • Liquidity risk; • Price risk; • Foreign exchange risk; • Transaction risk; • Compliance risk; • Strategic risk; and • Reputation risk.

Investment and Treasury Activities 15 Further, national banks must determine that there is adequate evidence that an obligor possesses resources sufficient to provide for all required payments on its obligations. If the national bank’s activities involve securities deemed to be “investment securities,” the bank must reasonably believe, based on reliable estimates, that the obligor will satisfy the obligation. A security is an “investment security” if it is rated investment grade or if it is the credit equivalent of a security rate investment grade. State member banks are subject to all of the securities limitations of national banks, including the limitations of the OCC’s Investment Securities Regulations. State nonmember banks are not subject directly to the OCC’s Investment Securities Regulations. FDICIA, however, limits the securities activities that state-insured banks may engage in as principal to those activities permitted to national banks. As such, state banks also should be guided by the OCC’s regulations. Thrifts are subject to separate securities rules that are discussed below. Type I Securities A bank may purchase, underwrite, and deal in Type I securities without limitation, subject to the exercise of prudent banking judgment. Type I securities are bank-eligible securities. Type I securities include obligations of the United States, general obligations of any state or political subdivision of a state, and other designated obligations. Obligations of the United States include securities issued, insured, or guaranteed by a department or agency of the U.S. government, so long as the security commits the full faith and credit of the United States for repayment. General obligations are securities backed by the full faith and credit of an obligor possessing general powers of taxation. Type I securities also include qualified Canadian government obligations, which include any debt obligations backed by Canada, any province of Canada, or any political subdivision of any province. Debt obligations of any agent of any of the aforementioned entities also qualify as Type I securities if the political entity is liable ultimately and unconditionally for the obligation. Type II Securities Type II securities include obligations of the International Bank for Reconstruction and Development (World Bank), Inter-American Development Bank, African Development Bank, Inter-American Investment Corporation, and Tennessee Valley Authority. Type II securities also include obligations issued

16 The Securities Regulatory Handbook by any state or any political subdivision or agency of a state or a political subdivision for housing, university, or dormitory purposes. Generally, a bank may purchase, underwrite, and deal in Type II securities provided the bank’s holdings of these securities issued by any one obligor do not exceed 10 percent of the bank’s capital and surplus. However, for industrial development bonds, the limit on the value of the obligations will apply to each issue rather than each issuer––the application of this limitation applies to Type III securities also. Type III Securities Type III securities are “investment securities” that are not Type I, II, IV, or V securities, such as corporate or municipal revenue bonds. A bank may purchase and sell Type III securities for its own account, provided the securities issued by any one obligor and held by the bank do not exceed 10 percent of the bank’s capital and surplus. A bank may not underwrite or deal in Type III securities. Type IV Securities Type IV securities are asset-backed securities that are composed of interests in a pool of loans to “numerous obligors.” Type IV securities include certain residential and commercial mortgage-related securities and small businessrelated securities, as those terms are defined in relevant provisions of the federal securities laws. Generally, a Type IV security must be rated investment-grade or the credit equivalent of an investment-grade security. However, certain commercial and residential mortgage-related securities must be rated in one of the top two investment-grade-rating categories. In general, a bank may buy and sell Type IV securities for its own account without being limited by a predetermined percentage of its capital and surplus. Additionally, a bank may, without limitation, deal in Type IV securities that are fully secured by Type I securities. However, a bank’s holdings of small business-related securities from one issuer that are rated in the third or fourth investment-grade categories are limited to 25 percent of its capital and surplus. Other underwriting and dealing activities in Type IV securities must be done either through a financial holding company’s securities affiliate or a Section 20 securities affiliate.

Investment and Treasury Activities 17 Type V Securities Type V securities are marketable investment-grade securities that are not Type IV securities and that include any asset-backed security that is rated investment-grade. Type V securities must be fully secured by interests in a pool of loans to numerous obligors and in which a bank could invest directly. A bank may purchase and sell Type V securities for its own account; however, the bank may not hold more than 25 percent of its capital and surplus in Type V securities issued by one issuer. Other underwriting and dealing activities in Type V securities must be done either through a financial holding company’s securities affiliate or a Section 20 securities affiliate. Debts Previously Contracted (DPC) Stock The investment securities restrictions and limitations do not apply to securities acquired through debts previously contracted (DPC), acquired through foreclosure on collateral, or acquired in good faith by way of a compromise on a doubtful claim. However, DPC stock must be disposed of within five years of acquisition, unless granted an extension by the OCC of an additional five years. Equity Investments With some exceptions, the Glass-Steagall Act prohibits national banks from investing in any shares of stock in any corporation. Moreover, the purchase of securities convertible into stock at the option of the issuer is prohibited. Several of the exceptions to the restriction on equity investments, most of which are subject to some limitations, include equity holdings of the following: operating subsidiaries, small business investment companies, bank service corporations, foreign banking corporations, community development corporations, certain government-sponsored entities, and stock acquired through debts previously contracted. The OCC also has ruled that warrants to purchase equity interests may be held by national banks but must be sold before exercise. Private Placements Generally, the absence of a public market for securities that are “privately placed” makes them ineligible as investments for bank investment portfolios. However, SEC Rule 144A, which permits the resale of privately placed securities to qualified purchasers under certain conditions, has expanded the market and the potential liquidity of privately placed securities. Accordingly, the OCC allows banks to invest in these 144A securities when, upon thorough

18 The Securities Regulatory Handbook analysis of a security’s creditworthiness, the bank has determined that the security is the credit equivalent of an investment-grade security as would be rated by a Nationally Recognized Securities Rating Organization (NRSRO). Mutual Funds and Investment Companies A bank may purchase and sell for its own account investment company shares and, upon approval from the OCC, interests in an entity that is not required to register as an investment company, provided the bank could directly purchase and sell the assets underlying the portfolio of the investment company or other entity. A bank’s limitation on its investment is calculated by determining its pro rata share of a particular investment “type” held by the investment company or other entity and combining that amount with the amount that the bank has directly invested in that security “type.” The bank’s aggregate investment in a particular security “type” may not exceed the investment limitation for that particular security “type.” A national bank is permitted to avoid using the aggregation method described above if the securities issued by one issuer and held in the portfolio of the investment company or other entity do not exceed 5 percent of the total portfolio, and the bank’s shares in the investment company or other entity do not exceed the most stringent investment limitation that would apply to any of the securities in the portfolio if the securities were purchased directly by the bank. Equity Investments by State Nonmember Banks The FDI Act, as amended by FDICIA, prohibits state nonmember banks from making equity investments of a type, or in an amount, that is not permissible for a national bank. Affected banks are required to divest any ineligible equity investments as quickly and as prudently as can be done, but in no event later than December 19, 1996. The act also included several exceptions to its general restriction on equity investments, and these exceptions are discussed below. Under the FDI Act’s grandfather clause, banks may be eligible to continue making equity investments at their pre-FDICIA levels. If, prior to September 30, 1991, applicable state law permitted the bank to invest in nationally listed common or preferred stock or shares of a registered investment company, then the bank may maintain its pre-FDICIA holdings at a level not to exceed 100 percent of capital and surplus. Moreover, the level of ineligible securities holdings may not exceed the maximum amount held between September 30, 1990, and November 26, 1991.

Investment and Treasury Activities 19 The FDIC also requires that the bank file written notice with the FDIC and receive its approval before acquiring shares or maintaining previously held investments. The FDIC may condition its approval and require divestiture of certain investments if they are determined to be a significant risk to the insurance fund or the safety and soundness of the bank. Repurchase Agreements Overview A repurchase agreement is one in which a party that owns securities acquires funds by transferring the securities to another party under an agreement to repurchase the securities at an agreed-upon future date. A reverse repurchase, or resale, agreement is one in which a party provides funds by acquiring securities pursuant to an agreement to resell them at an agreed-upon future date. Because of the apparent safety of repurchase agreements, which generally are collateralized by highly liquid U.S. government securities, many portfolio managers can underestimate severely the credit risk associated with the performance of the counterparty to the transaction and, as a result, they fail to adopt the basic safeguards necessary to assure proper control over the underlying securities. Regulatory Guidelines In December 1985, in response to the bankruptcies of several U.S. government securities dealers, the FFIEC adopted a policy statement providing guidelines that banks should follow in the purchase and sale of repurchase agreements. In order to minimize the credit risk associated with repurchase agreements, the policy statement requires that depository institutions establish written policies that, at a minimum: • Require identification and periodic credit evaluations of each counterparty; • Establish maximum position and exposure limits for each counterparty; • Mandate individual or master written agreements for all repurchase agreement transactions that specify: — Acceptable collateral types and maturities; — Call, default, and sellout provisions; — Ownership rights;

20 The Securities Regulatory Handbook — Substitute collateral rights; and — Persons authorized to transact business on behalf of both parties; • Provide for acceptable control provisions over underlying securities; • Provide for collateral custody by the bank or an independent third party acting for the bank; • Subject the underlying securities of a resale agreement to periodic market valuation in order to determine market exposure; • Mandate credit approvals for parties providing securities acquired under agreements to resell; and • Insist that characteristics of the money market instruments be compatible with the bank’s own investment standards. Depository institutions that actively engage in repurchase agreements are encouraged to have more comprehensive policies and controls to suit their particular circumstances. Banks engaging in hold-in-custody repurchase agreements are subject to the Government Securities Act (GSA) regulations that cover such transactions. The GSA regulations on hold-in-custody repurchase agreements are covered in detail in Chapter V, “Underwriting and Dealing.” Securities Lending Introduction A bank may lend securities held in its investment account. Banks also may lend customers’ securities held in trust or custody accounts to a third party pursuant to a written agreement with the customer. Securities dealers and commercial banks are the primary borrowers of securities. They borrow securities to cover “fails” (securities sold but not available for delivery), short sales, and option and arbitrage positions. The objective of securities lending is to generate additional fee income while assuring a safe return of the securities, no diminution of value, and normal interest or dividends. Securities lending is conducted through open-ended “loan” agreements, which may be terminated on short notice by the lender or borrower. The borrower of

Investment and Treasury Activities 21 the securities pays a fee to the owner of the securities. A bank lending customer securities will share in the fee income generated by loaning the securities. Securities loans are collateralized with cash, U.S. government or federal agency securities, or letters of credit. At the outset, each loan is collateralized at a predetermined margin. If the market value of the collateral falls below the predetermined acceptable level while a loan is outstanding, a call for additional collateral is made by the lender institution. If a loan becomes over-collateralized because of appreciation of collateral or market depreciation of a loaned security, the borrower usually has the opportunity to request the return of any excessive margin. It is often the practice for a bank to indemnify its customers against specified losses where it lends customer securities. When a securities loan is terminated, the securities are returned to the lender and the collateral to the borrower. Fees received on securities loans are divided between the lender institution and the customer account that owns the securities. In situations involving cash collateral, part of the interest earned on the temporary investment of cash is returned to the borrower and the remainder is divided between the lender institution and the customer account that owns the securities. FFIEC Policy Statement on Securities Lending The FFIEC has adopted a Supervisory Policy Statement with respect to securities lending by financial institutions that has been adopted by each of the federal bank regulatory agencies. The policy statement requires that all institutions participating in securities lending activities establish written policies and procedures governing these activities. At a minimum, the policies and procedures should cover each of the following areas: • Recordkeeping; • Administrative procedures; • Credit analysis and approval of borrowers; • Credit and concentration limits; • Collateral management; • Written agreements; • Use of finders;

22 The Securities Regulatory Handbook • Employee benefit plans; • Indemnification; and • Regulatory reporting. Recordkeeping A financial institution engaged in securities lending activities must have in place an adequate recordkeeping system. At a minimum, the system should produce daily reports showing which securities are available for lending and which are currently lent, outstanding loans by borrower, outstanding loans by account, new loans, returns of loaned securities, and transactions by account. These records should be updated as often as necessary to ensure that the lender institution fully accounts for all outstanding loans, that adequate collateral is required and maintained, and that policies and concentration limits are being followed. Administrative Procedures All securities lent and all securities standing as collateral must be marked to market daily. Procedures must ensure that any necessary calls for additional margin are made on a timely basis. In addition, written procedures should outline how to choose the customer account that will be the source of the lent securities when they are held in more than one account. The procedures should ensure that securities loans are allocated fairly among all accounts participating in a securities lending program. Internal controls should include timely management reporting systems and operating procedures designed to segregate duties. Periodic internal audits should assess the accuracy of accounting records, the timeliness of management reports, and the lender institution’s overall compliance with established policies and procedures. Credit Analysis Securities lending transactions with any borrower must be approved formally by a duly established management or supervisory committee of the lending institution. Credit and limit approvals should be based on a credit analysis of the borrower. A review should be performed before establishing such a relationship, and reviews should be conducted at regular intervals thereafter. Credit reviews should include an analysis of the borrower’s financial statement and

Investment and Treasury Activities 23 should consider capitalization, management, earnings, business reputation, and any other factors that appear relevant. Analyses should be performed in an independent department of the lender institution. Credit and Concentration Limits Management should establish individual credit limits for each borrower. The limit should be based on the market value of the securities to be borrowed, and should take into account possible temporary (overnight) exposures resulting from a decline in collateral values or from occasional inadvertent delays in transferring collateral. Credit and concentration limits should take into account other extensions of credit by the lender institution to the same borrower or related interests. Such information, if provided to a bank trust department conducting a securities lending program, would not be considered material inside information and therefore would not violate “Chinese Wall” policies designed to protect against the misuse of inside information. Procedures should be established to ensure that credit and concentration limits are not exceeded without proper authorization from management. Collateral Management Securities borrowers generally pledge and maintain collateral at a level equal to at least 100 percent of the value of the securities borrowed. The minimum amount of excess collateral, or “margin,” acceptable to the lender institution should relate to the price volatility of the loaned securities and the noncash collateral. Generally, the minimum initial collateral on securities loans is at least 102 percent of the market value of the lent securities plus, for debt securities, any accrued interest. Collateral must be maintained at the agreed margin. A daily “mark to market” or valuation procedure must be in place to ensure that calls for additional collateral are made on a timely basis. The valuation procedures should take into account the value of the accrued interest on debt securities. Securities should not be lent unless collateral has been received or will be received simultaneously with the loan. As a minimum step toward perfecting the lender’s interest, collateral should be delivered directly to the lender institution or an independent third-party trustee. When cash is used as collateral, the lender institution is responsible for making it produce income. Lenders should establish written guidelines for selecting investments for cash collateral. If the lender institution is acting in any

24 The Securities Regulatory Handbook capacity other than as principal, the written agreement authorizing the lending relationship should specify how cash collateral is to be invested. Investing cash collateral in liabilities of the lending institution or its holding company would be an improper conflict of interest unless that strategy was authorized specifically in writing by the owner of the lent securities. If a lender institution plans to accept letters of credit as collateral, it should establish guidelines for their use. Those guidelines should require a credit analysis of the bank issuing the letter of credit before securities are lent against that collateral. Analyses must be periodically updated and reevaluated. The lender institution also should establish concentration limits for the banks issuing the letters of credit, and procedures should ensure they are not exceeded. In establishing concentration limits on letters of credit accepted as collateral, the lender institution’s total outstanding credit exposures from the issuing bank should be considered. Written Agreements Securities should be lent only pursuant to a written agreement between the lender institution and the owner of the securities specifically authorizing the institution to offer the securities for loan. The agreement should outline the lender institution’s authority to reinvest cash collateral (if any) and responsibilities with regard to custody and valuation of collateral. In addition, the agreement should detail the fee or compensation that will go to the owner of the securities in the form of a fee schedule or other specific provision. Other items that should be included in the written agreement have been discussed above. A lender institution also must have written agreements with the parties who wish to borrow securities. These agreements should specify the duties and responsibilities of each party in regard to the transaction. Use of Finders Some lender institutions may use a finder to place securities, and some financial institutions may act as finders. A finder brings together a borrower and lender for a fee. Finders should not take possession of securities or collateral. The delivery of securities loaned and collateral should occur directly between the borrower and the lender. A finder should not be involved in the delivery process. The finder should act only as a fully disclosed intermediary. The lender institution must always know the name and financial condition of the borrower of any securities to whom it lends. If the lender institution does not have that information, it and its customers are exposed to unacceptable risks.

Investment and Treasury Activities 25 Written policies should be in place concerning the use of finders in a securities lending program. These policies should cover the circumstances in which a finder will be used, which party pays the fee, and which finders the lender institution will use. Employee Benefit Plans The Department of Labor has issued two class exemptions that deal with securities lending programs for employee benefit plans covered by ERISA— Prohibited Transaction Exemption 81-6 (February 3, 1981) and Prohibited Transaction Exemption 82-63 (April 6, 1982). The exemptions authorize transactions that might otherwise constitute unintended “prohibited transactions” under ERISA. Any institution engaged in lending of securities for an employee benefit plan subject to ERISA should take all steps necessary to design and maintain its program to conform with these exemptions. Prohibited Transaction Exemption (PTE) 81-6 permits the lending of securities owned by employee benefit plans to persons who could be parties in interest with respect to such plans, provided certain conditions specified in the exemption are met. Under those conditions neither the borrower nor an affiliate of the borrower can have discretionary control over the investment of plan assets, or offer investment advice concerning the assets, and the loan must be made pursuant to a written agreement. The exemption also establishes a minimum acceptable level for collateral based on the market value of the loaned securities. PTE 82-63 permits compensation of a fiduciary for services rendered in connection with loans of plan assets that are securities. The exemption details certain conditions that must be met. Indemnification Certain lender institutions offer participating accounts indemnification against losses in connection with securities lending programs. Such indemnifications may cover a variety of occurrences including all financial loss, losses from a borrower default, or losses from collateral default. Lender institutions that offer such indemnification should obtain a legal opinion from counsel concerning the legality of their specific form of indemnification under federal and/or state law. There also may be risk-based capital implications for the banks from such indemnification liabilities. In December 1992, the Federal Reserve adopted

26 The Securities Regulatory Handbook an amendment to its risk-based capital rules that, in effect, provides that a bank is entitled to a zero risk weight only if (1) any reinvestment risk associated with the cash collateral is borne by the customer and (2) any indemnification provided by the bank is limited to the difference between the market value of the lent securities and the amount received as collateral. A lender institution that offers an indemnity to its customers may, in light of other related factors, be assuming the benefits and, more important, the liabilities of a principal. Therefore, lender institutions offering indemnification also should obtain written opinions from their accountants concerning the proper financial statement disclosure of their actual or contingent liabilities. Reporting of Securities Transactions General Financial Accounting Standards Board Statement No. 115, Accounting for Certain Investments in Debt and Equity Securities (FASB 115), provides that for financial reporting purposes, financial institutions should divide their securities holdings among three categories: held-to-maturity, trading securities, and available-for-sale. The accounting standard provides a different accounting treatment for each category. In accordance with FASB 115, financial institutions should adopt the following accounting guidelines for their securities portfolios: Held-to-Maturity Investments in debt securities are classified as “held-to-maturity” and measured at amortized cost in the statement of financial position only if the financial institution has the positive intent and ability to hold those securities to maturity. A financial institution may not classify a debt security as held-to-maturity if it only has the intent to hold the security for an indefinite period. Therefore, a debt security should not, for example, be classified as held-to-maturity if the institution anticipates that the security would be available to be sold in response to: • Changes in market interest rates and related changes in the security’s prepayment risk;

Investment and Treasury Activities 27 • Needs for liquidity; • Changes in the availability of and the yield on alternative investments; • Changes in funding sources and terms; and • Changes in foreign currency risk. Trading Securities Securities that are bought and held principally for the purpose of selling them in the near term (thus held only a short period of time) are classified as “trading securities.” Trading generally reflects active and frequent buying and selling, and trading securities are generally used with the objective of generating profits on short-term differences in price. Mortgage-backed securities that are held-for-sale in conjunction with mortgage banking activities, as described in FASB Statement No. 65, are classified as trading securities. Trading securities are reported at fair value with unrealized gains and losses recognized in current income. Available-for-Sale Investments not classified as trading securities (or as held-to-maturity securities) are classified as “available-for-sale.” Available-for-sale securities are reported at fair value. Any unrealized appreciation or depreciation in the value of the securities available-for-sale are to be reported directly as a separate component of equity capital. Regulatory authorities expect to find written investment policies and objectives to support the appropriate accounting treatment for particular holdings. Unsuitable Investment Practices The following is a brief description of unsuitable investment practices and their proper characterization or treatment.

28 The Securities Regulatory Handbook 1. Gains Trading Gains trading involves purchasing a security as an investment portfolio asset and the subsequent sale of that security at a profit after a short-term holding period. Securities that cannot be sold for a profit are retained in the investment portfolio. Because the intent in these cases is to profit from short-term price movements, the activity is better characterized as available-for-sale or trading activity and should be accounted for accordingly. 2. “When Issued” Securities Trading “When issued” securities trading involves the buying and selling of securities in the period between the announcement of an offering and the issuance and payment date of the securities. Because these activities involve speculation on price movements without paying for the securities, they should be treated as trading activities. 3. “Pair Offs” A “pair off” involves a commitment to purchase a security followed by a sale to another party prior to the original transaction’s settlement date. Because of their speculative nature, “pair offs” also should be treated as trading activities. 4. Corporate or Extended Settlements Any use of a settlement period in excess of the normal settlement period in order to speculate on price movements without paying for the securities is considered an unsuitable investment practice. Such practices should be treated as trading activities. 5. Repositioning Repurchase Agreements A repositioning repurchase agreement is a service provided by a dealer so a buyer can hold a speculative position until it can be sold at a gain. The purchaser pays the dealer a “margin” that approximates the loss the purchaser has suffered between purchase and settlement. The dealer then agrees to repurchase the securities, essentially funding the buyer’s purchase. The use of such agreements indicates speculation in short-term price swings by the buyer and accordingly should be treated as available-for-sale or trading activities.

Investment and Treasury Activities 29 6. Short Sales Short sales, the selling of a security not currently owned in order to speculate on a drop in the securities price, should be treated as a trading activity. A short sale that involves delivery of the security by borrowing it from the bank’s investment portfolio should be treated as a sale of the security with a recognition of gain or loss on the transaction. 7. Delegation of Discretionary Investment Authority When a financial institution delegates its investment discretionary authority to a nonaffiliated firm or employee, the securities controlled by that party must be treated as available-for-sale. Such securities may not be treated as held-to-maturity securities because the institution no longer has control over the investment strategy that will be utilized with the securities. 8. Covered Calls Covered calls involve a security holder granting the buyer of a call option the opportunity to purchase a security at a predetermined price within a certain time period. The fee received for the call option provides a means for the security holder to partially hedge against any losses suffered by a fall in the security’s price. Because the writer of the call option loses control over when it may have to sell the security, investment securities for which covered calls have been written should be treated as available-for-sale securities. If the option calls for the option writer to settle in cash rather than delivering the security, then the security may still be treated as a held-to-maturity security. 9. Adjusted Trading Adjusted trading is the practice of selling a security to a broker-dealer at a price in excess of the current market value and at the same time purchasing a lower-quality security from the broker-dealer as a means of compensation. This permits a financial institution to defer recognition of losses on security holdings. Because these transactions inappropriately result in deferred recognition of losses on security sales and create inflated book values for the securities purchased, they are prohibited for all financial institutions.

30 The Securities Regulatory Handbook Selection of Securities Dealers Introduction Financial institutions should adopt policies to ensure that management has sufficient information regarding a securities dealer and its personnel before doing business with it. If the securities firm is unwilling to provide adequate information, then the financial institution should not engage in securities transactions with it. Regulatory Guidelines Minimum Considerations In selecting a securities dealer the following should be the minimum considerations: • The securities firm’s ability to meet its commitments as evidenced by its capital level, earnings, and liquidity; • The firm’s reputation for fair dealing and financial stability as communicated by current customers of the firm; • Any state or federal enforcement actions against the firm, or other actions by self-regulatory agencies such as the National Association of Securities Dealers; and • Where the institution is relying on the advice of a sales representative of the firm, the background and experience of that representative. Board Responsibility The board of directors is responsible for establishing policies and procedures to ensure that the process of selecting securities dealers includes the foregoing considerations. The board also is responsible for reviewing and approving a list of qualified securities firms. Limits should be established on the amounts and types of transactions that may be transacted with each authorized securities firm. The board should consider limits on the dollar amounts of unsettled trades, safekeeping agreements, repurchase transactions, securities lending and borrowing, other transactions with credit risk, and total credit risk with an individual dealer. In its policies the board also should consider interactions between its employees and the selected dealer. Procedures should be established to avoid potential conflicts of interest.

Investment and Treasury Activities 31 Control of Securities Procedures also should be established for obtaining and maintaining possession or control of securities purchased through the dealer. Securities should be left in safekeeping with the dealer only if the board is satisfied with the creditworthiness of the dealer and the aggregate market value of the securities left with the dealer is within the credit limits set by the board for unsecured transactions. References Laws: 12 U.S.C. 24 (Seventh) Regulations: 12 CFR 1 Regulatory Guidelines: FFIEC Policy Statement on Securities Activities (February 3, 1992); as modified by FFIEC Policy Statement on Securities Activities (May 26, 1998) Revised Policy Statement on Securities Lending (62 FR 38991, July 21, 1997) Interagency Statement on the Regulatory Treatment of Securities under FASB Statement No. 115 (August 10, 1993) Interagency Supervisory Policy Statement on Repurchase Agreements (50 FR 49764, December 4, 1985)


Overview of Bank Derivatives Activities

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III. Overview of Bank Derivatives Activities Introduction ........................................................................................................................................ 34 Description of Common Derivative Instruments ................................................................................ 34 Credit Derivatives ............................................................................................................................... 36 Derivatives Disclosure ........................................................................................................................ 37 Risk Management of Financial Derivatives ........................................................................................ 40 References .......................................................................................................................................... 47

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34 The Securities Regulatory Handbook Introduction Derivative instruments (“derivatives”) are financial contracts whose value depends on the values of one or more underlying assets or indexes of asset values. Their primary purpose is to transfer risks associated with fluctuations in asset values. Derivatives include instruments such as swaps, futures, options, caps/floors/collars, forwards, and forward rate agreements. The use of derivatives by banks for risk-management purposes is considered an activity incidental to the traditional business of banking, and therefore permissible. Bank regulatory agencies are considering incorporating an interest rate and market risk component into the risk-based capital guidelines. This may result in the expanded use of derivatives by banks as hedging devices. While the use of derivatives as a hedging device can be a very effective method for managing portfolio risks, regulators are concerned that speculation and trading in the derivatives market can expose a bank to significant safety and soundness risks. This section of the Handbook is intended to provide a brief overview of the primary derivative instruments and the risks they pose to bank safety and soundness. As a result of regulatory and congressional concerns, regulatory scrutiny of the derivative activities of banks is likely to increase in the near future. Banks should be aware of the potential risks involved in derivatives and should have appropriate policies and procedures in place to address these risks. Description of Common Derivative Instruments Swaps A financial transaction in which two counterparties agree to exchange streams of payments, over time, according to a predetermined rule. A swap normally is used to transform the market exposure associated with a loan or bond borrowing from one interest rate base (fixed-term or floating rate), or currency of denomination, to another. Such swaps are known as interest rate swaps and currency swaps. Options An option is a contractual right, but not an obligation, to buy or sell a specified amount of a given financial instrument at a fixed price before or at a


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designated future date. A call option grants the holder the right to buy the financial instrument, whereas a put confers the right to sell. Futures Contracts A futures contract is an exchange-traded contract generally requiring the delivery of a specified amount of a certain commodity or financial instrument at a fixed date in the future. Forward Contracts A forward contract is a customized obligation to receive or deliver a specified amount of a commodity or security, at a specified price, at a specific date in the future. The terms of the contract are negotiated directly by the counterparties and can be terminated only with the consent of both parties. Forward contracts differ from future contracts in that there is no exchange acting as an intermediary, no daily settlement, and no margin requirement. These differences lead to a greater level of credit risk in forward contracts. The most common forwards used by banks are foreign exchange forwards and forward rate agreements. Foreign Exchange Forwards A foreign exchange forward is a contract to deliver, or receive, a specified amount of a foreign currency, at a specified price, some time in the future. These contracts allow banks to hedge foreign currency risk by locking in an exchange rate now, for delivery later. Forward Rate Agreements A forward rate agreement is a contract in which two counterparties agree on the interest rate to be paid on a notional deposit of specified maturity at a specific future time. In most cases, the principal amount is never exchanged; instead the difference between the contract rate and the prevailing market rate is settled in cash. Caps, Floors, and Collars Caps and floors are option-like contracts where the purchaser pays the seller a premium to protect against rising or falling interest rates. These contracts normally are set for a specified principal amount for a set period of time. If interest rates rise above the level protected by a cap, the seller of the cap pays the

36 The Securities Regulatory Handbook purchaser the average rate differential over the time period. The same settlement procedure would apply to a floor if interest rates fell. A collar involves the simultaneous purchase of a cap and sale of a floor. A collar has the effect of maintaining interest rates within a defined range. The cost of the cap is offset by the premium received from the sale of the floor. Credit Derivatives Credit derivatives are financial instruments marketed as an efficient way to manage credit exposure. Credit derivatives are generally off-balance sheet items that banks use to assume or lay off credit risk on loans and other assets— sometimes to only a limited extent. Banks may also use credit derivatives to reduce credit concentrations and manage overall credit risk exposure. Increasingly, banks are employing these instruments either as end-users, purchasing credit protection from––or providing credit protection to––third parties, or as dealers intermediating such protection. There are three principal types of credit derivatives: credit default swaps, total rate of return (TROR) swaps, and creditlinked notes. Credit Default Swaps Credit default swaps are similar to standby letters of credit. The risk hedger (i.e., buyer of credit protection) pays a fee, which effectively represents an option premium, in return for the right to receive a conditional payment if a specified “reference credit” defaults. A reference credit is simply the party whose credit performance will determine credit derivative cash flows. Typically, the reference credit has a borrowing relationship with the bank that is buying credit protection. The bank may diversify its portfolio by reducing its exposure to the borrower, and the swap enables it to do so without disturbing its relationship with the customer. The methods used to determine the amount of the payment that would be triggered by the default vary by instrument. In some contracts, the amount of the payment is agreed upon at the inception of the contract. In others, the amount paid is determined after the default event and is based upon the observed prices of similar debt obligations of the borrower in the corporate bond market. A default event typically must exceed a materiality threshold in order to trigger a payment under the swap contract. Total Rate of Return (TROR) Swaps A TROR swap transfers the total economic performance of a reference asset (or index) that includes all associated cash flows as well as capital appreciation or depreciation. The total return payer pays the total rate of return on a


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reference asset, which includes contractual payments plus any price appreciation, in return for a floating rate plus any depreciation on the reference asset. The total return payer has hedged its credit risk, while the total return receiver has accepted credit risk. If the reference asset depreciates, the total return payer will receive the depreciation amount from its counterparty. Although the hedger has transferred the risk of the asset, it does not transfer the asset itself. It retains the customer relationship and must continue to fund the earning asset. TROR swaps may, but need not, terminate upon a default event. Credit-Linked Notes Unlike the credit default and TROR swap, a credit-linked note is an onbalance-sheet instrument. Credit-linked notes are cash market-structured notes often issued by a special purpose trust vehicle. The note represents a synthetic corporate bond or loan, because a credit derivative (credit default or TROR swap) is embedded in the structure. Depending upon the performance of a specified reference credit, and the type of derivative embedded in the note, the note may not be redeemable at par value. Investors in credit-linked notes assume credit risk of both the reference credit and the underlying collateral. The trust is generally collateralized with high-quality assets to assure payment of contractual amounts due. Like other structured notes, credit-linked notes allow an investor to take a customized investment view. Credit-linked notes may contain leverage that can magnify the risk and return of the asset. Derivatives Disclosure During the last several years, the use of derivative financial instruments, other financial instruments, and derivative commodity instruments (collectively, “derivatives”) increased substantially. Although these instruments can be effective tools for managing exposure to market risks, the SEC recognizes that the use of derivatives has caused some organizations to experience significant, and sometimes unexpected, losses. These losses resulted from changes in interest rates, foreign currency exchange rates, and commodity prices, among other things. In light of the losses and the substantial growth in the use of derivatives, the SEC now requires certain disclosures for organizations using derivatives. On January 28, 1997, the SEC released its rules on disclosure of market risk. Generally, these disclosures require: • Enhanced descriptions of accounting policies for derivatives in the footnotes to the financial statements; • Quantitative and qualitative information about market risks for derivatives and other financial instruments––these disclosures must be presented outside the financial statements; and

38 The Securities Regulatory Handbook • Disclosures about derivatives that directly or indirectly affect reported items such as commodity positions, firm commitments, and anticipated transactions, to the extent that the effects of such information are material and necessary to prevent the disclosures about the reported items from being misleading. Derivatives Accounting Policies in the Footnotes to the Financial Statements To facilitate a more informed assessment of the effects of derivatives on financial statements, the following seven items must be disclosed in the derivatives accounting policies footnote, when material: • A discussion of each method used to account for derivative financial instruments and derivative commodity instruments; • The types of derivative financial instruments and derivative commodity instruments accounted for under each method; • The criteria required to be met for each accounting method used, including a discussion of the criteria required to be met for hedge or deferral accounting and accrual or settlement accounting (e.g., whether and how risk reduction, correlation, designation, and effectiveness tests are applied); • The accounting method used if the specified criteria are not met; • The method used to account for termination of derivatives designated as hedges or derivatives used to affect directly or indirectly the terms, fair values, or cash flows of a designated item; • The method used to account for derivatives when the designated item matures, is sold, is extinguished, or is terminated. In addition, the method used to account for derivatives designated to an anticipated transaction, when the anticipated transaction is no longer likely to occur; and • Where and when derivative financial instruments and derivative commodity instruments, and their related gains and losses, are reported in the statements of financial position, cash flows, and results of operations. When assessing the materiality of an item, an institution should consider the financial statement effects of all derivatives, including those not recognized


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in the statement of financial position and the relative effects of using the accounting method selected as compared to the other methods available (e.g., accrual, deferral, or fair value methods of accounting). Quantitative and Qualitative Disclosures The primary objective of quantitative disclosures is to provide investors with forward-looking information about potential exposures to market risk. By their nature, these forward-looking choices are only estimates and may be different from what actually occurs. In preparing quantitative information, derivatives should be categorized by instruments entered into for trading purposes and instruments entered into for purposes other than trading. Within both the trading and other than trading portfolios, separate quantitative information should be presented for each market risk exposure category (i.e., interest rate risk, foreign currency exchange rate risk, commodity price risk, and other relevant market risks, such as equity price risk). Quantitative information about derivatives must be presented in one or more of the following alternatives although different disclosure alternatives for each of the separate disclosures may be used: • Tabular presentation of fair value information and contract terms relevant to determining future cash flows, categorized by expected maturity dates; • Sensitivity analysis expressing the potential loss in future earnings, fair values, or cash flows from selected hypothetical changes in market rates and prices; or • Value at risk disclosures expressing the potential loss in future earnings, fair values, or cash flows from market movements over a selected period of time and with a selected likelihood of occurrence. Qualitative information about market risk is intended to complement quantitative disclosures. Qualitative disclosures help investors to understand market risk management activities in the appropriate context. Qualitative disclosures about market risk include: • Disclosure of primary market risk exposures at the end of the current reporting period; • Disclosure of how the exposures are managed (such as a description of the objectives, general strategies, and instruments, if any, used to manage those exposures); and

40 The Securities Regulatory Handbook • Disclosure of changes in either primary market risk exposures or how exposures are managed, when compared to the most recent reporting period and what is known or expected in future periods. Quantitative and qualitative information that includes forward-looking disclosures fall within the statutory safe harbor under the Securities Act of 1933 and Securities Exchange Act of 1934. Disclosures That Are Material and Necessary to Prevent Reported Items from Being Misleading Under securities laws it is fundamental that any filings or reports contain any material information that make those filings or reports not misleading. Consequently, a financial institution should disclose all information about derivatives that directly or indirectly affect the terms, fair values, or cash flows of the reported items, including derivative transactions that are designated to reported items under generally accepted accounting principles. Risk Management of Financial Derivatives The bank regulatory agencies recognize that financial derivatives can be effectively used to reduce interest rate and currency risk, can provide users with low-cost funding alternatives, and can be offered to bank customers seeking risk management tools to assist in meeting business objectives. However, the banking agencies also recognize that banks engaging in derivatives transactions must do so in accordance with safe and sound banking practices. The banking agencies believe that the best defense against sizable individual losses by banks or significant systemic disruptions is the implementation and use by individual banks of sound and efficient risk management systems. This section outlines the management processes required to adequately address market, credit, liquidity, and operations systems risks as well as the risks regarding the legal enforceability of netting arrangements. Risks Associated with Derivatives Counterparty Credit Risk Counterparty credit risk is the risk of loss in the event the counterparty to a transaction defaults or otherwise fails to perform under the terms of a contract. Once the amount of credit exposure is estimated, it can be evaluated and


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controlled through traditional methods of assessing the creditworthiness of a counterparty. Market Risk The market risk of a derivative is the risk of a decline in the value of a contract arising from adverse movements in the price, index, or rate of the instrument underlying the contract. Settlement Risk Settlement risk is the exposure to loss arising when an institution either pays out funds or delivers assets before receiving assets or payments from its counterparty. Operating Risk Operating risk is the risk that inadequate internal controls, procedures, human error, system failure, or fraud can result in unexpected losses. Liquidity Risk Liquidity risk is the risk that a financial asset or off-balance sheet instrument cannot be sold or replaced quickly at, or very close to, its fundamental value. Other Risks Other risks associated with derivatives include legal risks and aggregation or interconnection risks. Senior Management and Board Oversight A bank engaging in derivatives activities should have effective senior management supervision and oversight by the board of directors to ensure that such activities are conducted in a safe and sound manner and are consistent with the board of directors’ overall risk management philosophy and the bank’s business strategies. Written Policies and Procedures A bank should have comprehensive written policies and procedures to govern its use of derivatives. Senior management should review the adequacy of these

42 The Securities Regulatory Handbook policies and procedures, in light of the bank’s activities and market conditions, at least annually. Appropriate governance by the board of directors should include an initial endorsement of significant policies (and changes, as applicable) and periodic approval thereafter, as appropriate, considering the scope, size, and complexity of the bank’s derivatives activities. General Risk Monitoring and Control Senior management of any bank engaging in derivatives transactions should establish an independent unit or individual responsible for measuring and reporting risk exposures. That responsibility should include monitoring compliance with bank policies and risk exposure limits. Risk Management Systems A bank engaged in financial derivatives transactions should have comprehensive risk management systems that are commensurate with the scope, size, and complexity of its activities and the risks it assumes. Such systems must ensure that market factors affecting risk exposures are adequately measured, monitored, and controlled. These factors include changes in interest and currency exchange rates, commodity and equity prices and their associated volatility, changes in the credit quality of counterparties, changes in market liquidity, and the potential for major market disruptions. Risk management procedures also should adequately control potential losses arising from system deficiencies. Audit Coverage A bank should have audit coverage of its financial derivatives activities adequate to ensure timely identification of internal control weaknesses and/or system deficiencies. Such audit coverage should be provided by competent professionals who are knowledgeable of the risks inherent in the financial derivatives transactions. Market Risk Management The sophistication of a bank’s market risk management system will depend on the level of the bank’s involvement in financial derivatives. Dealers and Active Position-Takers A bank whose financial derivatives activities involve dealing or active position taking should have risk measurement systems that can quantify risk ex-


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posures arising from changes in market factors. Those systems should be structured to enable management to initiate prompt remedial action. The systems also should facilitate stress testing and enable management to assess the potential impact of various changes in market factors on earnings and capital. Limited End-Users A bank whose derivatives activities are limited in volume and confined to risk management activities may need less sophisticated risk measurement systems than those required by a dealer or active position-taker. Senior management at such a bank should ensure that all significant risks arising from its derivatives transactions can be quantified, monitored, and controlled. At a minimum, risk management systems should evaluate the possible impact on the bank’s earnings and capital, which may result from adverse changes in interest rates and other market conditions that are relevant to the bank’s risk exposure and the effectiveness of financial derivatives transactions in the bank’s overall risk management. Credit Risk Management Credit risk management should parallel the prudent controls expected in traditional lending activities. Policies and procedures should be formalized to address concerns such as significant counterparty exposures, concentrations, credit exceptions, risk ratings, nonperforming contracts, and allowance allocations. Timely, meaningful reports should be generated and distributed consistent with policy and procedure requirements. Credit Approval Function To ensure safe and sound management of derivatives credit risk exposure, bank management should make sure that credit authorizations are provided by personnel independent of the trading unit. Credit officers should be qualified to identify and assess the level of credit risk inherent in a proposed derivatives transaction. Approving officers also should be able to identify if a proposed derivatives transaction is consistent with a counterparty’s policies and procedures with respect to derivatives activities, as they are known to the bank. Presettlement Risk The system a bank uses to quantify presettlement credit risk exposure should take into account current exposure (“mark-to-market”) as well as potential

44 The Securities Regulatory Handbook credit risk due to possible future changes in applicable market rates or prices (“add-on”). That system should use a reliable source for determining the credit risk factor used to calculate the credit risk add-on. Settlement Risk A bank’s system for managing counterparty credit risk should address settlement risk. Settlement risk is the risk that a bank faces when it has performed its obligations under a contract but has not yet received value from its counterparty. Settlement risk limits should be established separately from presettlement credit limits and should consider the bank’s capital adequacy, operations efficiency, and credit analysis expertise. Credit Risk Monitoring Credit risk monitoring should be independent of the units that create financial derivatives exposures. This risk monitoring unit should be responsible for producing and distributing timely, accurate information about credit exposures such as line usage, concentrations, credit quality, limit exceptions, and significant counterparty exposures. Credit exposure reports should provide aggregate information about the bank’s credit risk to a given counterparty (including products such as loans, securities underwritings, and other traded products). The risk monitoring unit should ensure that appropriate levels of senior management and the board of directors receive relevant information about credit exposure arising from derivatives activities on a periodic and timely basis. Liquidity Risk Management Bank management should establish effective controls over the liquidity exposure arising from financial derivatives activities. Key principles in the governance and management of this risk are diversification and communication. Market/Product Liquidity Risk Exposure to market/product liquidity risk should be formally addressed within market risk limits. Diversification policies specifically addressing known or potential liquidity problems also should be implemented. Limits should be designed to trigger management action and control loss. Quality and timely communication also should be an integral part of a bank’s risk management culture.


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Cash Flow/Funding Liquidity Risk A bank should have liquidity policies to formally govern its exposure to cash flow gaps (from intermediate payments or settlements) arising from financial derivatives activities. Early Termination Arrangements and Credit Enhancements Policies should control the bank’s exposure arising from early termination arrangements, as well as collateralization or other credit enhancements. Monitoring Banks should have management information systems that permit daily monitoring of liquidity positions relative to limits. These reports should be prepared by an area or employee(s) independent of the trading unit. Operations and Systems Risk Management The board of directors and senior management should ensure the proper dedication of resources (financial and personnel) to support operations and systems development and maintenance. The operations unit for financial derivatives activities, consistent with other trading and investment activities, should report to an independent unit, and should be managed independently of the business unit. The sophistication of the systems support and operational capacity should be commensurate with the size and complexity of the derivatives business activity. Quality of Personnel Senior management should recognize the need for, and devote appropriate resources to, employing knowledgeable and experienced personnel in the operations area. Systems Systems design and needs may vary according to the size and complexity of a bank’s financial derivatives business. However, each system should provide for accurate and timely processing and allow for proper risk exposure monitoring. Segregation of Duties Segregation of operational duties, exposure reporting, and risk monitoring from the business unit is critical to proper internal control.

46 The Securities Regulatory Handbook Valuation Issues Banks that engage in financial derivatives activities should ensure that the methods they use to value their derivatives positions are appropriate and that the assumptions underlying those methods are reasonable. Documentation Bank management should ensure that a mechanism exists whereby financial derivatives contract documentation is confirmed, maintained, and safeguarded. Documentation exceptions should be properly monitored and resolved. Legal Issues Prior to engaging in derivatives transactions, a bank should reasonably satisfy itself that its counterparties have the legal, and any necessary regulatory, authority to engage in those transactions. In addition to determining the authority of a counterparty to enter into a derivatives transaction, a bank also should reasonably satisfy itself that the terms of any contract governing its derivatives activities with a counterparty are legally sound. Bilateral Netting In order to reduce counterparty credit exposure, a bank should use master closeout netting agreements with its counterparties to the broadest extent legally enforceable, including in any possible insolvency proceedings of such counterparties. However, the reliance on such agreements where their enforceability against a particular counterparty has not been legally established should be considered carefully and will be scrutinized closely by the OCC. The FDIC Improvement Act of 1991 established that, as a matter of contract law, netting contracts in the United States are legally enforceable. The enforceability of such provisions against many foreign counterparties or U.S. branches or offices of some foreign counterparties, however, is less certain. In those instances, bank policies should require that netting not be considered in calculating the bank’s potential credit and systemic risk exposure with the counterparty. Multilateral Netting A bank should determine credit and liquidity exposure and account for financial derivatives transactions on a multilaterally netted basis only if cleared


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through a clearinghouse, organization, or facility that meets the conditions set forth in the Report of the Committee on Interbank Netting Schemes of the Central Bank of the Group of 10 Countries, Bank for International Settlements, November 1990 (Lamfalussy Report). Physical Commodity Transactions Banks may engage in physical commodity transactions in order to manage the risks arising out of physical commodity financial derivatives transactions if they meet the following conditions: • Any physical transactions supplement the bank’s existing risk management activities, constitute a nominal percentage of a bank’s risk management activities, are used only to manage risk arising from otherwise permissible (customer-driven) banking activities, and are not entered into for speculative purposes; and • Before entering into any such physical transactions, the bank has submitted a detailed plan for the activity to the appropriate bank regulatory agency and the plan has been approved. Capital Adequacy The board of directors should ensure that the bank maintains sufficient capital to support the risk exposures (e.g., market risk, credit risk, liquidity risk, operation and systems risk, etc.) that may arise from its derivatives activities. Significant changes in the size or scope of a bank’s activities should prompt an analysis of the adequacy of the amount of capital supporting those various activities by senior management and/or the board of directors. This analysis should be approved by the board of directors and be available for bank examiner review. In addition to internal reviews of capital adequacy, senior management should ensure that the bank meets all regulatory capital standards for financial derivatives activities. References Regulatory Guidelines: OCC Banking Circular 277 (October 27, 1993) OCC Banking Circular 277 Questions and Answers (May 1994) OCC Supervisory Letter 96-43, Credit Derivatives FRB Trading Activities Manual (February 1998)


Brokerage Activities

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IV. Brokerage Activities Introduction ........................................................................................................................................ 50 Instruments That a Bank May Broker ................................................................................................ 50 Activities Allowing Expanded Brokerage .......................................................................................... 51 Broker-Dealer Registration ................................................................................................................. 54 References .......................................................................................................................................... 55 Nondeposit Investment Products Sales Guidelines ............................................................................ 55 References .......................................................................................................................................... 63 Recordkeeping and Confirmation Requirements................................................................................ 63 References .......................................................................................................................................... 67 Securities Fraud and Insider Trading .................................................................................................. 68 References .......................................................................................................................................... 70

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50 The Securities Regulatory Handbook Introduction The Securities Exchange Act of 1934 contained a “bank exemption,” permitting a bank to provide securities brokerage to customers through the bank itself, rather than through an SEC-registered nonbank subsidiary or affiliate. GLBA largely eliminated this exemption. Specifically, GLBA defined a limited set of products that a bank may broker, effectively prohibiting banks from brokering most corporate debt and equity securities. Originally, this “push out” rule mandated that after May 12, 2001, banks either: (a) cease brokering prohibited products, or (b) push them out of the bank and into an SEC-registered broker-dealer. In May 2001, the SEC delayed the compliance date for the “push out” rule until October 1, 2001. As before, a bank still may engage in bank-permissible securities activities through a registered broker-dealer subsidiary. If the subsidiary limits itself to securities transactions permitted the bank itself, the subsidiary is treated for bank regulatory purposes as if it were part of the bank: No special capital or funding restrictions apply. The effect of the push-out mandate ranges from irrelevant to significant depending on the business of a particular bank. Most bank securities sales to institutional customers may continue as before because they involve products that are exempt from the push-out provisions. Most retail brokerage already occurs within subsidiary or affiliate SEC-registered broker-dealers, rather than within the bank. For private bankers, however, the GLBA push-out rules have forced significant strategic and structural changes. Instruments That a Bank May Broker Under GLBA, a bank may buy or sell as agent for the account of its customers (“broker”) “identified banking products,” as well as certain specifically permitted securities. Identified Banking Products GLBA allows banks to broker the following “identified banking products”: • Certificates of deposit and other deposit accounts; • Banker’s acceptances;


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• Letters of credit or bank loans; • Debit accounts arising from credit card arrangements; • Loan participations (that the bank or an affiliate funds, participates in, or owns) sold to qualified investors or informed and sophisticated investors; and • Swap agreements, except that equity swaps must be sold directly to qualified investors. Permissible Securities Additionally, GLBA permits a bank to broker the following types of securities: • Commercial paper and commercial bills; • U.S. and qualifying Canadian government and agency securities; • Brady bonds; • Mortgage and consumer-related asset-backed securities that are: — Predominantly originated by the bank, a nonbroker-dealer affiliate, or a syndicate of banks of which the bank is a member; and — Issued through a special purpose vehicle; and • For “well-capitalized” banks, all types of municipal securities, including municipal revenue bonds. Banks may continue to develop and offer new products, unless the SEC determines by regulation that the new product is a hybrid product that should be offered by a registered securities broker-dealer. The SEC must consult the Fed before proposing to regulate the product, and the Fed may sue to challenge a final SEC regulation. Any SEC regulation will be prospective only: That is, a bank could not be sanctioned for offering the hybrid product before the SEC issued its regulation. Activities Allowing Expanded Brokerage In addition to the identified banking products and permissible securities discussed above, banks are granted more leeway to act as a broker for private

52 The Securities Regulatory Handbook banking and trust customers (fiduciary activities), through third-party networking arrangements with brokers, for the account of an affiliate, or in connection with transfer agent activities and certain other described functions. In May 2001, the SEC promulgated an interim final rule designed to clarify the meaning of certain terms used in the list of situations in which a bank is exempt from the definition of a broker-dealer. Fiduciary Activities A bank may continue to provide securities brokerage services through its private banking or trust department only if the bank: • Effects brokerage transactions in a trustee or fiduciary capacity; • Executes its trades though a registered broker-dealer, or permissibly crosses trades; • Receives compensation chiefly through administrative or annual fees, a percentage of assets under management, or a flat per order processing fee that does not exceed the bank’s cost to execute the transaction; and • Does not publicly solicit brokerage business. Transfer Agent and Custodial Activities A bank has new limits on its authority to conduct securities transactions in its role as a transfer agent for certain stock plans, or as part of its safekeeping and custodial activities. For those transactions, a bank must: • Direct any trades to a registered broker-dealer for execution; • Ensure that the trade is a cross by the bank or between the bank and a fiduciary, and is in accordance with fiduciary principles; or • Ensure that the trade is otherwise permitted under rules the SEC will issue.


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In addition, when providing safekeeping and custody services, a bank cannot act as carrying broker for any broker-dealer, except in connection with government securities. For additional detail on the trust-related exemptions to SEC brokerdealer registration, please refer to The Trust Regulatory Handbook. Third-Party Networking Full brokerage activities are allowed through third-party networking arrangements with registered broker-dealers. Third-party networking arrangements are contractual arrangements with affiliated or nonaffiliated broker-dealers that allow the broker-dealer to offer products and services to bank customers, whether on or off premises. When a bank employee refers a customer to a broker providing brokerage though a third-party networking arrangement, the customer becomes the potential customer of the third-party broker-dealer. Before the broker may accept the customer’s order, the broker-dealer must establish a new account for the customer. From the broker-dealer’s perspective, this is referred to as a “fully disclosed” relationship with the broker-dealer “carrying” the customer account. Additionally, the bank must assure that the broker-dealer: • Clearly identifies itself and provides services in an area that is physically separate from deposit-taking; • Uses advertising materials that comply with federal securities laws; • Restricts unregistered bank employee participation to ministerial tasks (e.g., scheduling appointments) or providing general descriptions of types of investments available from the broker-dealer; • Limits unregistered bank employee referral fees to a nominal one-time fixed dollar amount not contingent upon the customer trade; and • Provides an Interagency Statement on the Sale of Nondeposit Investment Products (NDIP) disclosure (see section below). The relationship between the institution and the third party should also be memorialized in a written agreement that is approved by the institution’s board of directors. Senior management should periodically monitor compliance with the agreement.

54 The Securities Regulatory Handbook At a minimum, the agreement should: • Describe the duties and responsibilities of each party, including a description of permissible activities by the third party on the institution’s premises, terms regarding the use of the institution’s space, personnel, and equipment, and compensation agreements for personnel of the institution and the third party; • Specify that the third party will comply with all applicable laws and regulations and will act consistently with the provisions relating to customer disclosures; • Authorize the institution to monitor the third party and periodically review and verify that the third party and its sales representatives are complying with their agreement with the institution; • Authorize the institution and the appropriate banking agency to have access to such records of the third party as are necessary or appropriate to evaluate such compliance; • Require the third party to indemnify the institution for any potential liability resulting from actions of the third party with regard to the investment product sales program; and • Provide for written employment contracts, satisfactory to the institution, for personnel who are employees of both the institution and the third party. Additional guidance on brokerage sales practices for bank customers is provided below. De Minimis Activity A bank also may broker up to 500 nonexempted transactions a year without being required to push out those activities into a registered broker-dealer. Broker-Dealer Registration The prior section described the brokerage activities that a bank may conduct without registering a broker-dealer. A banker wishing after October 1, 2001, to broaden other brokerage of registered securities must do so through a broker-dealer registered with the SEC under the Securities Exchange Act of 1934.


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All registered broker-dealers are required to join a registered securities association before transacting any securities business. The only current registered securities association is the National Association of Securities Dealers, Inc. (NASD). NASD rules are interpreted and enforced by the NASD’s subsidiary, the National Association of Securities Dealers Regulation, Inc. (NASDR). An exception to this requirement is available if the broker-dealer is a member of a national exchange, derives annual gross income of $1,000 or less for securities transactions not completed on that exchange, and does not carry any customer accounts. All brokerage activities are subject to the antifraud provisions of the Exchange Act. The antifraud and insider trading provisions of the Exchange Act will be covered in the section on Securities Fraud and Insider Trading. References Laws: 12 U.S.C. 24 (Seventh) 12 U.S.C. 2 §92a 12 U.S.C. 17 §1843 Regulations: FRB Regulation Y, 12 CFR 225 SEC Interim Final Rule 66 Federal Register 27760 Nondeposit Investment Products Sales Guidelines On February 15, 1994, the federal bank regulatory agencies issued an Interagency Statement on the Retail Sales of Nondeposit Investment Products (the “Statement”) to provide guidance to financial institutions selling mutual funds, annuities, and other nondeposit investment products to customers. The Statement is intended to consolidate, make uniform, and supersede the guidance previously issued separately by the various agencies. The Statement seeks to assure that customers of a financial institution who purchase nondeposit investment products through the institution understand that the products are not insured by the FDIC, are not obligations of or guaranteed by the financial institution, and involve investment risk, including the possible loss of principal. The Statement requires financial institutions to disclose these facts clearly and conspicuously to their brokerage

56 The Securities Regulatory Handbook customers and to adopt policies and procedures to minimize any potential customer confusion. Any institution that provides brokerage services to its customers or has arranged for brokerage services to be provided by a third party must adopt policies and procedures that ensure compliance with the Statement. The banking agencies will monitor compliance with such policies and procedures by the institution, as well as by any third-party provider. The failure to establish and observe appropriate policies and procedures consistent with the Statement will subject the institution to regulatory criticism and appropriate corrective action. GLBA codifies certain identification, separation, referral, and disclosure provisions, largely duplicative of those currently mandated by the Interagency Statement on the Sale of Nondeposit Investment Products (NDIP). However, unlike the NDIP, GLBA imposes such conditions on all networked brokerage, whether on or off bank premises. Scope The Statement applies whenever retail sales or recommendations of mutual funds or other nondeposit investment products are made by: • Employees of the financial institution; • Employees of an affiliated or unaffiliated third party occurring on the premises of the institution (including telephone sales or recommendations by employees located on the institution’s premises or sales or recommendations initiated by a mailing from the institution’s premises); and • Employees of an affiliated or unaffiliated third party resulting from a referral by the institution when it receives a benefit for the referral. Retail Sales In late 1995, the agencies issued a joint statement clarifying several matters under the Statement. In the 1995 interpretation the agencies determined that any sales in a bank lobby area, or adjacent to it, must be presumed to be retail. Sales elsewhere may be retail sales as well depending on the facts and circumstances.


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In addition, the regulators agreed with industry assertions that most fiduciary accounts are not retail accounts within the intent of the Statement. The regulators retained an exception for self-directed individual retirement accounts and any others not administered by a financial institution or a professional money manager. For those categories of fiduciary accounts, the Statement disclosures are still necessary. The disclosures are not necessary for the professionally managed accounts. The new joint statement also clarifies the status of governments and municipals sold by the dealer department. When the dealer department sells those securities in a location that is not the lobby area of a financial institution, they are not retail sales and are not subject to the Statement disclosures. For sales to individuals and sales from the lobby area, the brokerage must continue to make the disclosures that the Statement requires for retail sales. Program Management Institutions involved in the sale of retail investment products should adopt a written statement that addresses the risks associated with the sales program and contains a summary of policies and procedures adopted to follow the guidelines presented by the Statement. The level of detail of the written statement will vary depending on the level of the institution’s involvement in investment product sales activities. Where applicable, every written statement should address the scope of any third party’s involvement, as well as the procedures designed to ensure the third party’s compliance with the policies and procedures adopted by the financial institution. The board of directors of the institution should adopt and periodically review the written statement. Disclosures The regulators are concerned that in a financial institution’s sales of investment products, customers of the institution would not be able to distinguish between insured deposit products and uninsured investment products, such as mutual funds and annuity products. Therefore, ensuring that customers receive appropriate disclosures regarding the nature of, and the risks involved in, investment products sold by or through the institution should be a priority for senior management. The disclosures should be conspicuous and presented in a clear and concise manner, and at a minimum specify that the product is:

58 The Securities Regulatory Handbook • Not insured by the FDIC; • Not a deposit or other obligation of, or guaranteed by, the financial institution; and • Subject to investment risks, including possible loss of the principal amount invested. Where applicable, an institution should disclose the existence of an advisory or other material relationship between the institution or an affiliate of the institution and an investment company whose shares are sold by the institution. Any material relationship between the institution and an affiliate involved in providing nondeposit investment products should also be disclosed. Finally, where applicable, the existence of any fees, penalties, or surrender charges should also be disclosed. These disclosures should be provided to the customer: • Orally during any sales presentation; • Orally when investment advice concerning nondeposit investment products is provided; • Orally and in writing prior to or at the time an investment account is opened to purchase these products; and • In advertisements and other promotional materials. A statement, signed by the customer, should be obtained at the time such an account is opened acknowledging that the customer has received and understands the disclosures. For previously opened accounts, the acknowledgment should be obtained at the time of the next transaction. Confirmations and account statements for investment products that contain the name or logo of the financial institution or an affiliate should contain at least the minimum disclosures. If a customer’s periodic deposit account statement includes account information concerning the customer’s nondeposit investment products, the investment product information should be clearly separated from the deposit information and should be introduced with the minimum disclosures and identify the entity conducting the nondeposit transaction.


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If sales activities include any written or oral representations concerning insurance coverage provided by any entity other than the FDIC (e.g., the Securities Investor Protection Corporation, a state insurance fund, or a private insurance company), then clear and accurate written explanations of the coverage must be provided to customers when the representations are made. This is intended to minimize possible confusion with FDIC insurance. Any such representations should not suggest or imply that any alternative insurance coverage is the same as, or similar to, FDIC insurance. In their late 1995 joint statement interpreting the Statement, the regulators clarified and simplified the Interagency Statement’s disclosure requirements. The regulators decided that the Interagency Statement disclosures need not be made in: • Radio broadcasts of 30 seconds or less; • Electronic signs; and • Signs used primarily as location indicators. For logo format disclosures, the regulators have agreed on a shortened format for the disclosures. The disclosures would be in a box, conspicuously displayed, which includes the statements: • Not FDIC insured; • May lose value; and • No bank guarantee. Names of Mutual Funds Because of the possibility of customer confusion, a mutual fund sold through a financial institution must not have a name that is identical to the name of the institution. Recommending or selling mutual funds with a name similar to that of the institution should only occur in a sales program designed to minimize the risk of customer confusion. In those cases, the institution should also take appropriate steps to ensure that the issuer of the mutual fund has complied with any applicable requirements established by the SEC regarding the use of similar names. The OCC has instructed its examiners to criticize any sales program with fund names so similar to the bank’s that even mitigating circumstances are

60 The Securities Regulatory Handbook unlikely to eliminate customer confusion. The OCC will also increase scrutiny of all aspects of an institution’s sales program if the name of the fund is greatly similar to that of the bank. The SEC’s current position is that a common name between a federally insured financial institution and funds sold by or through that institution is “presumptively misleading.” This presumption can be rebutted through prominent disclosure on the cover page of the prospectus that the fund’s shares are not insured by the FDIC, the Federal Reserve Board, or any other agency and are not deposits or obligations of, or guaranteed or endorsed by, the institution. Advertising Advertisements and other promotional and sales material, written or otherwise, regarding nondeposit investment products sold to retail customers should include the minimum disclosures required under the Statement. The minimum disclosures should be emphasized in telemarketing contacts. The materials must not suggest or convey any inaccurate or misleading impression about the nature of the product or its lack of FDIC insurance. If brochures, signs, or other written material contain information about both FDIC-insured deposits and nondeposit investment products, these materials should clearly segregate information about the investment products from the information about deposits. Any third-party advertising or promotional material should clearly identify the company selling the investment product and should not suggest that the financial institution is the seller. Setting and Circumstances To minimize customer confusion of investment products with deposit products, on-premises sales or recommendations of investment products should be conducted in a physical location distinct from the area where the institution accepts retail deposits. Signs or other means should distinguish the investment product sales area. In the limited situations where physical considerations prevent the institution from selling investment products in a distinct area, the institution has a heightened responsibility to ensure that appropriate measures are in place to minimize customer confusion. Tellers and other employees, while located in the deposit-taking area of a financial institution, should not make general or specific recommendations regarding investment products, qualify a customer as eligible to purchase such


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products, or accept orders for such products, even if unsolicited. Tellers and other employees who are not authorized to sell investment products may refer customers to those employees designated and trained to assist customers interested in nondeposit investment products. Qualifications and Training A financial institution should ensure that its employees who are authorized to sell investment products or provide investment advice are adequately trained with regard to the products being sold or recommended. Training should be the substantive equivalent of that required for NASD registered sales representatives and should, at a minimum, address: • Sales methods; • The products involved; • The applicable legal restrictions; and • Customer protection requirements. Personnel with supervisory responsibilities should receive training appropriate to that position. The institution should provide general training to all employees who have direct contact with customers to ensure a basic understanding of the institution’s investment sales activities and its policy of limiting the involvement of employees who are not authorized sales personnel. Training should be periodically updated and provided to employees on an ongoing basis. Financial institutions should investigate the backgrounds of employees hired for their investment product sales program. This should include a check for possible disciplinary actions by securities industry or other regulators if the employee has previous investment industry experience. Suitability and Sales Practices Financial institution personnel involved in selling nondeposit investment products must adhere to fair and reasonable sales practices and be subject to effective management and compliance reviews with regard to such practices. In this regard, if sales personnel recommend investment products to customers, they should have reasonable grounds for believing that the specific product recommended is suitable for the particular customer based on information

62 The Securities Regulatory Handbook disclosed by the customer. Sales personnel should make a reasonable effort to obtain from the customer information regarding: • The customer’s financial and tax status; • The customer’s investment objectives; and • Any other information relevant to the suitability determination. This information should be documented and updated periodically. The OCC has instructed its examiners to pay particular attention to recommendations made to first-time, risk-averse, elderly, or surviving spouse customers to ensure that they are suitable. Compensation Financial institution personnel, including tellers, may receive a one-time nominal fee of a fixed dollar amount for each customer referral for investment products. The payment of this referral fee should not depend on whether the referral results in a transaction. Authorized sales personnel may receive incentive compensation, such as commissions, for transactions entered into by customers. However, incentive programs must not be structured in such a way as to result in unsuitable sales or recommendations to customers. Internal compliance and audit personnel should not receive incentive compensation directly related to the results of the investment sales program. Compliance A financial institution should develop and implement policies and procedures designed to ensure that it conducts its investment product sales activities in compliance with applicable laws and regulations, the institution’s internal policies and procedures, and the Statement. Compliance procedures should identify any potential conflicts of interest and how such conflicts should be addressed. The procedures should also provide for a system to monitor customer complaints and their resolution. Where applicable, procedures should call for verification that third-party sales are being conducted in a manner consistent with the governing agreement with the financial institution.


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The compliance function should be conducted independently of investment product sales and management activities. Compliance personnel should determine the scope and frequency of their own review, and findings of compliance reviews should be periodically reported directly to the institution’s board of directors or to a designated committee of the board. Appropriate procedures for the investment sales program should also be incorporated into the institution’s audit program. References Supervisory Material: Interagency Statement on Retail Sales of Nondeposit Investment Products (February 15, 1994) Recordkeeping and Confirmation Requirements Recordkeeping Requirements The OCC, FRB, and the FDIC have issued regulations placing recordkeeping and confirmation requirements on banks engaging in brokerage activities. The regulations require a bank to maintain the following records for at least three years after completing a securities transaction for a customer: • Chronological records containing an itemized daily record of all purchases and sales of securities that include: — The account or customer for which the transaction was completed; — A description of the security; — The unit and aggregate sales price; — The trade date; and — The name of the broker-dealer or other person from whom the security was purchased. • Account records for each customer reflecting purchases and sales of securities, receipts and deliveries of securities, and receipts and disbursements of cash with respect to customers’ securities transactions.

64 The Securities Regulatory Handbook • A separate order ticket for each order to purchase or sell securities, which should include: — The account for which the transaction was effected; — Whether the transaction was a market order, limit order, or subject to special instructions; — The time the order was received by the trader or bank employee responsible for the transaction; — The time the order was placed with the broker-dealer, or if no broker-dealer, the time the order was executed or canceled; — The price at which the order was executed; and — The broker-dealer utilized. • A record of all broker-dealers selected by the bank to effect securities transactions and the amount of commissions paid or allocated to each broker during the year. • Copies of the confirmations which a bank must provide to customers for whom it effects securities transactions. Confirmation Requirements An institution offering brokerage services must also consider certain customer disclosure issues. Customer account agreements, confirmations, account statements, fee schedules, and option or margin account agreements are considered disclosure documents. The institution should be careful to ensure that information presented on all such documents is accurate and not misleading. Banks effecting securities transactions for customers must provide certain notifications to those customers at or before the completion of the transactions. Banks may comply with the notification requirement by meeting either one of the following: • A copy of the confirmation generated by the associated broker and a statement concerning the source and amount of remuneration to be received by the bank. This latter disclosure requirement can be satisfied by a written agreement between the bank and the customer disclosing the source and amount of any remuneration to be received by the bank; or


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• The bank may supply to customers its own confirmation disclosing: — The name of the bank; — The name of the customer; — The bank’s capacity (e.g., as agent for the customer or some other person, or as principal for the bank’s own account); — The date of execution and a statement that the time of execution will be furnished upon written request; — The identity, price, and number of shares (or, in the case of debt securities, the principal amount) of each security purchased or sold; — The source and amount of any other remuneration to be received by the bank in connection with the transaction, unless this remuneration is received pursuant to a written agreement between the customer and the bank (In the case of U.S. government, federal agency, and municipal securities, this disclosure is required only on agency transactions.); — The amount of remuneration to be received directly or indirectly from a customer in connection with the transaction; — The name of the associated broker; and — As applicable, in the case of certain transactions in debt securities, a statement regarding whether the security is callable, the dollar price and yield at which the transaction was effected, certain factors that may affect the yield, whether the security is rated by a NRSRO, and whether more information regarding any of the aforementioned items is available to the customer upon request. If the bank satisfies the notification requirement by providing a copy of the broker-dealer confirmation, the bank must give or send the confirmation to the customer within one business day from the bank’s receipt from the brokerdealer. Otherwise, the bank must provide the notification upon or before completing the transaction. Depending upon the type of customer account or customer preferences, the bank may provide alternative forms of customer notification. Alternative forms of notification may be subject to different time requirements, and, in some instances, the bank may charge a reasonable fee for alternative notification.

66 The Securities Regulatory Handbook References to FDIC insurance should convey clearly to a customer that this insurance covers only cash maintained on deposit with the bank and does not apply to any securities being held in safekeeping. Safekeeping disclosures should give the customer information on the location of their securities. Disclosures should not imply that SIPC insurance is available to brokerage customers while securities or cash are maintained within the institution. The NASD requires that customers be notified which party actually carries their brokerage account. Accounts of bank brokerage customers most often are carried by the associated broker with whom a contractual relationship has been established. Most banks have included a statement in the customer’s account agreement indicating that the account is carried by the associated broker. Settlement of Securities Transactions Generally, contracts for the purchase or sale of securities should provide that the transaction be completed within three business days. However, a brokerdealer and the purchaser or seller may agree to a different arrangement upon entering the contract. Policies and Procedures Financial institution management must ensure that the brokerage operation is supervised properly. The level of service the institution intends to offer may oblige it to hire from the brokerage industry persons who have the necessary experience, but there are no specific professional qualification requirements, at this time. An institution’s written supervisory policies and procedures should address the prior securities industry experience and professional qualifications of all brokerage supervisors. In addition to staffing the brokerage service with qualified persons, written policies and procedures, including internal controls and audit procedures, must be established. Lines of authority within the brokerage service should be clearly defined in a written plan. Duties and responsibilities for all staff members should be developed and communicated to them. Regulations require written policies and procedures that assign responsibility for supervision of all bank employees involved in brokerage activities. Where possible, a separation of duties should be maintained within the brokerage operation. For instance, persons separate from the order-taking process should perform reconcilements, posting of accounts, following up on unexecuted securities orders and customer complaints, and covering margin calls. Under no circumstances should


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an employee be permitted to post transactions for his or her own account, an account of a family member, or for any other account in which the employee has a personal interest. Management should establish in writing which employees, if any, have the authority to make discretionary decisions such as permitting exceptions to established fee schedules or waiving procedures for the opening of new accounts. Contingency plans also should be instituted for continuing the brokerage services under alternate operating procedures if unforeseen circumstances such as fire, flood, or power failure disrupt normal operations. The audit staff should conduct periodic reviews to determine compliance with supervisory policies. Examinations Under functional regulation mandated by GLBA, bank and thrift regulatory agencies, generally, do not examine SEC-registered brokerage affiliates and subsidiaries of financial institutions. Such affiliates are subject to examination by NASDR, unless the broker-dealer has selected another Self Regulatory Organization (SRO) (e.g., the New York Stock Exchange), the SEC, and state securities regulators. References Laws: 12 U.S.C. 92a; 1817–1819 Regulations: 12 CFR 12 (OCC) 12 CFR 344 (FDIC) Interagency Statements: Interagency Statement on Retail Sales of Nondeposit Investment Products (February 15, 1994)

68 The Securities Regulatory Handbook Securities Fraud and Insider Trading Antifraud Provisions of the Exchange Act The antifraud provisions of the securities laws are generalized prohibitions against fraud, deceit, and manipulative or deceptive practices in the sale of securities. Section 10b of the Securities Exchange Act of 1934 and SEC Rule 10b-5 are the main antifraud provisions. They apply to any purchase or sale, by any person, of any security. Banks engaged in brokerage activities are subject to these provisions. Insider Trading and Securities Fraud Enforcement Act Insider trading involves the use of material, nonpublic information in the purchase or sale of a security. Insider trading is illegal under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5. Those parties found guilty of insider trading may be subject to disgorgement of profits and civil penalties of up to three times profits realized or losses avoided. The Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA) amended the 1934 Act extending insider trading liability to a party that controls the person guilty of illegal insider trading. The act also requires that registered broker-dealers and investment advisers establish policies and procedures to avoid insider trading. Banks may be privy to confidential, nonpublic information in their banking relationships with customers. If a bank’s securities subsidiary or affiliate uses the inside information, the bank may have insider trading liability as a controlling person. Therefore, banks and bank holding companies must establish policies and procedures to reduce their potential liability. A “controlling person” may include “any person with the power to influence or control the direction or the management, policies, or activities of another person.” A bank holding company may be considered a “controlling person” of its bank and nonbank subsidiaries and their employees and therefore may be subject to liability under ITSFEA. The controlling party will be found liable only if it “knew or recklessly disregarded the fact that such controlled person was likely to engage in the act or acts constituting the violation and failed to take appropriate steps to prevent them before they occurred.” A controlling person may be liable for civil damages of up to $1 million or three times the profit gained or losses avoided for each of the controlled persons’ violations.


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Every registered broker-dealer and investment adviser must “establish, maintain, and enforce written policies and procedures reasonably designed . . . to prevent the misuse . . . of material, nonpublic information by the broker-dealer or any person associated with the broker-dealer.” While banks are exempt from registration as broker-dealers, their subsidiaries and affiliates are not and are subject to these requirements. A bank or bank holding company that is a “controlling person” will be found liable if it “knowingly or recklessly failed to establish, maintain, or enforce any of the policies or procedures” required by ITSFEA and the failure substantially contributed to, or permitted, the insider trading violation. Banks and bank holding companies also must take into account the requirement that the controlling person “take appropriate steps to prevent” insider trading by controlled parties. The policies and procedures required are examples of what are known as “Chinese Walls.” “Chinese Walls” restrict the flow of inside information from the bank to the securities subsidiaries and affiliates. The SEC has rule-making authority to establish requirements for “Chinese Walls” but has delegated that responsibility to self-regulatory examination programs. The SEC has, however, prescribed the minimum necessary elements for examination programs. Those elements include: • Review of employee and proprietary trading; • Memorialization and documentation of firm procedures; • Substantive supervision of interdepartmental communication by the firm’s compliance department; and • Procedures concerning proprietary trading when the firm is in possession of material, nonpublic information. In addition to “Chinese Walls,” the SEC recommends the implementation of “restricted” lists and “watch” or “grey” lists. A restricted list is a list of securities about which the bank has nonpublic information. The bank, its securities affiliate, and its employees may not recommend or trade the securities on the list. Watch or grey lists are lists of securities about which the bank or securities affiliate has, or will have, nonpublic information. Any trading of securities on the list by the bank, its securities affiliate, or employees or customers of either should be monitored closely to ensure they are not trading on the nonpublic information. The SEC notes that the prudent course of action would be to restrict the trading of securities on the watch list by placing them on the restricted list as soon as possible.

70 The Securities Regulatory Handbook Employee Transactions Each of the federal bank regulatory agencies has regulations requiring banks to adopt policies and procedures regarding the reporting of employee securities transactions. Bank officers and employees who make investment recommendations or decisions for the accounts of customers, or who have access to information regarding which securities are being purchased or sold or recommended, must report to the bank, within 10 business days after the end of the calendar quarter (the FRB does not specify whether for state member banks the 10-day period is business days or calendar days), all transactions in securities made by them or on their behalf. The report, which covers transactions at the bank or at another firm, must identify the securities purchased or sold, the dates of transactions, and whether the transactions were purchases or sales. The report need not cover: • Transactions for the benefit of the employee over which the employee has no control; • Transactions in mutual fund shares or U.S. government or agency obligations; and • All transactions involving in the aggregate $10,000 or less during the calendar quarter. If a bank employee, officer, or director must file a report under the SEC’s Rule 17j-1, which affects investment advisers to investment companies registered under the Investment Company Act of 1940, the individual need not file another report as long as the information contained in each report would be identical. References Laws: 15 U.S.C. 78j

Brokerage Activities Regulations: 17 CFR 200 (SEC) 17 CFR 228 (SEC) 17 CFR 229 (SEC) 17 CFR 230 (SEC) 17 CFR 240.10b-5 (SEC) 17 CFR 242 (SEC) 17 CFR 270.17j-1 12 CFR 12 (OCC) 12 CFR 344 (FDIC)

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Underwriting and Dealing 73

V. Underwriting and Dealing Introduction ........................................................................................................................................ 74 Underwriting and Dealing .................................................................................................................. 74 Dealing Activities That May Occur in a Bank .................................................................................... 75 Financial Holding Companies (FHCs) ............................................................................................... 76 Applicability of Operating Standards to FHC Subsidiaries................................................................ 77 Financial Subsidiaries of National and State Member Banks ............................................................ 78 State Nonmember Bank Subsidiaries ................................................................................................. 82 Section 20 Subsidiaries ....................................................................................................................... 82 National Bank Operating Subsidiaries ............................................................................................... 88 References .......................................................................................................................................... 88 Municipal Securities Activities ........................................................................................................... 88 References ........................................................................................................................................ 102 Government Securities Act ............................................................................................................... 102 References ........................................................................................................................................ 112

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74 The Securities Regulatory Handbook Introduction The passage of GLBA fundamentally changed how banking entities underwrite and deal in securities. GLBA eliminated both the prior restrictions on affiliations between commercial and investment banks and many of the prudential limitations governing the activities of a subsidiary engaged in underwriting and dealing. This chapter outlines the dealing activities that may occur in a bank without being “pushed out” of the bank to a registered brokerdealer, introduces the financial holding company, introduces the financial subsidiary, and discusses the impact that these new entities have on Section 20 securities subsidiaries and national bank operating subsidiaries. Underwriting and Dealing Underwriting A bank is engaged in underwriting when it agrees with the issuer of securities to distribute those securities to the public. There are two different types of underwriting: “firm commitment” and “best efforts.” A “firm commitment” underwriter agrees to purchase the securities of an issuer and subsequently distribute the securities to the public. A “best efforts” underwriter agrees, for a fee, to act as an agent for the issuer in distributing the securities to the public but does not purchase the securities as a principal. Dealing A dealer in securities is a party that continuously holds itself out to the public as willing to buy or sell that particular security at any given time. Trading Versus Dealing The terms “trading” and “dealing” often are used synonymously when referring to bank securities activities. However, there are regulatory interpretations that distinguish trading from dealing that would, under certain circumstances, permit a bank to trade investment securities in which the bank could not “deal.” Trading activity is limited to “investment securities” and conducted with the bank’s own investment and liquidity objectives in mind. Generally, as long as a bank does not maintain an inventory from which it regularly quotes prices to third parties, hold itself out as a dealer, engage in trading for the benefit of customers, or engage in “market making,” the bank’s activities are not considered “dealing.”

Underwriting and Dealing 75 Dealing Activities That May Occur in a Bank Prior to the passage of GLBA, the Securities Exchange Act of 1934 exempted banks, and all permissible bank securities activities, from its registration requirements. GLBA significantly limits that exemption. Unless it registers with the SEC as a broker-dealer, a bank now may engage in only certain of the securities activities (“exempt activities”) that it traditionally may have conducted. A bank must move, or “push out,” its nonexempt securities activities into a registered broker-dealer affiliate or subsidiary. Banks may deal in the following without pushing them out to a registered broker-dealer: • Commercial paper and commercial bills; • U.S. and qualifying Canadian government and agency securities; • Brady bonds; • Mortgage- and consumer-related asset-backed securities that are: — Predominantly originated by the bank, a nonbroker-dealer affiliate or syndicate of which the bank is a member; and — Issued through a special purpose vehicle; • For well-capitalized banks, all types of municipal securities including municipal revenue bonds; and • “Identified banking products” including: — Deposit accounts, certificates of deposit, etc.; — Bankers’ acceptances; — Letters of credit or bank loans; — Debit accounts at banks arising from credit card arrangements; — Loan participations (that the bank or an affiliate funds, participates in, or owns) sold to qualified investors or informed and sophisticated investors; and

76 The Securities Regulatory Handbook — Swap agreements, except that equity swaps must be sold directly to sophisticated investors. The final sections of this chapter outline the laws, regulations, and selfregulatory organization rules that apply to bank municipal securities dealers and government securities dealers. Private Placements A “private placement” involves the placement of new issues of securities with a limited number of sophisticated purchasers in a nonpublic offering. Securities that are placed privately are not subject to the registration requirements of the Securities Act of 1933, and are offered only to financially sophisticated institutions and individuals and not to the general public. GLBA permits banks to place privately government and municipal securities without pushing those activities out to a registered broker-dealer. For other securities, GLBA prohibits banks from engaging in private placement activity, if: • The bank is affiliated with a broker-dealer on November 12, 2000; or • The aggregate amount of any offering exceeds 25 percent of the bank’s capital. GLBA created a new securities license for private placement personnel forced to move out of the bank and into a broker-dealer. Bank personnel automatically qualify for this license if they have been engaging in private placement activities for the six months preceding GLBA’s enactment. Financial Holding Companies (FHCs) Prior to the passage of GLBA, Section 20 of Glass-Steagall prohibited a member bank from affiliating with any firm “engaged principally” in securities underwriting and dealing activities. The FRB ruled that bank holding companies could underwrite and deal in certain “bank ineligible” securities through Section 20 subsidiaries subject to certain restrictions without being “engaged principally” in securities underwriting and dealing. Under these restrictions, bank-affiliated securities firms could not derive more than 25 percent of their gross revenue from underwriting and dealing activities.

Underwriting and Dealing 77 GLBA expands the options available for banking entities to engage in underwriting and dealing activities by creating the financial holding company (FHC). Securities subsidiaries of FHCs do not face the revenue constraints of Section 20s and must abide by only an abbreviated version of the Operating Standards and certain prudential limitations. A firm must meet certain requirements to become an FHC. Existing domestic BHCs and foreign BHCs (that have only a bank subsidiary in the United States but do not have a U.S. branch or agency) can become an FHC by filing a declaration with the FRB in which the institution certifies that: • All of its insured depository institutions: — Are “well capitalized” (i.e., a depository institution must have a Tier I risk-based capital ratio of at least 6 percent, a total risk-based capital ratio of at least 10 percent, a leverage ratio of 5 percent or greater, and not be subject to any agency enforcement action); — Are “well managed” (i.e., a depository institution must have a satisfactory composite rating and a satisfactory management and compliance rating); and — Received at least a satisfactory CRA rating in their most recent examination. This designation allows the FHC to own and control, among other various entities, firms engaged in “financial activities.” “Financial activities” include securities underwriting and dealing and merchant banking activities. Once the BHC files its declaration with the FRB to become an FHC, it also needs to file an additional notice with the FRB declaring its intent to create a subsidiary or expand the activities of an existing subsidiary to include the securities activities permitted by GLBA. This notice must be filed no later than 30 days after commencing those activities. Applicability of Operating Standards to FHC Subsidiaries GLBA’s implementing regulations clarify the applicability of the FRB’s Section 20 Operating Standards to financial subsidiaries of FHCs. These subsidiaries:

78 The Securities Regulatory Handbook • May conduct underwriting and dealing activities without regard to the 25 percent revenue limit imposed on Section 20 subsidiaries; • May conduct dealing activities without regard to the 5 percent ownership limit contained in the Bank Holding Company Act regarding ownership of voting securities; • Must comply with the following two Operating Standards: — Operating Standard #5—Intra-day credit extensions to a securities affiliate by an affiliated bank or U.S. branch or agency of a foreign bank must meet the arm’s length standards of Federal Reserve Act 23B; and — Operating Standard #8—Sections 23A and 23B limitations continue to apply to “covered transactions” between a U.S. branch or agency of a foreign bank and its securities affiliate; • Are not required to file the FR Y-20 Report; • Are not required to seek prior approval to engage in securities activities; and • Are not subject to infrastructure reviews by the FRB before the FHC acquires a securities firm. However, the FRB examines the risk management systems and internal controls of the FHC after the affiliation between a securities firm and FHC is complete. Financial Subsidiaries of National and State Member Banks GLBA created an additional legal entity that may engage in expanded financial activities, the “financial subsidiary.” National banks and state member banks can use this subsidiary as an alternative to the FHC structure. Financial subsidiaries of national and state member banks may engage in activities that are “financial in nature or incidental to a financial activity.” These activities include underwriting, dealing, and market making activities. GLBA prohibits financial subsidiaries from engaging in merchant banking activities for five years.

Underwriting and Dealing 79 This section outlines the conditions that national and state member banks must meet to own or control a financial subsidiary, the financial activities that financial subsidiaries may pursue, and the operating conditions that national and state member banks that own financial subsidiaries must follow. These conditions, activities, and operating conditions are generally similar. However, the OCC’s notification procedures for national banks to engage in activities permitted by GLBA through a financial subsidiary differ from the FRB’s procedures for state member banks. Bank Qualifications A national or state member bank may control, hold an interest in a financial subsidiary, or expand the financial activities of an existing subsidiary if: • The bank and each of its depository institution affiliates are well capitalized and well managed; • The total assets of all of the bank’s financial subsidiaries may not exceed 45 percent of the bank’s consolidated total assets or $50 billion (indexed for inflation), whichever is smaller; • The bank must be able to issue subordinated long-term debt rated in one of the three highest categories by an independent rating agency, if it is one of the 50 largest U.S. banks; • The bank must either have issued highly rated subordinated debt or conform to other criteria established jointly by the FRB and the Treasury Department, if it is one of the second 50 largest U.S banks; and • The bank and its insured depository institution affiliates have a “satisfactory” CRA rating. Notice Like an FHC, a national and state member bank must file a notice with the appropriate regulatory agency that the bank intends to acquire control of, or an interest in, a financial subsidiary. National banks have alternatives when submitting notice to the OCC. The first alternative allows a bank to submit a “Financial Subsidiary Certification.” This certification lists the national bank’s depository institution affiliates, and certifies that the bank and each of those affiliates are “well capitalized”

80 The Securities Regulatory Handbook and “well managed.” When the bank later acquires interest or control in a new financial subsidiary or expands the activities of an existing financial subsidiary, it files a “Financial Subsidiary Notice.” This notice must: • Confirm the continued validity of the Financial Subsidiary Certification; • Describe the activities the financial subsidiary will perform and cite the authority that permits those activities; • Confirm that the aggregate consolidated total assets of the financial subsidiaries do not exceed the lesser of 45 percent of the bank’s total assets or $50 billion; • Confirm that the bank will remain well capitalized after necessary adjustments; and • Confirm that the bank meets the eligible debt requirement, if applicable. Under the second alternative, a national bank may file a combined “Financial Subsidiary Certification and Notice” with the appropriate OCC district office at least five business days prior to acquiring control of, or an interest in, a financial subsidiary or commencing a new expanded financial activity in an existing financial subsidiary. A state member bank may not acquire control, or an interest in, a financial subsidiary unless it files a notice with the appropriate Reserve Bank. Further, a state member bank cannot expand the activities of an existing financial subsidiary without notifying the appropriate Reserve Bank. Either of these notices must: • Describe the transaction in which the bank intends to acquire control, or an interest in, the financial subsidiary (if applicable); • Provide the name and head office address of the subsidiary; • Provide a description of the current and proposed activities of the financial subsidiary and the specific authority permitting each activity; • Certify that the bank and each of its depository institution affiliates were well capitalized at the close of the previous calendar quarter and remain well capitalized as of the date the bank files its notice;

Underwriting and Dealing 81 • Certify that the bank and each of its depository institution affiliates are well managed as of the date the bank files its notice; • Certify that the bank meets the debt rating or, if the bank is one of the second 50 largest insured banks, that the bank satisfies any alternative criteria established by the FRB and the Secretary of the Treasury; and • Certify that the bank and its financial subsidiaries comply with the asset limits for controlling, or holding an interest in, a financial subsidiary before submitting the notice and on a pro forma basis. This notice is deemed to be approved 15 days after receipt by the appropriate Reserve Bank unless the state member bank receives prior notice of an approval. Requirements and Restrictions National and state member banks with financial subsidiaries are subject to the following requirements. The bank must: • Deduct its outstanding aggregate equity investment, including retained earnings, in all financial subsidiaries from its total assets and tangible equity; • Deduct this investment from its total risk-based capital; • Not consolidate the financial subsidiary’s assets with its assets; • In addition to providing information prepared in accordance with GAAP, separately present the financial information for the bank reflecting the capital deduction discussed above; • Establish financial and operational risk management procedures within the bank and the financial subsidiary; • Establish reasonable policies and procedures to preserve the separate corporate identity and limited liability of the state member bank and its financial subsidiaries; and • Comply with certain affiliate transaction limitations contained in Federal Reserve Act Sections 23A and 23B.

82 The Securities Regulatory Handbook State Nonmember Bank Subsidiaries Prior to the passage of GLBA, subsidiaries of state nonmember banks could underwrite and deal in securities that were not permitted for subsidiaries of national banks subject to certain qualification requirements and operating restrictions. GLBA removed the restrictions on underwriting and dealing that applied to financial subsidiaries of national banks, thereby eliminating the utility of this exemption for state nonmember banks. GLBA allowed subsidiaries operating under this exemption to continue doing so subject to operating restrictions that existed prior to the passage of GLBA. However, any future expanded underwriting and dealing activities or acquisitions of firms engaged in these activities by a state nonmember bank must occur in a financial subsidiary. Qualifications A state nonmember bank may control or hold an interest in a subsidiary that engages in securities underwriting and dealing and market-making activities if: • The state bank and each of its insured depository institution affiliates are well capitalized after making the capital deduction required for national banks (discussed above); • The state bank complies with the capital deduction and financial statement disclosure requirements applicable to national banks; • The state bank complies with the financial and operational safeguards applicable to national banks and their financial subsidiaries; • The state bank and its financial subsidiary comply with the affiliate transactions restrictions applicable to national banks and their financial subsidiaries; and • The state bank and its insured depository institution affiliates must have a “satisfactory” CRA rating. Section 20 Subsidiaries While GLBA has permitted FHCs to engage in virtually unlimited securities activities, some BHCs and foreign banks cannot meet the qualification requirements for becoming an FHC. These banking organizations may underwrite and deal in eligible securities only through a so-called Section 20 subsidiary.

Underwriting and Dealing 83 Prior to its repeal by GLBA, Section 20 of the Glass-Steagall Act prohibited the affiliation of a Federal Reserve member bank with a company “engaged principally” in underwriting or dealing in securities. The FRB permitted bank holding companies to engage, through separate subsidiaries (“Section 20 subsidiaries”), in underwriting and dealing in securities that a bank may not underwrite and deal in directly (“ineligible securities”). The FRB limited the amount of revenue that a Section 20 subsidiary may derive from ineligible securities activities to 25 percent of the subsidiary’s total revenue. Section 20 subsidiaries must determine their percentage of ineligible securities revenues using a two-year (eight-quarter) rolling average of current revenue levels. In 1987 the FRB authorized several bank holding companies to underwrite and deal in the following ineligible securities (“Tier I powers”): • Municipal revenue bonds that are rated as investment quality (i.e., in one of the top four categories) by a nationally recognized rating agency, except that industrial development bonds in these categories are limited to “public ownership” industrial development bonds; • Mortgage-related securities (obligations secured by or representing an interest in one- to four-family residential real estate) rated as investment quality (i.e., in one of the top four categories by a nationally recognized rating agency); • Commercial paper that is exempt from the registration and prospectus requirements of the SEC pursuant to the Securities Act of 1933 and that is short term, of “prime quality,” and issued in denominations no smaller than $100,000; and • Consumer receivable-related securities that are rated investment quality (added shortly after the 1987 order). In 1989, the FRB allowed five Section 20 subsidiaries to underwrite and deal in any type of corporate debt and equity securities (“Tier II powers”). Prior to approving Tier II powers, the FRB required that a Section 20 subsidiary possess the operational and managerial infrastructure necessary to prevent securities underwriting and dealing risks from being passed from a Section 20 subsidiary to an affiliated insured depository institution. In 1997, the FRB promulgated “operating standards” to govern the activities of Section 20 subsidiaries. In addition to the “Operating Standards” discussed below, the FRB

84 The Securities Regulatory Handbook expected all Section 20 subsidiaries to comply with all of the financial reporting, antifraud, and financial responsibility rules applicable to any other broker-dealer. Moreover, the FRB required that any transactions between a Section 20 subsidiary and its insured depository affiliates will comply with Sections 23A and 23B of the Federal Reserve Act. Finally, the FRB expected the Section 20 subsidiaries to be operated in a prudent manner––such operation would include observing corporate formalities, such as maintaining separate accounting and corporate records, and instituting appropriate risk management. Operating Standards Effective October 27, 1997, the FRB replaced a series of prior restrictions (known as “firewalls”) on Section 20 subsidiaries with eight operating standards. The “Operating Standards” apply equally to both Tier I and Tier II Section 20 subsidiaries. Operating Standard #1: Capital A BHC operating a Section 20 subsidiary must maintain an adequate capital level on a fully consolidated basis; and a BHC operating a Section 20 subsidiary with Tier II powers must maintain a “strong” capital level. In the event that a bank which is affiliated with a Section 20 subsidiary becomes less than well capitalized, the Board may reimpose funding, credit extension, and credit enhancement “firewalls,” or the Board may order the bank holding company to divest of the Section 20 subsidiary. Foreign banking organizations that operate Section 20 subsidiaries must also maintain strong capital levels—above the minimum levels required by the Basel Capital Accord. Operating Standard #2: Internal Controls All banks, including U.S. branches and agencies of foreign banks, must adopt policies and procedures, including appropriate exposure limits, that govern their participation in transactions underwritten or arranged by their Section 20 affiliate. Additionally, when participating in a transaction underwritten or arranged by their affiliated Section 20 subsidiary, banks must ensure that an independent and thorough credit evaluation is performed. This credit evaluation must be adequately documented for evaluation by regulatory examiners.

Underwriting and Dealing 85 Operating Standard #3: Interlocks Restrictions Directors, officers, or employees of a Section 20 subsidiary must not constitute a majority of the board of directors, or serve as the chief executive officer, of an affiliated bank or thrift subsidiary, or of a U.S. branch or agency of a foreign bank. Additionally, Operating Standard #3 prohibits the directors, officers, or employees of a bank or thrift or a U.S. branch or agency of a foreign bank operating in the United States from serving as a majority of the board of directors or the chief executive officer of an affiliated Section 20 subsidiary. However, the manager of a branch or agency of a foreign bank may act as a director of the Section 20. In determining whether a foreign banking organization and its affiliate Section 20 are complying with Operating Standard #3, the manager of a branch or agency is considered to be the chief executive officer of the branch or agency. Operating Standard #4: Customer Disclosure Section 20 subsidiaries must provide retail customers with the same written and oral disclosures, and obtain the same customer acknowledgment, as required of banks by the Interagency Statement on Retail Sales of Nondeposit Investment Products. As part of making the customer disclosures, the Section 20 subsidiary must inform the customer that the purchased security: • Is not insured by the FDIC; • Is not a deposit or other obligation of, or guaranteed by, the depository institution; and • Is subject to investment risks, including possible loss of the principal amount invested. These minimum disclosures should be provided to the customer: • Orally during any sales presentation; • Orally when investment advice concerning nondeposit investment products is provided;

86 The Securities Regulatory Handbook • Orally and in writing prior to or at the time an investment account is opened to purchase these products; and • In advertisements and other promotional materials, as described below. Section 20 subsidiaries are also required to obtain a statement, signed by the customer, at the time an account is opened which acknowledges that the customer has received and understands the disclosures. For investment accounts established prior to the Operating Standard #4 requirements, the Section 20 subsidiary should consider obtaining such a signed statement at the time of the next transaction. For the purposes of Operating Standard #4, a retail customer is any customer who is not considered an “accredited investor” under securities laws. Operating Standard #4 also requires certain disclosures to be made when a director, officer, or employee of a bank, thrift, or U.S. branch or agency of a foreign bank provides investment advice about certain securities. Specifically, if the director, officer, or employee expresses an opinion on the value or advisability of purchasing or selling an ineligible security that he or she knows is being underwritten by the affiliated Section 20 subsidiary, the individual must notify the customer of the role of the Section 20. Operating Standard #5: Intra-day Credit Any intra-day extension of credit to a Section 20 subsidiary by an affiliated bank must be on market terms consistent with Section 23B of the Federal Reserve Act. Operating Standard #6: Restriction on Funding Purchases of Securities During the Underwriting Period Banks may not knowingly provide funding to a customer to purchase, or secure, ineligible securities that an affiliated Section 20 subsidiary is underwriting or has underwritten within the last 30 days, unless one of the following conditions is met. First, the funding may be made pursuant to, and consistent with any conditions imposed on, a preexisting line of credit. The preexisting line of credit cannot be one that was established in contemplation of the underwriting. Second, funding may also be provided in connection with clearing transactions for the Section 20 subsidiary.

Underwriting and Dealing 87 Operating Standard #7: Reporting Requirement Section 20 subsidiaries must file FOCUS and FR Y-20 reports with the appropriate Federal Reserve Bank. Both the FOCUS and the FR Y-20 reports should be filed on a quarterly basis with the applicable Reserve Bank. Additionally, if a Section 20 subsidiary is required to file an early warning notification with the SEC concerning its capitalization as required by 17 CFR 240.17a-11, the Section 20 subsidiary should also file the notification with the appropriate Federal Reserve Bank. Operating Standard #8: Foreign Banks Operating Standard #8 applies Sections 23A and 23B of the Federal Reserve Act to certain transactions between the U.S. branch or agency of a foreign bank and its Section 20 affiliate. In particular, foreign banks must ensure that any extensions of credit by their U.S. branches or agencies to a Section 20 affiliate conform with Sections 23A and 23B. Additionally, any principal or fiduciary purchases of securities by a U.S. branch or agency from a Section 20 affiliate in which the Section 20 subsidiary is the principal underwriter must conform with Section 23B. Finally, Operating Standard #8 applies Section 23B(c) to U.S. branches and agencies and requires that the branch or agency not suggest or advertise that they are responsible for the obligations of the Section 20 affiliate. Private Placements Private placement involves the placement of new issues of securities with a limited number of sophisticated purchasers in a nonpublic offering. A financial intermediary in a private placement transaction acts solely as an agent of the issuer in soliciting purchasers, and does not purchase the securities and attempt to resell them. Securities that are placed privately are not subject to the registration requirements of the Securities Act of 1933, and are offered only to financially sophisticated institutions and individuals and not to the public. Bank holding companies may engage in private placement activities; however, they must comply with certain conditions. First, the bank holding company’s private placement activities must be conducted in accordance with the Securities Act of 1933 and the rules of the SEC. Second, bank holding companies may not purchase for their own account securities that they are placing unless they have been approved for Section 20 powers and treat the resulting revenues as ineligible.

88 The Securities Regulatory Handbook National Bank Operating Subsidiaries GLBA did not eliminate national bank operating subsidiaries. National bank operating subsidiaries may continue to underwrite, deal, and make markets in bank-permissible securities and purchase and sell as principal asset-backed obligations. References Laws: Gramm-Leach-Bliley Act, P.L. 106-102, 113 Stat. 1338 (1999) Glass-Steagall Act, Section 20 (12 USC 377) 12 U.S.C. 1831w Regulations: 12 CFR 5 12 CFR 208.71 et seq. 12 CFR 225.200 Miscellaneous Supervisory Materials: Federal Reserve Press Release (August 22, 1997) Municipal Securities Activities Municipal Securities Rulemaking Board Regulations The Securities Acts Amendments of 1975 extended a comprehensive network of federal regulation to the municipal securities markets. Municipal securities brokers and dealers are required to register with the Securities and Exchange Commission (SEC). The act also created a separate, self-regulatory body— the Municipal Securities Rulemaking Board (MSRB)—to formulate working rules for the regulation of the municipal securities industry. The federal bank regulatory agencies are responsible for enforcing the MSRB rules as they apply to depository institutions. A bank or, at its option, a separately identifiable department “engaged in the business of buying and selling municipal securities” must register with the SEC as a municipal securities dealer. A copy of the registration Form MSD

Underwriting and Dealing 89 also must be filed with the appropriate bank regulatory agency. A bank that buys and sells municipal securities for its investment portfolio or in a fiduciary capacity generally is not considered a dealer. Under SEC guidelines, a bank must register if it is involved in: • Underwriting or participating in a syndicate or joint account for the purpose of purchasing securities; • Maintaining a trading account or carrying dealer inventory; or • Advertising or listing itself as a dealer in trade publications or otherwise holding itself out as a dealer to other dealers or investors. “Separately Identifiable Department” MSRB Rule G-1 defines a “separately identifiable department or division of a bank” as a unit, under the supervision of officers designated by the bank’s board of directors, responsible for municipal securities dealer activities, maintaining separate or separately extractable records, and performing any of the following: • Underwrites, trades, and/or sells municipal securities; • Offers financial advisory and consultant services for issuers in connection with the issuance of municipal securities; • Provides processing and clearing services for municipal securities; • Offers research and investment advice on municipal securities; • Communicates in other ways with public investors in municipal securities; or • Maintains records of the above described activities. Professional Qualification Standards MSRB Rules G-2 and G-3 prohibit transactions in municipal securities unless the dealer and all associated persons are properly qualified. These rules include minimum supervisory staffing requirements for dealers. A bank with 10 or fewer people in its municipal securities dealer operations must have at least one “municipal securities principal.” A municipal securities

90 The Securities Regulatory Handbook principal is an individual engaged in the management, direction, and supervision of municipal securities activities and in the training of municipal securities personnel. Banks with more than 10 people in their municipal securities dealer operations must have at least two municipal securities principals. A municipal securities representative is defined as a person engaged in a municipal securities dealer activity other than in a supervisory or clerical capacity. Generally, all municipal securities principals and representatives are required to pass a qualification examination. There are certain exceptions to that requirement based on prior qualification or history or experience in a field closely related to the municipal securities business. A person who ceases his or her association with a municipal securities broker or dealer for two or more years must take and pass an appropriate examination before again effecting transactions in municipal securities. An individual entering the municipal securities business must serve a 90-day apprenticeship before transacting such business with the public. There are some blanket disqualifications under statute, and persons or firms who are subject to restrictions because of regulatory disciplinary action also may be prohibited from transacting municipal securities business. Every bank or bank department registered as a municipal securities dealer must maintain a record identifying each associated person, the type of functions he or she performs, and whether he or she was exempt or has taken and passed a qualifying examination. Municipal securities dealers must obtain information on the identity, education, past employment, and disciplinary history of all associated persons. When an individual becomes associated with a municipal securities dealer, the dealer must verify that information by contacting each person who employed the individual during the preceding three years. The information must be corrected by the associated person if it becomes inaccurate or incomplete. Each bank dealer must file a Form MSD-4 with the appropriate bank regulatory agency for each municipal securities principal or municipal securities representative. The Form MSD-4 provides certain information on municipal securities principals or representatives prior to their association with the bank. If any such information becomes materially inaccurate or incomplete, the applicant must furnish the correct or missing information to the bank. The bank, within 10 days of receiving such information, must submit it to the appropriate bank regulatory agency. Within 30 days after an association ceases, bank management must prepare Form MSD-5 explaining the reason for the termination and file the form with the appropriate bank regulatory agency.

Underwriting and Dealing 91 MSRB Rule G-3 also outlines the continuing education requirements. This rule describes the timing requirements for the Regulatory Element of continuing education that apply to registered persons. “Registered persons” include anyone registered with the appropriate regulatory agency as a municipal securities representative, municipal securities principal, municipal securities sales principal, or financial and operations principal. The rule also describes the substantive and administrative requirements associated with the Firm Element. Only registered persons who have contact with customers in the conduct of sales must participate in the Firm Element training. Recordkeeping Rules MSRB Rule G-8 describes the records to be maintained by each registered municipal securities dealer for all municipal security transactions. Among the records required are the following: • “Blotters,” journals, or other records of original entry containing an itemized daily record of all purchases, sales, receipts, and deliveries of municipal securities; all receipts and disbursements of cash; and all other debits and credits pertaining to municipal securities transactions; • Account records for each customer account; • Securities records, showing all positions in each municipal security held for the bank’s own account; • A memorandum of each agency order and accompanying instructions, and terms; • A memorandum of each principal transaction in municipal securities, showing the price, date, and time of execution; • Records of all put options and repurchase agreements with respect to municipal securities; • Records on each syndicate or similar account formed for the purchase of municipal securities must be maintained by a managing underwriter designated by those accounts; • A copy of all confirmations of purchase and sale, notices of debits and credits, cash, and other items;

92 The Securities Regulatory Handbook • Customer account information, consisting of a record of each customer’s name and address, whether he or she is of legal age, tax identification or social security number, occupation, and name and address of employer; • Customer information required by Rule G-19 such as financial background, tax status, investment objectives, or other information used or necessary when making recommendations to a customer; • A record of delivery of required disclosures to purchasers of new issue municipal securities; • Records of all written customer complaints and notations of the bank’s actions concerning those grievances; • Records concerning political contributions and prohibitions on municipal securities business pursuant to Rule G-37, including the Forms G-37/G-38 submitted to the MSRB along with the certified or registered mail receipt or other record of sending the forms to the MSRB; • Records of any gifts and gratuities permissible under Rule G-20; • Records concerning the use of consultants including a copy of the Consultant Agreement required by Rule G-38; and • A centralized list of persons who do not wish to receive telephone solicitations. Rule G-8 does not require bank dealers to maintain records in a specific manner. Required information may be set forth on a single record or a group of secondary records provided that it is reflected clearly and accurately and is sufficient for audit or examination purposes. For example, account records may be kept in several different formats to satisfy the requirements, such as separate ledgers for each customer or copies of confirmations and other source documents filed by customer name. In either case, the required information must appear. Groups of secondary records must be available for immediate inspection by examiners and to facilitate proper internal supervisory control to be effective for examination purposes. Under Rule G-8, a bank lacking securities clearance services does not have to maintain required records provided that they are kept by the person performing those services. However, if the bank’s clearing agent is not a clearing broker or dealer (registered broker or dealer), the bank must ensure that the

Underwriting and Dealing 93 records are maintained and preserved correctly. MSRB Rule G-9 lists various time frames for preservation of required municipal security records. Records must be maintained in an easily accessible place for at least two years and thereafter be available to bank examiners within a reasonable period of time. They may be retained in any manner, provided the bank has adequate facilities for retrieval and for production of readable copies. Underwriting Syndicates MSRB Rule G-11 addresses the operation of underwriting syndicates. Every bank dealer submitting an order to a syndicate to purchase securities must disclose if the order is being submitted for the dealer’s own account or for the account of related municipal securities portfolios (i.e., bank-owned or affiliated bank portfolios or trust portfolios). Every bank dealer submitting a group order (an order for the account of all syndicate members on a pro rata basis according to each member’s interest in the syndicate) must disclose the identity of the person for whom the order is submitted. Every bank dealer functioning as the senior manager of a syndicate must disclose, in writing: • The identity of each related portfolio for which an order was submitted, including the par amounts and maturities so allocated; • The identity of each person submitting a group order to which securities have been allocated; and • A summary of the allocation of securities to other orders, including any order confirmed at a price other than the original list price that indicates par value and maturity. Every syndicate must establish the priority of different types of orders for purchase of syndicate securities, whether this priority can be changed, and the procedures for doing so. Prior to offering securities, the syndicate manager must, in writing, communicate to syndicate members: • The terms and conditions required by the issuer; • The priority of orders; • Procedures for changing order priority;

94 The Securities Regulatory Handbook • That the manager is permitted to allocate securities on a case-by-case basis; and • Whether orders may be confirmed prior to the end of the period during which orders are being solicited. Any changes in procedures governing the priority of various types of orders have to be communicated promptly in writing by the syndicate manager to members. At or before final settlement of the syndicate, the senior manager must furnish members with an itemized statement setting forth the nature and amount of expenses incurred for the syndicate. Uniform Processing, Clearance, and Settlement Practices Rule G-12 establishes uniform industry practices for the processing, clearance, and settlement of transactions in municipal securities between brokers and dealers. The rule does not apply to transactions with customers. Provisions of the rule cover: • Uniform settlement dates; • Dealer-to-dealer confirmation procedures and content; • Reporting and resolving unrecognized transactions; • Acceptable methods of delivery and payment; • Use of automated comparison, clearance, and settlement systems; • Procedures for rejections and reclamations; • Close-out procedures; and • Time periods for the return of good faith deposits and the settlement of syndicate accounts. Sections of the rule addressing dealer confirmations, the return of good faith deposits, the settlement of syndicate accounts, and the distribution of credits on designated orders must be observed as written. Other requirements may be altered by mutual agreement between a buyer and seller.

Underwriting and Dealing 95 Quotations and Reports of Sales and Purchases MSRB Rule G-13 applies to all municipal securities quotations disseminated by or on behalf of a bank dealer. For purposes of the rule, the term “quotations” means any bid for and offer of municipal securities, or any requests for bids for or offers of municipal securities. The rule prohibits a bank municipal securities dealer from disseminating quotations unless the bank is prepared to buy or sell securities according to stated conditions. Nominal quotations given merely as an indication of price, and solely for informational purposes, must be clearly identified as nominal quotations when given. No bank dealer may issue any quotation unless, in the dealer’s best judgment, it represents the fair market value for the securities. MSRB Rule G-14 provides that a bank dealer may only disseminate a report of purchases and sales of municipal securities if it believes that a purchase or sale actually occurred. Rule G-14 also requires that a dealer report to the MSRB all transactions in municipal securities, unless the transaction is not eligible to be reported. Customer Confirmations Confirmations must be sent or given to customers at or before completion of a transaction in municipal securities. The timing and content of those confirmations are governed by MSRB Rule G-15. Customer confirmations must contain: • All of the information required to be disclosed on dealer confirmations except concession data; • The time of execution of a trade or a statement that the time will be furnished upon written request of the customer; • Disclosure of capacity as principal or as agent for the customer, or for a person other than the customer, or for both the customer and another person; and • For transactions effected on the basis of dollar price, both the dollar price and the lowest of the resulting yield to premium call, par option, or maturity.

96 The Securities Regulatory Handbook Customer confirmations of agency transactions must disclose: • The amount and source of any commission, fee, or other remuneration received or to be received by a bank dealer. If any remuneration is received from a party other than the customer, then as an alternative the dealer may note on the confirmation that such remuneration has been or will be received and that the source of such remuneration is available upon written request by the customer; and • The name of the counterparty or a statement that the information will be furnished upon request. Requests for information required to be disclosed by G-15 must be responded to within five business days of receipt of a request. When a transaction takes place 30 days prior to receipt of a request, a response must be made within 15 business days. Standards of Fair Practice MSRB Rule G-17 requires bank dealers to deal fairly with all persons and not engage in any deceptive, dishonest, or unfair practices. MSRB Rule G-18, “Execution of Transactions,” requires bank dealers executing transactions as agent for a customer to make a reasonable effort to obtain a price that is fair and reasonable relative to the prevailing market for all customers. The rule also pertains to a bank dealer acting in a “broker’s broker” capacity (i.e., effecting transactions for other brokers or dealers on a regular basis). The capacity in which a bank dealer acts is determined by instructions from the customer. If the customer intends the bank dealer to buy (or sell) a security for the customer without the bank dealer actually being the seller (or buyer), the bank would be the customer’s agent. A practice has developed among some bank dealers to consider the bank’s capacity as agent for the customer in all securities transactions that are ineligible for a bank dealer to deal in as principal, and to consider the bank’s capacity as principal in all transactions in eligible securities. This is an improper practice and will be criticized by bank examiners. The fairness and reasonableness of a price may be determined by comparing trade prices to independently established market prices. Independent market prices often may be observed merely by looking at the other side of a “riskless” principal sale or by noting the prices of contemporaneous principal sales of the same security. If independent price quotes cannot be obtained, trade value should be tested by comparative yield analysis. Reasonable mark-ups and/or fees on “riskless” principal or agent sales of securities purchased from dealers

Underwriting and Dealing 97 seldom exceed the amount of dealer concession. For “riskless” principal sales of securities purchased from a customer, a reasonable markup seldom exceeds 2 percent and rarely exceeds 4 percent of the market value of the security. MSRB Rule G-19, “Suitability of Recommendations and Transactions: Discretionary Accounts,” requires that the bank dealer have all the basic customer information required by MSRB Rule G-8(a)(xi) before completing a municipal securities transaction for a customer. When recommending a municipal securities transaction, a bank dealer must also make reasonable efforts to obtain information concerning: • The customer’s financial status; • The customer’s tax status; • The customer’s investment objective; and • Other information considered reasonable and necessary in making recommendations to the customer. A municipal securities dealer cannot recommend a municipal securities transaction unless it has reasonable grounds, based upon the information available from the issuer and the facts disclosed by the customer, to believe that the transaction is suitable. Customer suitability information specified in MSRB Rule G-19 is required to be maintained in written form. Discretionary accounts offered to customers in municipal securities must have prior written authorization of the customer and must be accepted in writing by a municipal securities principal. All discretionary account transactions must meet suitability standards for the customer unless specifically authorized by the customer. Churning is defined as the practice of effecting transactions that are excessive in size and frequency in view of the information known about the customer. Churning an account is prohibited. All gifts and gratuities incidental to the bank’s dealer activities are subject to MSRB Rule G-20. Generally, they are considered as gifts given in the normal course of business dealings (meals, theater tickets, etc.) limited to approximately $100 annually to any one person.

98 The Securities Regulatory Handbook Advertising MSRB Rule G-21 defines “advertisement” as any material (other than listings of offerings) published or designed for use in the public media or any promotional literature designed for dissemination to the public, including any notice, circular, report, market letter, form letter, or reprint or excerpt of the foregoing. The term does not apply to preliminary official statements or official statements, but does pertain to abstracts or summaries of official statements, offering circulars, and other such similar documents prepared by municipal securities brokers or municipal securities dealers. The rule prohibits the bank from publishing or causing to be published any materially false or misleading advertisements concerning municipal securities or its facilities, services, or skills as a municipal securities dealer. All advertisements must be approved in writing by a municipal securities principal prior to first use, and each municipal securities dealer shall make and keep current in a separate file records of all such advertisements. Control Relationships MSRB Rule G-22 concerns municipal securities transactions in which a control relationship exists. A control relationship exists when a bank controls, is controlled by, or is under common control with the issuer of a security. For example, if a bank dealer also sat on the board of a debt-issuing school district, any transaction between the two would be subject to this rule. If such a relationship exists, the written disclosure of the relationship must be made before completing the transaction. Financial Advisers to Issuers MSRB Rule G-23 establishes ethical standards and disclosure requirements for bank dealers who act as financial advisers to issuers of municipal securities. A financial advisory relationship exists when a bank dealer renders or enters into an agreement to provide financial advisory or consultant services to an issuer for new issue municipal securities. The services are furnished by the financial adviser for a fee or other compensation (including deposits) and may include advice on the structure, timing, terms, etc., of new issue municipal securities. Conflicts of interest may exist in situations where a financial adviser also acts as underwriter, or placement agent, in bringing a new issue to market. Rule G-23 is designed to minimize conflicts of interest when a financial adviser, also acting as underwriter or placement agent, renders advice to an issuer on a new issue in such a manner as to benefit unduly the financial adviser/underwriter at the expense of the issuer.

Underwriting and Dealing 99 Other MSRB Rules MSRB Rule G-24, “Use of Ownership Information Obtained in Fiduciary or Agency Capacity,” prohibits the use of any nonpublic information to effect securities transactions. In that instance, a bank dealer acting in an agency capacity is forbidden to use any information obtained through this relationship without first obtaining written approval from the affected party. A prohibited data source would be the bank’s trust division. MSRB Rule G-25, “Improper Use of Assets,” forbids a bank dealer from using customer funds or securities in any way that would be detrimental to the customer’s best interest. Furthermore, the bank shall not guarantee any customer against loss or share in the profits or losses of municipal securities transactions. Put options and repurchase agreements are not guarantees if their terms are provided in writing to the customer with or on the confirmation of the transaction, and records are maintained in accordance with G-8. MSRB Rule G-26, “Customer Account Transfers,” establishes procedures for transferring a customer’s municipal securities account from one dealer to another. When the customer gives written notice of the transfer of municipal securities, both dealers must expedite and coordinate activities within the time frames specified in the rule. MSRB Rule G-27 specifies, in part, that a municipal securities dealer shall supervise the activities of its associated persons and its municipal securities business. At least one municipal securities principal must be designated as responsible for: • Enforcing the procedures specified in Rule G-27; • Maintaining and preserving the books and records; and • Supervising the activities of municipal securities dealers of each location in which an associated person engages in municipal securities activities. This rule also requires that the bank dealer establish, maintain, and enforce written supervisory procedures to assure compliance with all the MSRB rules and applicable provisions of securities laws, rules, and regulations. The written procedures must, at a minimum, provide for:

100 The Securities Regulatory Handbook • The designation of at least one qualified municipal securities principal as responsible for supervision; • The prompt review and written approval by the designated municipal securities principal of: — The opening of each municipal securities customer account; — Each transaction in municipal securities; — The handling of all written customer complaints; — All correspondence pertaining to the solicitation or execution of municipal securities; — Other matters required by rule to be reviewed or approved by a municipal securities principal; and • The prompt review and written approval of each municipal transaction effected for a discretionary account and the regular and frequent examination of customer accounts to detect and prevent irregularities and abuses. MSRB Rule G-28, “Transactions with Employees and Partners of Other Municipal Securities Professionals,” states that any municipal securities transactions between a bank and employees or partners of other dealers require that written notice be given to the employer of such customer at the time of opening of the account. This rule also requires that a duplicate copy of each transaction confirmation be sent to the customer’s employer. MSRB Rule G-29, “Availability of Board Rules,” says that a complete, up-to-date copy of the MSRB rules must be maintained in each office of the bank where dealer activities are performed. MSRB Rule G-30, “Prices and Commissions,” requires that all principal transactions and all transactions effected in an agency capacity be done at prices and commissions that are fair and reasonable relative to the fair market value of the securities at the time of the transaction. This rule does not require that the municipal securities dealer establish written price mark-up guidelines or “as agent” fee schedules. MSRB Rule G-31, “Reciprocal Dealings with Municipal Securities Investment Companies,” prohibits a municipal securities dealer from soliciting

Underwriting and Dealing 101 municipal securities transactions with or for an investment company as compensation for sales by that dealer of shares, units, or participations in that fund. MSRB Rule G-32, “Disclosures in Connection with New Issues,” states that in the sale of new issue securities, the bank must furnish all available information to the customer prior to sending final written confirmation. G-32 requires furnishing of: • A copy of the official statement, if received from the issuer; • Any fees received by the bank acting as agent for the issuer; • The underwriting spread; and • The initial offering price for each maturity in the issue. MSRB Rule G-33, “Calculations,” establishes the mathematical calculations for accrued interest, interest-bearing securities, and discounted securities. MSRB Rule G-34, “CUSIP Numbers and New Issue Requirements,” specifies that each municipal securities dealer who acquires a new issue security, either as principal or as agent, apply for and affix to the security a CUSIP number. MSRB Rule G-35, “Arbitration,” provides for the establishment of an arbitration board to hear any claim, dispute, or controversy arising out of a bank’s dealer activities. The arbitration committee consists of seven members appointed by the MSRB. MSRB Rule G-36, “Delivery of Official Statements,” requires that managing underwriters deliver to the Board copies of final official statements and Form G-36(OS) for most primary offerings of municipal securities if an official statement was prepared. SEC Rule 15c2-12 determines whether an official statement is required for a particular municipal offering. For those primary offerings subject to SEC Rule 15c2-12, Rule G-36 requires the official statements to be delivered to the Board within one business day after receipt of the final official statement from the issuer or its designated agent, but no later than 10 business days after any final agreement to purchase, offer, or sell the municipal securities. If official statements are prepared for primary offerings of municipal securities not within the scope of Rule 15c2-12, Rule G-36 requires that the official statement be sent to the Board within one business day

102 The Securities Regulatory Handbook of delivery of the securities by the issuer to the dealer; however, this requirement does not apply to limited placements that are exempt from Rule 15c2-12. MSRB Rule G-37, “Political Contributions and Prohibitions on Municipal Securities Business,” prohibits dealers from engaging in municipal securities business with an issuer within two years after any contribution to an official of such issuer made by: • The dealer; • Any municipal finance professional associated with such dealer; or • Any political action committee controlled by the dealer or any municipal finance professional. MSRB Rule G-38, “Consultants,” requires dealers who use consultants for the purpose of obtaining or retaining municipal securities business to evidence the consulting agreement in writing. Dealers must also make disclosures in writing on such consulting arrangements to any issuer with which it is doing business. Rule G-38 also requires dealers to submit to the Board, on a quarterly basis, reports of all consultants used by the dealer. MSRB Rule G-39, “Telemarketing,” imposes timing and disclosure requirements on bank dealers’ telephone calls to solicit municipal securities purchases or other related services. References Laws: 15 U.S.C. 78o-4 Rules: Municipal Securities Rulemaking Board Rules Government Securities Act Introduction Congress passed the Government Securities Act of 1986 (GSA) to address certain improper practices in the largely unregulated government securities

Underwriting and Dealing 103 market. The stated purpose of the GSA is to enhance the protection of investors in government securities by establishing and enforcing appropriate financial responsibility and custodial standards. The GSA applies to all financial institutions that engage in government securities activities, including state and federally licensed branches and agencies of foreign banks. For the purposes of the GSA, government securities include: • U.S. Treasury securities; • Securities issued or guaranteed by federal agencies such as the SBA; and • The securities of government-sponsored corporations such as GNMA, FNMA, FHLMC, SLMA, and the Farm Credit System. The definition of “government securities” also includes off-exchange options on these securities except when the term is used in conjunction with the rules on custodial holdings of government securities. The Treasury regulations issued under the GSA (17 CFR Chapter IV) subject government securities brokers and dealers to registration requirements and rules regarding financial responsibility, custodial holdings, recordkeeping, and reporting and auditing. Banks acting as government securities brokers and dealers are not subject to the financial responsibility or reporting and auditing sections of the Treasury’s rules. Banks also may be exempt from other requirements of the regulations if they meet certain conditions. In 1997, the Federal Reserve Board, the OCC, and the FDIC adopted rules regarding transactions in government securities by depository institutions. The agencies adopted the rules to provide consistent treatment for customers of both bank and nonbank dealers and brokers in government securities. The rules are substantially identical to the NASD Business Conduct and Suitability Rules and the NASD Suitability Interpretation that apply to nonbank brokers and dealers in government securities. Broker-Dealer Registration Requirements Banks that are government securities brokers or dealers are required to notify their primary federal regulator on Form G-FIN. A government securities broker includes any bank that is engaged regularly in the business of effecting transactions in government securities for the accounts of others.

104 The Securities Regulatory Handbook A government securities dealer includes any bank engaged in the business of buying and selling government securities for its own account, other than in a fiduciary capacity, through a broker or otherwise. The G-FIN details the bank’s capacity, the locations where government securities activities are performed, and the persons responsible for supervision. The bank also is responsible for filing a Form G-FIN-4, which provides personal history on parties associated with the government securities broker-dealer. If a current MSD-4, which is required by the MSRB rules for municipal securities dealers, or a Form U-4, which is required by SEC-registered broker-dealers, is already on file for a person, the Form G-FIN-4 need not be filed. Once a bank has filed notice of its status as a government securities broker or dealer, any changes to the status of its filing must be reported within 30 days. If a bank ceases its government securities activities, it must file a notice of termination using Form G-FIN-W. If an associated person is terminated from the bank, a Form G-FIN-5 must be filed within 30 days. Exemptions Banks engaged in the following government securities activities are not subject to the registration and recordkeeping requirements of the GSA regulations: • Banks purchasing government securities strictly for investment purposes; • Banks selling or purchasing government securities in a fiduciary capacity (the bank still will be subject to custodial holdings requirements); • Banks selling and purchasing government securities in connection with a repurchase or reverse repurchase agreement (the bank still will be required to comply with the GSA regulations regarding hold-in-custody repurchase agreements); • Banks that submit tenders or subscriptions for purchase on original issues of U.S. Treasury securities for the account of customers on a fully disclosed basis and whose transactions in government securities are otherwise limited to transactions not subjecting the bank to the registration requirements; • Banks handling only U.S. savings bond transactions or submitting tender offers on original issue U.S. Treasury securities; • Banks effecting fewer than 500 government securities brokerage transactions annually, excluding savings bond transactions and Treasury tender offers (the bank still will be subject to custodial holdings requirements); and

Underwriting and Dealing 105 • Banks effecting transactions with a registered broker-dealer under a “networking” arrangement or effecting brokerage transactions that do not involve active solicitation, but only if they meet the following requirements (the bank still will be subject to custodial holdings requirements): — The transacting broker must be identified clearly; — Bank employees perform only clerical or ministerial duties and do not receive transaction-based compensation; and — The registered broker-dealer receives and maintains all required information for each customer. Branches and agencies of foreign banks relying on any of these exemptions from registration (except for the exemptions for savings bond transactions and tender offers on Treasury securities) must maintain a deposit account at an insured bank for customers’ credit balances. Branches and agencies of foreign banks also are exempt from the registration requirements if their activities are limited solely to engaging in government securities transactions for non-U.S. citizens that reside outside of the United States. If this exemption is relied on, the branch or agency will be required to comply with the requirements regarding custodial holdings. Recordkeeping Requirements All banks that are government securities brokers or dealers are subject to the recordkeeping requirements of the GSA regulations. These regulations impose specific SEC recordkeeping and confirmation requirements on government securities brokers and dealers with some slight modifications. They also impose SEC requirements regarding preservation of those records. A bank will not have to comply with the recordkeeping requirements of the GSA regulations if the following conditions are met: • The bank is subject to OCC, FRB, or FDIC regulations that place recordkeeping and confirmation requirements on banks effecting securities transactions for customers, and the bank complies with those requirements for government securities; • The bank complies with the recordkeeping aspect of the GSA regulations on custodial holdings (17 CFR Part 450);

106 The Securities Regulatory Handbook • The bank makes and keeps current a securities record or ledger (maintained for not less than six years, the first two years in an easily accessible place) that, as of the settlement date, reflects: — All “long” and “short” positions of each government security held in its own account or for the account of its customers; — The locations of all government securities “long”; — The offsetting position to all government securities “short”; — “Long” and “short” security count differences, classified by the date of the count and verification in which they were discovered, and in all cases the name or designation of the account in which each position is carried; and • The bank keeps copies of all G-FIN, G-FIN-W, G-FIN-4, and G-FIN-5 forms for at least three years after the incident triggering the notification requirement. Custodial Holding Requirements All banks that hold or safekeep U.S. government securities as fiduciary, custodian, or otherwise for the account of a customer must comply with requirements relating to the safeguarding and custody of those securities (17 CFR Part 450). These requirements apply when a bank holds the customer’s securities directly or maintains the customer’s securities through another institution. Treasury regulations require banks to observe the following requirements with respect to the custodial holding of securities for customers: • All government securities held for customers, including those subject to repurchase agreements with customers, must be segregated from the bank’s own assets and kept free from liens of any third parties; • A bank that holds securities for a customer through another institution (“custodian institution”) must notify the custodian institution that the securities are customer securities; • The custodian institution must maintain the customer securities in an account that is designated for customers of the bank;

Underwriting and Dealing 107 • The bank must notify the custodian institution that these securities are to remain free of any lien, charge, or claim in favor of the custodian or any persons attempting to make a claim through the custodian. The custodian institution, upon receiving such notice from the bank, is required to treat these securities as customer securities and maintain them in compliance with the Treasury’s GSA regulations; and • When holding customer securities for a bank, the custodian institution does not have to keep records that identify individual customers of the depository unless the custodian institution is acting directly on behalf of the customer, such as in a tripartite repurchase agreement transaction. When a bank maintains customer securities in an account at a Federal Reserve Bank, it is deemed to be in compliance with requirements to hold customer securities free of lien if any lien of the Federal Reserve Bank, or other party claiming through it, expressly excludes customer securities. The bank is not required to maintain customer securities in a separate custody account at the Federal Reserve Bank, although such segregation is encouraged. However, the bank must segregate the customers’ securities on its own records and observe the following recordkeeping requirements: • A bank safekeeping U.S. government securities for customers must issue to the customer a confirmation or safekeeping receipt for each government security held; • The confirmation or safekeeping receipt must identify the issuer, maturity date, par amount, and coupon rate of the security being confirmed; • A records system of government securities held for customers must be maintained separate and distinct from other records of the bank. These records must: — Identify each customer and each government security held for a customer; — Describe the customer’s interest in the security; and — Indicate all receipts and deliveries of securities and cash in connection with the securities; • A copy of the safekeeping receipt or confirmation given to customers must be maintained;

108 The Securities Regulatory Handbook • This recordkeeping system must provide an adequate basis for audit; • The required records must be maintained in an easily accessible place for at least two years and not disposed of for at least six years; • The bank providing customer safekeeping is required to conduct a count of physical securities and securities held in book-entry form at least annually; • In order to count securities held outside of the depository, such as book-entry securities held at a Federal Reserve Bank, the bank must reconcile its records with those of the outside custodian; • The bank responsible for the count must verify any securities in transfer, in transit, pledged, loaned, borrowed, deposited, failed to receive or deliver, or subject to a repurchase or reverse repurchase agreement when the securities have been out of the depository’s possession for longer than 30 days; and • The dates and results of the counts and reconcilements must be documented within seven days of the required count, with the differences in securities counts noted. The Treasury Department has determined that the rules and standards of the federal banking agencies governing the holding of government securities in a fiduciary capacity are adequate. The Treasury therefore has provided an exemption for banks with respect to their government securities held in a fiduciary capacity, and to those held in a custodial capacity, if (1) the bank has adopted policies and procedures that subject its custodial holdings to all the requirements imposed by its appropriate federal regulatory agency that are applicable to government securities held in a fiduciary capacity, and (2) such custodial holdings are subject to examination by the appropriate regulatory agency for compliance with these fiduciary requirements. Hold-in-Custody Repurchase Agreements All banks that retain custody of securities sold under an agreement to repurchase must also comply with the GSA regulations regarding hold-in-custody repurchase agreements (17 CFR 403.5(d)). For purposes of the GSA, a bank also is considered to be retaining custody of the repurchase agreement securities when the securities are maintained through an account at another institution (e.g., a correspondent bank or the local Federal Reserve Bank) and the securities continue to be under the control of the bank.

Underwriting and Dealing 109 The following requirements apply to all hold-in-custody repurchase agreements: • Hold-in-custody repurchase agreements must be transacted pursuant to a written repurchase agreement; • If the customer agrees to allow substitution of securities in a hold-in-custody repurchase transaction, then authority for the bank to substitute securities must be contained in the written repurchase agreement; and • Where the bank reserves the right to substitute securities, it is required to include the following specific disclosure statement in the repurchase agreement. The (seller) is not permitted to substitute other securities for those subject to this agreement and therefore must keep the (buyer’s) securities segregated at all times, unless in this agreement the (buyer) grants the (seller) the right to substitute other securities. If the (buyer) grants the right to substitute, this means that the (buyer’s) securities will likely be commingled with the (seller’s) own securities during the trading day. The (buyer) is advised that, during any trading day that the (buyer’s) securities are commingled with the (seller’s) securities, they may be subject to liens granted by the (seller) to third parties and may be used by the (seller) for deliveries on other securities transactions. Whenever the securities are commingled, the (seller’s) ability to resegregate substitute securities for the (buyer) will be subject to the (seller’s) ability to satisfy any lien or to obtain substitute securities. The statement must be displayed prominently in the written repurchase agreement immediately preceding the provision allowing the right to substitute. The regulation does not permit editing or paraphrasing of the required language, except for the substitution of other terms for the words “buyer” and “seller” (which are bracketed in the disclosure statement): • A bank issuing a hold-in-custody repurchase agreement must disclose to the customer in writing that the funds held pursuant to a repurchase agreement are not a deposit and therefore are not insured by the Federal Deposit Insurance Corporation; • Written confirmations describing the specific securities subject to the transaction must be sent to the customer by close of business on the day the transaction is initiated, as well as on any day during which there is a substitution of securities. Only the security involved in the last substitution of the day must be disclosed on the confirmation ticket; and

110 The Securities Regulatory Handbook • Confirmations must identify the specific securities by issuer, maturity, coupon, par amount, market value, and CUSIP or mortgage pool number of the underlying securities. The frequency or short duration of a particular type of transaction, such as an overnight repurchase agreement or a daily “sweep” of a customer’s deposits into a hold-in-custody repurchase transaction, does not eliminate the requirement for a financial institution to send a prompt and accurate confirmation to the customer. Pooling of securities as collateral for repurchase agreements is no longer permitted. “Blind pooled” hold-in-custody repurchase transactions occur when a seller does not deliver securities and does not identify specific securities as belonging to a specific customer. Instead, the bank sets aside or otherwise designates a pool of securities to collateralize its outstanding repurchase obligations. The regulations require that the written confirmation sent to a customer must identify the specific securities that are the subject of the hold-in-custody repurchase transaction. A specific security identified to a customer must be in an authorized denomination (i.e., in a deliverable par amount). The regulations do not require written agreements for repurchase transactions where the securities are delivered to the customer or to another depository acting pursuant to a tripartite agreement with the financial institution and the customer. Government Securities Sales Practices The federal banking agencies’ government securities sales practices require that a bank which is a government securities broker or dealer and its associated persons: • Observe high standards of commercial honor and just and equitable principles of trade in the conduct of its business as a government securities broker or dealer; and • Have reasonable grounds for believing that recommendations are suitable for a customer based on the facts, if any, disclosed by a customer regarding the customer’s other securities holdings and financial situation and needs. If a bank is doing business with a noninstitutional customer, the bank must make reasonable efforts to obtain information concerning the customer’s financial situation and tax status and investment objectives before executing a

Underwriting and Dealing 111 transaction it recommended to the customer. The suitability rule, like the Suitability Rule of the NASD, applies only in situations where a bank makes a “recommendation” to its customer. Also similar to the NASD’s guidance in the area of government securities sales is the banking agencies’ suitability interpretation, which identifies factors that may be relevant when evaluating a bank’s compliance with the suitability rule when dealing with an institutional customer other than a natural person. The interpretation identifies: (a) the customer’s capability to evaluate investment risk independently; and (b) the extent to which the customer is exercising independent judgment in evaluating a bank’s recommendation as the two most important considerations in determining the scope of the bank’s responsibilities to an institutional customer. A bank will have met the requirements of the suitability rule with respect to a particular institutional customer where the bank has reasonable grounds to determine that the institutional customer is capable of independently evaluating investment risk and is exercising independent judgment in evaluating a recommendation. The suitability interpretation also sets forth certain factors for banks to apply in evaluating an institutional customer’s capability to evaluate investment risk independently. These factors include: • The customer’s use of consultants, investment advisers, or bank trust departments; • The experience of the customer generally and with respect to the specific instrument; • The customer’s ability to understand the investment and to evaluate independently the effect of market developments on the investment; and • The complexity of the security involved. The interpretation stresses that an institutional customer’s ability to evaluate investment risk independently may vary depending on the particular type of instrument or its risk. Moreover, the interpretation notes that an institutional customer with general ability to evaluate investment risk may be less able to do so when dealing with new types of instruments or instruments with which the customer has little or no experience. The suitability interpretation further provides that a determination that an institutional customer is making an independent investment decision depends

112 The Securities Regulatory Handbook on factors such as the understanding between the bank and its customer as to the nature of their relationship; the presence or absence of a pattern of acceptance of the bank’s recommendations; the customer’s use of ideas, suggestions, and information obtained from other market professionals; and the extent to which the customer has provided the bank with information concerning the customer’s portfolio or investment objectives. While the suitability interpretation states that these factors will be considered relevant in evaluating whether a bank that is a government securities broker or dealer has fulfilled the requirements of the suitability rule with respect to any institutional customer that is not a natural person, it further states that the factors cited would be considered most relevant for an institutional customer with at least $10 million invested in securities in the aggregate in its portfolio or under management. References Laws: The Government Securities Act of 1986 (15 U.S.C. 78c(a)(42)) Regulations: 17 CFR 400 et seq. 12 CFR Part 13 12 CFR Parts 208 and 211 (Regulations H and K) 12 CFR Part 368

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VI. Merchant Banking Introduction ...................................................................................................................................... 114 Legal Authority Permitting Merchant Banking Activities ................................................................ 114 Merchant Banking Regulation .......................................................................................................... 115 References ........................................................................................................................................ 119

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114 The Securities Regulatory Handbook Introduction GLBA permits an FHC to make investments in nonfinancial companies as part of a bona fide securities underwriting or merchant or investment banking activity. The FHC may hold any type of ownership interest in a nonfinancial entity (portfolio company), and may own any amount of the equity of a portfolio company. Investments made under this authority are referred to as “merchant banking” activities. GLBA imposes various restrictions on merchant banking activities, including: • The length of time that these investments may be held; • The financial holding company’s ability to routinely manage or operate the portfolio company; and • Other aspects of the relationship between the FHC and its affiliates and the FHC and the portfolio company. This chapter outlines permissible merchant banking activities and the restrictions placed on those activities. Legal Authority Permitting Merchant Banking Activities Even before GLBA’s enactment in the fall of 1999, investing in the equity of nonfinancial companies and lending to private equity-financed companies had emerged as increasingly important sources of earnings and business relationships at a number of banking organizations. These investments and activities were conducted under various different legal authorities: • Under sections 4(c)(6) and 4(c)(7) of the Bank Holding Company Act (BHC Act), BHCs may invest in up to 5 percent of the outstanding voting shares of any one company and up to 25 percent of the total equity of a company, with no aggregate limits on the total dollar amount of equity investments held by the BHC. • Banking organizations can make equity investments through Small Business Investment Corporations (SBICs), which can be a subsidiary of a bank or BHC. Investments made by SBIC subsidiaries are allowed up to a total of 50 percent of a portfolio company’s outstanding shares, but can be made only in companies defined as a small business, according to SBIC rules. A

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bank’s aggregate investment in the stock of SBICs is limited to 5 percent of the bank’s capital and surplus. In the case of BHCs, the aggregate investment is limited to 5 percent of the BHC’s proportionate interest in the capital and surplus of its subsidiary banks. • Under Regulation K, which implements Sections 25 and 25A of the Federal Reserve Act and Section 4(c)(13) of the BHC Act, banking organizations may, with FRB approval, make portfolio investments in non-U.S. companies that in the aggregate do not exceed 25 percent of the Tier 1 capital of the BHC. In addition, individual investments must be less than 20 percent of a portfolio company’s voting shares and not exceed 40 percent of the portfolio company’s total equity. In addition to this pre-existing authority, GLBA now permits a BHC whose subsidiary depository institutions are “well capitalized” and “well managed” to become a financial holding company and to engage in an expanded range of financial activities. Under GLBA, FHCs may engage in a broad range of merchant banking activities. Permissible merchant banking activities are broadly defined to include “investments in any amount of the shares, assets, or ownership interests of any type of non-financial company.” Merchant Banking Regulation On January 10, 2001, the FRB and the Secretary of the Treasury jointly adopted final regulations governing merchant banking activities by FHCs. The regulations, which became effective February 15, 2001, replace interim rules adopted on March 17, 2000. Under the regulations, an FHC need not obtain the FRB’s approval or provide notice before it begins making merchant banking investments or acquiring a company that makes such investments. However, whether it engages in such investment activity directly or indirectly, an FHC must provide the FRB a 30day after-the-fact notice. Following are highlights of the regulations: • FHCs eligible to make merchant banking investments. To qualify to make merchant banking investments, an FHC must have an affiliate registered under the Securities Exchange Act that is either a broker-dealer or municipal securities dealer. This affiliate could be a separately identifiable department of a bank that is a registered municipal securities dealer. • Bona fide requirement. The regulations require that merchant banking investments be made as part of a bona fide underwriting, merchant, or

116 The Securities Regulatory Handbook investment activity. This requirement is intended to prevent an FHC from using its merchant banking authority to engage indirectly in impermissible nonfinancial activities. • Direct and indirect investment. The regulations permit FHCs to make investments directly or through any subsidiary other than a depository institution, a subsidiary of a depository institution, or U.S. branches or agencies of foreign banks. Further, FHCs may make investments through private equity funds discussed below. • Private equity funds. The regulation allows FHCs to make merchant banking investments in and through private equity funds. An FHC may either control and manage a private equity fund or be a passive investor in the fund. An FHC controls a private equity fund if it (i) sponsors the fund, (ii) owns or controls more than 25 percent of its voting shares, (iii) selects, manages, or controls a majority of the fund’s board of directors, or (iv) owns more than 5 percent of the fund’s voting shares and serves as investment adviser. If a fund is controlled by an FHC, the fund must comply with the recordkeeping and reporting requirements of the rule, and the portfolio investments it owns or controls are subject to the cross-marketing and affiliate transaction limitations and prohibitions described below. • Qualifying private equity funds. The regulations provide more flexibility for investments made by FHCs in private equity funds that meet certain qualifications. Some of the qualifying criteria established by the FRB and Treasury include requirements that the fund: — Is formed for and exclusively engages in investing in shares, assets, and ownership interests of companies for resale or other disposition; — Is not an operating company; — Has no more than 25 percent of its total equity held, owned, or controlled by the FHC and its directors, officers, employees, and principal shareholders; and — Has an initial term of not more than 15 years. If a private equity fund does not meet these requirements, then an FHC investment in any such fund is treated the same as an FHC investment in a portfolio company.

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• Portfolio company. The regulations define a “portfolio company” as any company or entity that is engaged in an activity impermissible for FHCs or that houses merchant banking-related shares, assets, or ownership interests held, owned, or controlled by an FHC, including through a private equity fund. Generally, an FHC is prohibited from routinely managing or operating a portfolio company other than as may be required to obtain a reasonable return on the resale or disposition of an investment. Certain relationships are specifically prohibited as involving routine management, for example, FHCs cannot have interlocks with a portfolio company involving executive officers. Other relationships are presumed to be prohibited but can be rebutted, for example, interlocks involving employees or nonexecutive officers. There are also a number of “safe harbors” that allow an FHC to have director interlocks with a portfolio company and impose covenants that protect its investment, but do not involve it in day-to-day management of the company. • Investment holding periods. GLBA dictates that shares, assets, and ownership interests may be held only for a period of time that enables the sale or disposition of the interest on a reasonable basis consistent with the financial viability of the merchant banking activity. The FRB and Treasury have adopted a 10-year limit, which they believe is consistent with industry practice. Interests in a private equity fund can be held up to 15 years. • Aggregate thresholds on merchant banking investments. The regulations limit the aggregate carrying value for an FHC’s merchant banking investments to 30 percent of an FHC’s Tier I capital. A second sublimit applies to the aggregate carrying value of all merchant banking investments excluding investments made by the FHC in private equity funds—such investments are subject to a threshold of 20 percent of the FHC’s Tier I capital. An FHC may exceed either threshold with the prior approval of the FRB. • Risk management. FHCs are required to adopt policies, procedures, and systems reasonably designed to manage the risks associated with making merchant banking investments. For example, policies, procedures, and systems that: — Monitor and assess the value of individual investments and of the aggregate portfolio; — Identify and manage the market, credit, concentration, and other risks associated with merchant banking investments;

118 The Securities Regulatory Handbook — Identify, monitor, and assess the terms, amounts, and risks arising from transactions and relationships between different companies held as merchant banking investments; — Maintain corporate separateness between the FHC and each portfolio company sufficient to protect the FHC from legal liability arising from the conduct and financial obligations of portfolio companies; and — Ensure compliance with the statutory and regulatory provisions governing merchant banking activities. • Cross-marketing prohibitions. U.S. depository subsidiaries (including U.S. branches and agencies of foreign banks) of FHCs are prohibited from marketing or offering, or allowing to be marketed or offered, any product or service of any portfolio company in which its parent FHC owns or controls more than 5 percent of any class of voting shares. (This prohibition is not applicable to a portfolio company that is owned by a private equity fund or other investment vehicle in which the parent FHC has a passive noncontrolling interest.) • Section 23A and 23B restrictions. The regulations establish a rebuttable presumption of control for purposes of applying Section 23A and 23B restrictions on transactions between an FHC’s insured U.S. depository subsidiaries (including U.S. branches and agencies of foreign banks) and their subsidiaries, and portfolio companies that the FHC controls or is presumed to control. In this regard, an FHC that, directly or indirectly, or acting through one or more other persons, owns or controls 15 percent or more of the equity capital of any portfolio company is presumed to control such company for purposes of Sections 23A and 23B. (Under Sections 23A/ 23B, control is not ordinarily deemed to occur until ownership and control of 25 percent or more of voting shares.) There are certain regulatory exceptions from the 15 percent presumption, and the presumption also may be rebutted with the agreement of the FRB. • Capital treatment. The FRB and Treasury have proposed that merchant banking and other equity investments be subject to special capital requirements much higher than those that apply under the Basel regime. See further discussion in The Commercial Banking Regulatory Handbook chapter on “Capital Adequacy.”

Merchant Banking References Laws: Gramm-Leach-Bliley Act, P.L. 106-102, 113 Stat. 1338 (1999) 12 U.S.C. 1841 et seq. Regulations: 12 CFR Part 211 12 CFR 225 12 CFR 368

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Mutual Funds Activities

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VII. Mutual Funds Activities Introduction ...................................................................................................................................... 122 Mutual Funds––An Overview .......................................................................................................... 122 Registering As an Investment Adviser .............................................................................................. 123 FHC Subsidiaries and Financial Subsidiaries ................................................................................... 124 Bank and Bank Holding Company Permissible Mutual Fund Activities ......................................... 125 Organizing and Sponsoring Mutual Funds ....................................................................................... 125 Investment Adviser Activities ........................................................................................................... 126 Mutual Fund Names ......................................................................................................................... 127 Administrative Services for Mutual Funds ....................................................................................... 128 Mutual Fund Transfer Agent............................................................................................................. 130 Mutual Fund Custodian .................................................................................................................... 130 References ........................................................................................................................................ 131

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122 The Securities Regulatory Handbook Introduction Prior to the passage of GLBA, banks engaged in a variety of mutual fund activities including: selling mutual fund shares, providing investment advisory services, providing transfer agent and custodian services, and providing other administrative services to mutual funds. However, interpretations of the Glass-Steagall Act prevented banks from sponsoring or organizing a mutual fund or distributing its shares. GLBA removes these restrictions by allowing bank affiliates that meet certain requirements to sponsor, organize, manage, or control a mutual fund and act as underwriter or distributor of shares of all types of investment companies. Banks that cannot meet these requirements may continue to operate under the preexisting limitations. This chapter discusses GLBA’s impact on bank mutual fund activities and summarizes the permissible bank mutual fund activities and the restrictions or limitations placed on those activities by the courts, the federal bank regulatory agencies, and the Securities and Exchange Commission (SEC). The bank regulatory requirements relating to bank sales of mutual funds are addressed in the Brokerage Activities chapter of this Handbook; and any mutual fund-related activities performed through a bank’s trust department, such as custody and transfer agent services, are addressed in The Trust Regulatory Handbook. As discussed below, the SEC is the functional regulator of nonbank mutual fund activities under the Investment Company Act of 1940 (1940 Act) and the Investment Advisers Act of 1940 (Advisers Act). While some of the requirements imposed by the SEC under these statutes will be addressed briefly in this chapter, a detailed review of 1940 Act and Adviser Act requirements is beyond the scope of this Handbook. Mutual Funds— An Overview The term “mutual fund” commonly refers to an investment company registered with the SEC under the 1940 Act. A fund may be either “open-end” or “closed-end.” • An open-end investment company issues—or has outstanding—redeemable shares. Each share represents a proportionate share of the current value of the assets of the issuer. The market value—or net asset value (NAV)—of each share can be determined at any time simply by dividing the total market


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value of all assets owned by the fund by the total number of shares then outstanding. Shares of open-end funds usually cannot be traded (i.e., bought or sold) like shares in a business corporation. Instead, shares may only be purchased from, or sold to (“redeemed”), the issuing fund. Mutual funds typically are valued, and an NAV established for each share, at the close of each business day. (A particular fund might establish a shorter (e.g., hourly) period for valuing its assets and permitting sales or redemptions.) Managers of an open-end fund must maintain a level of liquid investments sufficient to meet any sudden shareholder demand to redeem shares. • A closed-end investment company issues a specified number of shares, and thereafter does not regularly sell or redeem its shares. A holder of these shares wishing to sell them cannot redeem the shares at their NAV from the fund itself. The holder, instead, must find a third party willing to buy them. The sales price could be either the higher (a premium) or lower (a discount) than the NAV. Shares of many closed-end funds are listed on the stock exchanges and actively traded. A mutual fund is simply a pool of assets. The fund itself has few, if any, day-to-day employees. The fund is organized typically as a corporation or a business trust governed by a board of directors or board of trustees. The board of a mutual fund has a fiduciary duty to the shareholders of the fund. To limit possible conflicts of interest, the 1940 Act requires that at least 40 percent of a mutual fund’s board of directors must be independent from any affiliates of the fund or any entities contracted to provide services to the fund. If the fund uses an affiliated entity to distribute the fund’s shares, at least 50 percent of the board must be independent from the distributor. Because mutual funds normally have no employees, third parties usually provide all of the services necessary to operate the fund. The board of directors is responsible for reviewing and approving the service agreements with those third parties, including the fund’s distributor, investment adviser, and any other provider of services to the fund. An affirmative vote of the majority of a fund’s independent directors is required to approve the fund’s investment advisory and distribution agreements. Registering As an Investment Adviser Prior to the passage of GLBA, the Advisers Act allowed banks to advise registered investment companies without registering with the SEC as investment

124 The Securities Regulatory Handbook advisers. As amended by GLBA, the Advisers Act now requires banks or any “separately identifiable department” within the bank that engages in this activity to register with the SEC. (Note: This section of GLBA becomes effective in May 2001.) An institution registers as an investment adviser with the SEC by completing Form ADV. Investment advisers have a duty to assure that the information contained on Form ADV remains accurate. Advisers can satisfy this duty by filing an amendment to Form ADV in the event any information listed on the form becomes inaccurate. The time frame for filing these amendments varies based on the information that is inaccurate and whether the inaccuracy is material. FHC Subsidiaries and Financial Subsidiaries A financial holding company (FHC) (see the discussion of FHCs in Chapter 1, “Overview of Bank Securities Laws”) may own and control firms engaged either in “financial activities” or “activities incidental to a financial activity.” These activities include: • Providing advisory, administrative, and other services to mutual funds (i.e., the bank-permissible mutual fund activities discussed in this chapter); and • Organizing, sponsoring, and managing a mutual fund, as long as: — The fund does not exercise managerial control over the entities in which the fund invests; and — The financial holding company reduces its ownership in the fund, if any, to less than 25 percent of the equity of the fund within one year of sponsoring the fund or such additional period as permitted by the FRB. When a BHC files its declaration with the FRB to become an FHC, it must file an additional notice with the FRB declaring its intent to create a subsidiary or expand the activities of an existing subsidiary to include the mutual fund activities permitted by GLBA. This notice must be filed with FRB within 30 days of commencing those activities. Under the concept of “functional regulation” (discussed in Chapter 1), the FRB has limited authority to examine “functionally regulated subsidiaries” including registered investment advisers and registered investment companies. The Board may examine a “functionally regulated subsidiary” when:


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• The FRB has reasonable cause to believe that the subsidiary is engaged in activities that pose a material risk to an affiliated depository institution; • After reviewing reports available to other functional regulators, the FRB reasonably determines an examination is necessary to be informed of the subsidiary’s systems for monitoring and controlling risk; or • The FRB has reasonable cause to believe that the subsidiary is not complying with GLBA or other laws over which the FRB has jurisdiction. GLBA prohibits the FRB from creating any capital adequacy rules, guidelines, standards, or requirements for any registered investment adviser or any functionally regulated subsidiary in compliance with the SEC’s applicable capital requirements. Financial subsidiaries of national banks, state member banks, and nonmember banks may also engage in GLBA’s expanded mutual fund activities—so long as the bank and its subsidiary comply with the qualification, operational, and notification requirements for financial subsidiaries (see requirements listed in Chapter V, “Underwriting and Dealing”). Bank and Bank Holding Company Permissible Mutual Fund Activities While FHCs and bank financial subsidiaries may engage in GLBA’s expanded mutual fund activities, banks and BHCs (that are not FHCs) will continue to operate under the laws, regulations, and interpretations that existed prior to GLBA. Organizing and Sponsoring Mutual Funds Approvals and rulings by the Office of the Comptroller of the Currency (OCC) and the FRB clarify that banks and bank holding companies may not “organize or sponsor” mutual funds, but the extent of this prohibition is unclear. For example, the OCC and FRB have permitted banks and bank holding companies to engage in activities traditionally associated with organizing a mutual fund—such as preparing and filing applicable registration forms with the SEC and providing the fund with office facilities and clerical support (see the section in this chapter on Administrative Services for Mutual Funds). However, the OCC and FRB have uniformly prohibited banks and bank holding companies from distributing fund shares.

126 The Securities Regulatory Handbook Investment Adviser Activities The most important service provided to a mutual fund is the investment management of the fund’s assets. While the fund’s board will determine its investment objectives, it is the responsibility of the investment adviser to the fund to strive to meet those objectives. The fund’s attractiveness to new shareholders depends on the investment adviser’s performance. The adviser normally will provide its services to the fund for a fee based on a percentage of the dollar amount of the assets under management. Mutual fund investment advisers generally must register with the SEC under the Advisers Act. Registered investment advisers are subject to reporting requirements and to prohibitions against fraudulent, deceptive, or manipulative acts or practices. Banks or “separately identifiable” departments or divisions that advise a registered investment company must register with the SEC and comply with the requirements of the Investment Company Act of 1940 and the Investment Advisers Act. Banks and bank holding companies are specifically exempted from the definition of a “functionally regulated subsidiary.” Therefore, bank holding companies and bank mutual fund activities are not subject to functional regulation. These institutions still appear to be subject to joint regulation by a federal banking agency and the SEC. Prior to the passage of GLBA, the OCC and the SEC conducted joint examinations of mutual funds advised by national banks and of national banks and their subsidiaries providing investment advisory services to mutual funds. These joint examinations evaluated several areas, including: • Internal control systems used to assure compliance with regulatory requirements; • Risk management systems used by the adviser to monitor and control risks in light of the fund’s objectives; • Management of conflicts of interest between the adviser and the funds, including the use of brokers, “soft dollar” arrangements, acquisition of new clients, allocation of orders, and personal securities transactions; • Revenues, expenses, and financial statements linked to investment advisory activities; and


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• The nature of the services provided by the bank itself to the fund, including custodian and transfer agent services. The OCC and the SEC have yet to indicate whether these joint examinations will continue to occur. The FRB’s Regulation Y specifically permits bank holding companies to provide investment advice to mutual funds. A 1997 revision of Regulation Y modified several of the restrictions previously imposed on bank holding company investment advisory activities. As revised, Regulation Y permits a BHC to: • Own shares of a mutual fund that it advises; • Extend credit to a mutual fund that it advises; and • Accept shares of a mutual fund that it advises as collateral for a loan to a customer to purchase shares of that mutual fund. Regulation Y already permitted a BHC to purchase, as fiduciary, shares of a mutual fund that it advises. Mutual Fund Names Banks often want their proprietary mutual funds to have names that customers will associate with the bank. The federal banking regulators and the Securities and Exchange Commission have differing views on the permissibility of these so-called common name funds. The OCC’s position on common name funds is that a national bank and its affiliates cannot sell mutual funds with a name that is identical to that of the bank. The OCC, however, does permit mutual funds to have names similar to the banks that advise them. Thus, for example, First National Bank may advise and sell First Funds, but not First Bank Funds or First National Funds. The OCC requires a national bank or any of its affiliates selling common name funds to tailor its retail sales program to minimize the potential for customer confusion regarding the nature of the mutual fund shares. While all national bank retail sales programs are subject to the Interagency Statement on the Retail Sale of Nondeposit Investment Products, a national bank selling common name funds will be held to a higher standard to assure that its customers know that the mutual fund shares are not obligations of the bank or insured by the FDIC (the Interagency Statement is addressed in detail in the Brokerage Activities chapter of this Handbook).

128 The Securities Regulatory Handbook The FRB will permit the mutual fund to have a name similar to the name of the bank holding company, or any of its subsidiary banks, as long as: • The mutual fund name is not identical to the bank holding company or an affiliated insured depository institution; • The mutual fund name does not include the term “bank”; and • The bank holding company or mutual fund discloses to customers in writing the role of the holding company as adviser to the mutual fund, and that shares of the mutual fund are not federally insured and are not obligations of or guaranteed by any insured depository institution. The Securities and Exchange Commission has also considered the permissibility of common name mutual funds. Under the Investment Company Act the SEC has the authority to issue an order declaring that any word or words that a mutual fund uses in its name are deceptive or misleading. The SEC has determined that the names of common name mutual funds sold by or through banks are presumptively misleading. This presumption, however, can be rebutted by disclosing prominently on the cover page of the prospectus that shares in the fund are “not deposits or obligations of, or guaranteed or endorsed by, the bank and that the shares are not federally insured or otherwise protected by the Federal Deposit Insurance Corporation, the Federal Reserve Board, or any other agency.” Administrative Services for Mutual Funds In evaluating whether a bank or bank affiliate may provide administrative services to a mutual fund, the OCC and the FRB look to whether they would provide the bank with control over the mutual fund. The list of administrative services traditionally authorized by the FRB and the OCC include: 1. Maintaining and preserving the fund records, including financial corporate records; 2. Computing net asset values, dividends, performance data, and financial information regarding the funds; 3. Furnishing statistical and research data;


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4. Preparing and filing with the SEC and state securities regulators registration statements (including prospectuses), notices, reports, and other material required to be filed under applicable laws; 5. Preparing reports and other informational materials regarding the funds, including proxies and other shareholder communications; 6. Providing legal and other regulatory advice to the funds in connection with other administrative services; 7. Providing office facilities and clerical support for the funds; 8. Developing and implementing procedures for monitoring compliance with regulatory requirements and compliance with the funds’ investment objectives, policies, and restrictions as established by the board of directors; 9. Providing routine fund accounting services and liaison with outside auditors; 10. Preparing and filing tax returns; 11. Reviewing and arranging for payment of fund expenses; 12. Providing communication and coordination services with regard to the transfer agent, custodian, and other service organizations that render recordkeeping or shareholder communication services; 13. Reviewing and providing advice to the fund regarding sales literature and marketing plans to assure regulatory compliance; 14. Participation in seminars, meetings, and conferences designed to present information to brokers; 15. Assisting existing funds in the development of additional portfolios; 16. Providing reports to the fund’s board with regard to its activities; and 17. Providing shareholder services.

130 The Securities Regulatory Handbook Mutual Fund Transfer Agent Banks and bank holding companies may also act as transfer agents for mutual funds. Bank transfer agents must register as transfer agents by filing Form TA-1 with the SEC. A copy of this form must also be filed with the applicable bank regulatory agency. Transfer agents are regulated by the SEC under Section 17A of the Securities Exchange Act of 1934. The principal services typically performed by a mutual fund transfer agent include: • Processing purchase and redemption of mutual fund shares; • Maintaining shareholder information; • Transferring ownership of shares; • Mailing prospectuses, reports, and confirmations; and • Tabulating proxies. Mutual Fund Custodian The 1940 Act requires that mutual funds, with some exceptions, place their securities and other assets in the hands of a custodian meeting specific requirements. Banks and bank holding companies may act as custodian for mutual funds. The requirements imposed on bank custody activities are addressed in detail in The Trust Regulatory Handbook. The services typically performed by a mutual fund custodian include: • Settling portfolio purchases and sales; • Identifying and collecting portfolio income; and • Providing safekeeping of securities and communications with centralized securities depositories. The FRB’s Investment Adviser Interpretation provides that a bank holding company that acts as a custodian and investment adviser for a mutual fund should exercise care to maintain demand deposit accounts of the mutual fund,


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which are placed with a bank affiliate at a set minimum level, and should not invest cash funds of the fund in any time deposit account (including certificates of deposit) of any bank affiliate. References Laws: Gramm-Leach-Bliley Act, P.L. 106-102, 113 Stat. 1338 (1999) 12 U.S.C. 1831w Investment Advisers Act of 1940, 15 U.S.C. 80b-1 et seq. Investment Company Act of 1940, 15 U.S.C. 80a-1 et seq. Regulations: 12 CFR Part 5 12 CFR 208.71 et seq. FRB Regulation Y, 12 CFR 225 12 CFR 368 SEC 1940 Act Rules and Regulations, 17 CFR 270 SEC Advisers Act Rules and Regulations, 17 CFR 201


Overseas Securities Activities

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VIII. Overseas Securities Activities Introduction ...................................................................................................................................... 134 Statutes and Regulations ................................................................................................................... 134 Operating Structures ......................................................................................................................... 135 Securities Activities of Overseas Branches ...................................................................................... 135 Overseas Investments ....................................................................................................................... 137 Portfolio Investments and Joint Ventures.......................................................................................... 139 Securities Activities of Overseas Subsidiaries .................................................................................. 140 Debt-for-Equity Conversions ............................................................................................................ 142 References ........................................................................................................................................ 144

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134 The Securities Regulatory Handbook Introduction FHCs and financial subsidiaries may engage in financial activities outside the United States without complying with Regulation K’s limitations. This chapter discusses the overseas activities of U.S. financial institutions that are not FHCs or financial subsidiaries. These institutions are governed primarily by the Bank Holding Company Act, the Federal Reserve Act, and Federal Reserve Board Regulation K. While the Federal Reserve has the primary responsibility for enforcing these laws and regulations, national bank activities also are subject to supervision and regulation by the Office of the Comptroller of the Currency. State nonmember banks are subject to regulation by the Federal Deposit Insurance Corporation, under provisions of the FDIC Act. Statutes and Regulations Federal Reserve Act Section 25 of the Federal Reserve Act grants national banks authority to operate overseas. Section 25 (12 U.S.C. 601) provides that any national bank with capital and surplus of at least $1 million may exercise the following powers: • Establish branches in foreign countries; • Invest up to 10 percent of capital and surplus in the stock of one or more banks or corporations principally engaged in international or foreign banking; and • Acquire and hold, directly or indirectly, the stock of a foreign bank that is not engaged in any activity in the United States, except those activities that the Federal Reserve Board finds to be incidental to their international or foreign business. Section 25 is made applicable to state member banks by 12 U.S.C. 321. Bank Holding Company Act The Bank Holding Company Act exempts bank holding company subsidiaries operating overseas from many U.S. activity restrictions. Specifically, Section 4(c)(13) exempts bank holding company subsidiaries from domestic bank holding company activity restrictions as long as they do no business in the United States that is not incidental to their international business. However, the Federal Reserve Board must determine, by order or regulation, that any exemption is in the public interest and consistent with the purposes of the Bank Holding Company Act.


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Regulation K Regulation K (12 CFR Part 211) implements the provisions of the Federal Reserve Act and the Bank Holding Company Act that govern the overseas activities of U.S. banks and bank holding companies. Regulation K applies to member banks, bank holding companies, and Edge and Agreement corporations. It sets forth procedures for investing in foreign organizations and establishing foreign branches and Edge corporations to engage in international banking. It also lists overseas activities that the Board has determined are permissible for each of these entities. Operating Structures U.S. banks and bank holding companies and their Edge or Agreement corporation subsidiaries may engage in securities activities overseas through the following operating structures: • Branches of member banks; • Portfolio investments in foreign institutions; • Foreign joint ventures; and • Overseas subsidiaries. The sections below summarize the limits and controls on each of these operating structures that the Board has implemented through Regulation K. Securities Activities of Overseas Branches Foreign branches of member banks may engage in those activities that are permitted to their domestic parent banks. Further, Regulation K authorizes foreign branches to engage in the following additional activities: Underwriting Foreign branches of member banks may underwrite, distribute, buy, and sell the obligations of: • The national government of the country in which the branch is located;

136 The Securities Regulatory Handbook • An agency or instrumentality of the national government where supported by the taxing authority, guarantee, or full faith and credit of the national government; and • A political subdivision of the country. A foreign branch is limited in the amount of these obligations it can hold for its own account. It may hold only, in the aggregate, an amount not exceeding the greater of: • 10 percent of the bank’s Tier I capital; or • 10 percent of the total deposits of the bank’s branches in that country on the preceding year-end call report date. Obligations held under an underwriting commitment will be considered in determining compliance with this limit. Investments Foreign branches may make and hold the following foreign investments: • Securities of the central bank, clearinghouses, other governmental entities in addition to those addressed above, and government-sponsored development banks of the country in which the foreign branch is located; • Other debt securities eligible to meet local reserve or similar requirements; and • Shares of automated electronic payments networks, professional societies, schools, and the like necessary to the business of the branch. The total investments of a bank’s foreign branches in one country, exclusive of those that are required by the law of the foreign country or permissible for national banks, may not exceed 1 percent of the total deposits of the bank’s branches in that country on the preceding year’s call report or, in the case of a branch that was not reported on the previous year’s call report, on the date the branch was acquired. Branch Subsidiaries Foreign branches may also acquire all the shares of overseas companies with the prior approval of the Federal Reserve Board. These subsidiaries will be


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limited to engaging solely in those activities that either are permissible for the member bank or are incidental to the activities of the overseas branch. Repurchase Agreements Overseas branches also may engage in repurchase agreements involving securities and commodities that are the functional equivalent of extensions of credit. Other Activities With Board approval, an overseas branch may engage in an activity if the Board determines that it is usual in connection with the transaction of the business of banking in the places where the branch transacts business. However, the Federal Reserve Act prohibits the Board from authorizing an overseas branch from engaging or participating in the underwriting, selling, or distribution of securities, except in those circumstances noted above. Overseas Investments Member banks and bank holding companies may have equity interests in overseas organizations—engaged in securities activities or otherwise—through overseas portfolio investments, overseas joint ventures, and ownership of overseas subsidiaries. While there are important distinctions between these forms of ownership, discussed below, the following restrictions apply to each: Member Bank Direct Investments Member bank direct equity investments are limited to three types of organizations under the Federal Reserve Act: • Foreign banks; • Foreign organizations formed to hold the shares of foreign banks or to provide nominee, fiduciary, or other services incidental to the activities of a foreign branch or a foreign bank affiliate of a member bank; or • Foreign branch subsidiaries, discussed above. Activities in the United States Unless otherwise authorized by the Federal Reserve Board, a member bank, Edge or Agreement corporation, or bank holding company (an “investor”) may not invest in a foreign organization that:

138 The Securities Regulatory Handbook • Engages in the general business of buying and selling of goods, wares, merchandise, or commodities in the United States; and • Engages directly or indirectly in other businesses in the United States not permitted to an Edge corporation (except that an investor may hold up to 5 percent of the shares of any foreign company). FRB Approval The Federal Reserve Board uses three different types of procedures for approving overseas investments: general consent, prior notice, or specific consent. In all cases, the investor must be adequately capitalized. In addition, if neither an institution nor any affiliate has ever invested in any overseas subsidiary or joint venture (an “initial investment”), then any such investment requires the specific consent of the Federal Reserve Board. Otherwise, the Federal Reserve Board grants general consent for any portfolio investment or investment (other than initial investments) in a subsidiary or joint venture that, in the case of any one transaction or series of transactions, does not exceed the lesser of $25 million or 5 percent of the investor’s Tier I capital when the investor is a member bank, bank holding company, or Edge corporation engaged in banking (or 25 percent of Tier I capital when the investor is an Edge corporation not engaged in banking). Further, the Federal Reserve Board grants general consent to any additional investment in an organization in a calendar year as long as the total amount invested during the year does not exceed 10 percent of the investor’s Tier I capital and cash dividends received during the prior 12 months that were reinvested, plus 10 percent of the investor’s historical cost in the organization (with a carry-forward provision for five years). General consent is also given to reinvest cash dividends received during the preceding 12 calendar months and to acquire an investment from an affiliate at its net asset value. An investment that does not qualify under the general consent procedures of Regulation K requires 45 days’ prior notice to the Federal Reserve Board. The Federal Reserve Board may waive the 45-day period if it finds that immediate action is necessary. Any investment that does not qualify for either general consent or prior notice requires specific consent from the Federal Reserve Board.


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Portfolio Investments and Joint Ventures In addition to ownership of an overseas subsidiary, member banks, Edge corporations, and bank holding companies may make investments in overseas securities organizations through portfolio investments and joint ventures. Joint Ventures Member bank, Edge corporation, or bank holding company ownership of between 20 percent and 50 percent of the voting shares of another organization is considered a “joint venture.” Member banks and bank holding companies may participate in overseas joint ventures subject to certain restrictions. Specifically, unless otherwise permitted by the Federal Reserve Board, no more than 10 percent of the consolidated assets or revenues of a joint venture may be derived from activities not permitted to overseas subsidiaries. Portfolio Investments Ownership of less than 20 percent of the voting shares of another organization is referred to as a “portfolio investment.” An organization held as a portfolio investment of a member bank, Edge corporation, or bank holding company can engage in any activities available to a joint venture or subsidiary. In addition, an organization held as a portfolio investment may engage in an unlimited amount of activities that are prohibited to an overseas subsidiary. However, when member banks, Edge corporations, and bank holding companies hold portfolio investments in organizations engaged in such prohibited activities, their interest may not: • Exceed 40 percent of the total equity of the overseas organization (including shares held in dealing or trading accounts or held under any other authority); or • Exceed 25 percent of Tier I capital if the investor is a bank holding company or 100 percent of Tier I capital if the investor is a member bank or Edge corporation (the portfolio investment must be combined with shares held in trading or dealing accounts or held under commitments in non-Section 20 subsidiaries). Any loans or extensions of credit by the member bank, Edge corporation, bank holding company, or its affiliates must be on an arm’s length basis.

140 The Securities Regulatory Handbook Securities Activities of Overseas Subsidiaries Overseas subsidiaries of U.S. bank holding companies may engage in more expansive securities activities than are permitted to their domestic counterparts. Section 20 operating standards also do not apply to overseas securities subsidiaries. An investment will be characterized as a subsidiary of the member bank, Edge corporation, or bank holding company where the holdings include more than 50 percent of the voting shares of an organization or where the U.S. investor otherwise is determined to have a controlling interest in the organization. Where a subsidiary is acquired as a going concern, no more than 5 percent of the consolidated assets or revenues of the subsidiary may be from activities prohibited to overseas subsidiaries. Regulation K provides a list of activities that the Board has determined are permissible activities for overseas subsidiaries. The permissible securitiesrelated activities are addressed below: Investments Overseas subsidiaries may invest in debt and equity securities to the same extent as their parent banking organization. The limits on overseas investments are addressed above. Underwriting Overseas subsidiaries may underwrite and deal in debt securities without limit, but equity underwriting and dealing is subject to prior Federal Reserve Board approval and several regulatory limitations. The volume of equity underwriting and dealing by an overseas subsidiary is subject to three limitations: • On a consolidated basis, underwriting commitments by the investor and its non-Section 20 affiliates are limited to the lesser of $60 million or 25 percent of the Tier I capital of the investor. This limitation will not apply when the underwriting subsidiary’s commitment is covered by a binding contract to resell the securities to a subunderwriter or other purchaser.


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• With prior Federal Reserve Board approval, dealing in the shares of an organization where the shares held in trading and dealing accounts and those held for more than 90 days past an underwriting, combined with shares held as overseas portfolio investments, do not exceed the lesser of $30 million or 10 percent of the Tier I capital of the subsidiary’s parent. This limit is applied on a net basis, that is, long and short positions in a security may be offset, or positions could be offset, by futures, forwards, options, and similar instruments. However, no position may be reduced by more than 75 percent. • Equity securities of companies engaged in nonpermissible activities that are held in trading and dealing accounts by the subsidiary and its affiliates are subject to the portfolio investment limitations, discussed above. Securities acquired pursuant to an underwriting agreement and held for less than 90 days are exempt from the 40 percent portfolio investment equity limitation, discussed above. Securities held by a Section 20 affiliate need only be included in computing the 40 percent equity limitation in the issue. With Federal Reserve Board approval, an overseas subsidiary may exceed the $60 million/25 percent consolidated underwriting limit provided it meets the following requirements: • Any level of underwriting approved in excess of the lesser of $60 million or 25 percent of Tier I capital must be deducted fully from the capital of its parent bank holding company, or parent bank if it is a bank subsidiary. Of this excess amount, 50 percent must be deducted from the parent’s Tier I capital with the other 50 percent coming from Tier II capital; and • The Federal Reserve Board must determine that after the deduction from capital the bank holding company or bank would remain strongly capitalized. Any banking organization that wants to take advantage of Regulation K’s expanded equity underwriting and dealing provisions must permit the Federal Reserve Board to conduct a review of its foreign securities operations. The review will focus on the adequacy of internal controls and procedures for dealing with the underwriting limits. The review also will evaluate whether the capital of existing foreign securities operations would be adequate to support the level of underwriting permitted under Regulation K. The Board has determined that overseas subsidiaries may deal in equity securities of U.S. corporations abroad; however, they may sell these securities only to, or buy them from, a foreign person. A foreign person is defined as an office or establishment located, or an individual residing, outside of the United States.

142 The Securities Regulatory Handbook Other Permissible Securities Activities Other securities-related activities of overseas subsidiaries authorized by Regulation K include the following: • Acting as a futures commission merchant in regard to financial instruments and exchanges that the Board previously has approved; • Acting as principal or agent in interest rate and foreign currency swap transactions and transactions in swap-related derivative products; • Acting as a fiduciary; • Providing investment, financial, or economic advisory services; • Providing full and discount brokerage services; and • Organizing, sponsoring, and managing a mutual fund if the fund’s shares are not sold or distributed in the United States or to U.S. residents and the fund does not exercise managerial control over the firms in which it invests. Debt-for-Equity Conversions As an alternative to the investment methods discussed above, Regulation K authorizes bank holding companies to acquire equity securities of foreign public and private sector companies through debt-for-equity conversions in eligible countries. Eligible countries include those countries that since 1980 have restructured their foreign sovereign debt obligations to foreign creditors, and any other country that the Board deems to be eligible. Debt-for-equity conversions may be funded in either of two ways: • Through direct debt-for-equity exchange (or “swap”) of either sovereign foreign debt or a private debt of a foreign country into equity ownership; or • By payment for the debt in local currency, the proceeds of which are used to purchase the equity securities. Additional cash investments may be made but may not exceed 10 percent of the fair value of the debt being converted.


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Ownership Restrictions The equity securities must be divested within the longer of 10 years from the date of the investment or two years from the date on which the bank holding company is permitted to repatriate in full the investment in the foreign country. In either event, divestiture must occur within 15 years of the date of the acquisition. The amount of equity ownership acquired through a swap also may be limited. Specifically, a bank holding company may acquire up to: • 100 percent of the shares of a foreign company if the shares are acquired from the government (e.g., in a privatization); or • 40 percent of the shares of a foreign company if the shares are not acquired from the government. In addition, if the shares were not acquired from the foreign government, the equity investment will be subject to the following limitations: • The investment may exceed 25 percent of the shares of the company only if a shareholder unaffiliated with the bank holding company holds a larger block of shares of the company; • The bank holding company and its affiliates may not extend credit to the company in amounts greater than 50 percent of the total loans to the company; and • The bank holding company’s representation on the board of directors or on management committees of the foreign company may be no more than is proportional to its shareholdings in the company. Moreover, the foreign company may not have a name similar to the bank holding company or its affiliates. Board Approval The Federal Reserve Board provides general consent for the conversions described above if the total investment does not exceed the greater of $25 million or 1 percent of the bank holding company’s Tier I capital. All other conversions require prior notice or specific consent.

144 The Securities Regulatory Handbook References Laws: Federal Reserve Act, 12 U.S.C. 601 12 U.S.C. 321 Bank Holding Company Act, 12 U.S.C. 1843(c)(13) Regulations: Regulation K, 12 CFR Part 211

Index 145

Index A Accounting for Certain Investments in Debt and Equity Securities (FASB 115), 26 Accredited investor, 86 Active position-takers, 42–43 Adjusted trading, 29 Administration of mutual funds, 128–129 of securities lending, 22 Advertising municipal securities, 98 nondeposit investment products, 60 African Development Bank, 15 Antifraud Provisions of the Exchange Act, 68 Arbitration, 101 Asset-backed securities, 16, 51 Audit coverage, 42 Available-for-sale securities, 27, 29

B Bank-eligible securities, 14 Type I, 14–15 Type II, 14–16 Type III, 14, 16 Type IV, 14, 16 Type V, 14, 17 Bank holding companies as financial holding companies (FHCs), 76–77 merchant banking, 115 mutual funds and, 125–127 Bank Holding Company Act (BHCA), 7–9, 78, 134, 135 merchant banking activities, 114 overseas activities, 134, 135 Bank for International Settlements, 47 Bank securities laws; see also specific laws Bank Holding Company Act, 7–9 Federal Deposit Insurance Act, 9 Federal Reserve Act, 9 Glass-Steagall Act, 7

Bank securities laws (continued) Government Securities Act, 9 Gramm-Leach-Bliley Act, 6 Home Owners Loan Act, 9 Investment Advisers Act of 1940, 11–12 Investment Company Act of 1940, 11 overview of, 6–12 Securities Act of 1933, 10 Securities Acts Amendments of 1975, 12 Securities Exchange Act of 1934, 10 state securities laws (blue sky), 12 Banking Act (1933), 7 Basel Capital Accord, 84 Best efforts underwriting, 74 Bilateral netting, 46 Blind pooled repurchase agreements, 110 Blue sky laws, 12 Brady bonds, 51, 75 Broker-dealer registration, 54–55 government securities, 103–105 Brokerage activities broker-deal registration, 54–55 Chinese Walls, 69 confirmation requirements, 64–66 custodial activities, 52–53 de minimis activity, 54 employee transactions, 70 examinations for, 67 fiduciary activities, 52 fraud and insider trading, 68–70 identified banking products, 50–51 Insider Trading and Securities Fraud Enforcement Act (ITSFEA), 68 instruments permitted, 50–51 nondeposit investment products, 55–63 advertising, 60 compensation, 62 compliance, 62–63 disclosures, 57–59 names of mutual funds, 59–60 personnel qualifications and training, 61

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146 The Securities Regulatory Handbook Brokerage activities nondeposit investment products (continued) program management, 57 reference, 63 retail sales, 56–57 scope of guidelines, 56 setting and circumstances, 60–61 suitability and sales practices, 61–62 overview of, 50 permissible securities, 51 recordkeeping requirements, 63–64 references, 55, 63, 67, 70–71 settlement transactions, 66 supervision policies and procedures, 66–67 third-party networking, 53–54 transfer agent, 52 Broker’s broker, 96

C Canadian government and agency securities, 15, 51, 75 Capital adequacy derivatives and, 47 merchant banking, 118 Section 20 operating standard, 84 Caps, 35–36 Cash flow and funding liquidity risk, 45 Certificates of deposit, 50, 75 Chinese Walls, 23, 69 Churning, 97 Closed-end investment company, 123 Collars, 35–36 Collateral management, 23–24 Commercial paper and bills, 51, 75, 83 Common name funds, 127 Compensation, 62 nondeposit investment products, 62 Compliance, 62 nondeposit investment products, 62–65 Compliance risk, 14 Concentration limits, securities lending, 23 Confirmation requirements brokerage activities, 64–66 municipal securities, 95–96 Conflict of interests, 126 Consultants, 102 Control relationships, 98 Controlling person, 68 Corporate settlements, 28

Counterparty credit risk, 40–41 Covered calls, 29 Credit analysis, securities lending, 22–23 Credit approval function, 43 Credit default swaps, 36 Credit derivatives, 36–37 credit default swaps, 36 credit-linked notes, 37 risk management for counterparty credit, 40–41, 43–44 credit authorization, 43 monitoring of, 44 presettlement, 43–44 settlement, 44 total rate of return (TROR) swaps, 36–37 Credit-linked notes, 37 Cross-marketing prohibitions, 118 CUSIP numbers, 101, 110 Custodial activities brokerage activities, 52–53 government securities, 106–108 mutual funds, 130–131 Customer disclosure, Section 20 operating standard, 85–86

D De minimis activity, 54 Dealers, 42–43 Dealing, 74–76 defined, 74 trading vs. dealing, 74 Debit accounts, 51, 75 Debt-for-equity conversions, 142 FRB approval of, 143 ownership restrictions, 143 Debts previously contracted (DPC) stock, 17 Deposit accounts, 75 Derivatives capital adequacy and, 47 caps, 35–36 collars, 35–36 counterparty credit risk, 40–41 approval function, 43 monitoring of, 44 presettlement risk, 43–44 settlement risk, 44 credit credit default swaps, 36

Index 147 Derivatives credit (continued) credit-linked notes, 37 total rate of return (TROR) swaps, 36–37 disclosure for, 37–40 in accounting policies footnotes, 38–39 misleading items, 40 quantitative and qualitative, 39–40 floors, 35–36 foreign exchange forwards, 35 forward contracts, 35 forward rate agreements, 35 futures contracts, 35 legal issues, 46–47 bilateral netting, 46 multilateral netting, 46–47 physical commodity transactions, 47 liquidity risks cash flow and funding, 45 defined, 41 market and product, 44 monitoring of, 45 market risk dealers and active position takers, 42–43 defined, 41 limited end-users, 43 operatiing risk defined, 41 documentation, 46 duty separation, 45 personnel quality, 45 systems quality, 45 valuation issues, 46 options, 34–35 overview of, 34 references regarding, 47 risk management for, 40–47 senior management supervision audit coverage, 42 risk responsibility, 42 risk systems, 42 written policies and procedures, 41–42 settlement risk, 41 swaps, 34 Direct and indirect investment, 116, 137–138 Disclosures customer disclosure, 85–86 for derivatives, 37–40 in accounting footnote, 38–39

Disclosures for derivatives (continued) misleading items, 40 quantitative and qualitative, 39–40 municipal securities, 101 nondeposit investment products, 57–59 Discretionary investment authority, 29, 97 Duty separation, 45

E Edge and Agreement corporations, 8, 135, 137–140 Employee benefit plans, 25 Employee Retirement Income Security Act (ERISA), 25 ERISA—Prohibited Transaction Exemption 81-6 (1981), 25 ERISA—Prohibited Transaction Exemption 82-63 (1982), 25 Employees municipal securities principal, 89–90 municipal securities representative, 90, 99–100 qualifications and training, 61, 66 securities transactions of, 70 Equity investments, 17–18 Examinations, brokerage activities, 67 Extended settlements, 28

F Fails, 20 Fair practice standards, underwriting and dealing, 96–97 Federal Deposit Insurance Act (FDIA), 9 Federal Deposit Insurance Corporation (FDIC), 9, 59–60, 66, 109, 127 recordkeeping requirements, 63–64 Federal Deposit Insurance Corporation Improvement Act of 1991, 46 Federal Reserve Act (FRA), 9, 81 overseas securities activities, 134, 137 Federal Reserve Bank (FRB), 107 reporting requirements, 87 Federal Reserve Board financial holding company (FHC) and, 6 indemnification liabilities, 25–26 investment advisory services, 127 mutual funds administrative services, 128–129 on nonbanking activities, 8 overseas investments, 118, 136–142 recordkeeping requirements, 63–64

148 The Securities Regulatory Handbook Federal Reserve Board (continued) Regulation K, 8, 115, 134–135, 138, 140–142 Section 20 operating standards, 77–78, 84–87 Tier I and II powers, 83–84 underwriting and dealing, 79–81 FFIEC repurchase agreements, 19–20 securities lending, 21–22 Fiduciary activities, brokerage activities, 52 Financial Accounting Standards Board Statement No. 65 (FASB 65), 27 Financial Accounting Standards Board Statement No. 115 (FASB 115), 26 Financial advisory relationships, 98 Financial holding companies (FHCs), 6, 76–77 merchant banking regulation, 115–118 operating standards, 77–78 operating standard #5, 78 operating standard #8, 78 Financial statements, derivatives accounting (footnotes), 38–39 Financial subsidiaries, national and state member banks, 78–81 bank qualifications, 79 notice, 79–81 requirements and restrictions, 81 “Financial Subsidiary Certification and Notice,” 79–80 Finders, securities lending, 24–25 Firewalls, 84 Firm commitment underwriting, 74 Floors, 35–36 FOCUS, 87 Foreign banks, Section 20 operating standard, 87 Foreign exchange forwards, 35 Foreign exchange risk, 14 Form ADV, 124 Form G-FIN, 103–104, 106 Form G-FIN-4, 104, 106 Form G-FIN-5, 104, 106 Form G-FIN-W, 104, 106 Form MSD-4, 90, 104 Form MSD-5, 90 Form TA-1, 130 Form U-4, 104 Forward contracts, 35 Forward rate agreements, 35 FR Y-20 Report, 78, 87 Fully disclosed relationship, 53 Functional regulation, 124–125 Futures contracts, 35

G Gains trading, 28 Gifts and gratuities, 97 Glass-Steagall Act, 7, 17, 76, 83 Government securities, defined, 103 Government Securities Act (GSA), 9, 20, 102–112 broker-dealer registration, 103–104 custodial holding requirements, 106–108 exemptions, 104–105 hold-in-custody repurchase agreements, 108–110 overview of, 102–103 recordkeeping requirements, 105–106 sales practices, 110–112 Government securities broker, 103 Government securities sales practices, 110–112 Gramm-Leach-Bliley Act (GLBA), 6; see also Section 20 subsidiaries bank securities activities, 6, 75, 77 brokerage activities, 50–51, 56, 67 financial subsidiaries, 78–81 functional regulation, 6 merchant banking, 114–115 mutual fund activities, 122 “push out” rule, 50, 74–75 underwriting and dealing, 74, 82 Grey lists, 69

H Held-to-maturity securities, 26–27 Hold-in-custody repurchase agreements, 108–110 Home Owners Loan Act (HOLA), 9

I Identified banking products, 50–51, 75–76 Indemnification, 25–26 Insider Trading and Securities Fraud Enforcement Act (ITSFEA), 10, 68–69 Institutional customer, 112 Inter-American Development Bank, 15 Inter-American Investment Corporation, 15 Interagency Statement on the Sale of Nondeposit Investment Products (NDIP), 53, 55–56, 85 Interest rate risk, 14 Interlocks restrictions, Section 20 operating standard, 85 Internal controls, Section 20 operating standard, 84

Index 149 International Bank for Reconstruction and Development, 15 Intra-day credit, Section 20 operating standard, 86 Investment adviser, defined, 12 Investment Advisers Act (1940), 11–12, 122–124, 126 Investment company, 18 defined, 11 Investment Company Act of 1940, 11, 70, 122–123, 126 Investment holding periods, 117 Investment risk, 111 Investment securities, 15–17 Investment and treasury activities laws and regulation references, 31 permissible, 14–19 debts previously contracted (DPC) stock, 17 equity investments, 17–19 mutual funds and investment companies, 18 private placements, 17–18 Type I securities, 14–16 Type II securities, 14–16 Type III securities, 14, 16 Type IV securities, 14, 17 Type V securities, 14, 16, 17 repurchase agreements, 19–20 overview of, 19 regulatory guidelines, 19–20 securities dealer selection, 30–31 board responsibility in, 30 minimum considerations, 30 overview of, 30 regulatory guidelines, 30–31 safekeeping, 31 securities lending, 20–26 administrative procedures, 22 collateral management, 23–24 credit analysis, 22–23 credit and concentration limits, 23 employee benefit plans, 25 FFIEC policy on, 21–22 finders for, 24–25 indemnification, 25–26 introduction, 20–21 recordkeeping, 22 written agreements, 24 securities transaction reporting, 26–27 available-for-sale, 27 held-to-maturity, 26–27 overview of, 26 trading securities, 27

Investment and treasury activities (continued) unsuitable investment practices, 27–29 adjusted trading, 29 corporate and extended settlements, 28 covered calls, 29 gains trading, 28 investment discretionary authority delegation, 29 “pair offs,” 28 repositioning repurchase agreements, 28 short sales, 29 “when issued” securities trading, 28

J Joint ventures, overseas, 139

L Lamfalussy Report, 47 Laws. See Bank securities laws Legal issues, 46–47 Letters of credit, 51, 75 Limited end-users, 43 Liquidity risks, derivatives cash flow and funding, 45 defined, 41 management, 44–45 market and product, 44 monitoring of, 45 Loan participations, 51, 75

M Margin, 23 Mark-to-market, 23, 43 Market making, 74 Market risks, derivatives dealers and active position takers, 42–43 defined, 41 limited end-users, 43 management, 42–43 Market and product liquidity risk, 44 Merchant banking legal authority of, 114–115 overview, 114 references, 119 regulation of, 115–118 aggregate thresholds, 117 bona fide requirement, 115–116

150 The Securities Regulatory Handbook Merchant banking regulation of (continued) capital treatment, 118 cross-marketing prohibitions, 118 direct and indirect investment, 116 FHCs eligible, 115 investment holding periods, 117 portfolio company, 117 private equity funds, 116 qualifying private equity funds, 116 risk management, 117–118 Section 23A and 23B restrictions, 118 Mortgage-backed securities, 51, 75, 83 MSRB Rule G-1, 89 MSRB Rule G-2, 89 MSRB Rule G-3, 89, 91 MSRB Rule G-8, 91–92, 99 MSRB Rule G-8(a)(xi), 97 MSRB Rule G-9, 93 MSRB Rule G-11, 93 MSRB Rule G-12, 94 MSRB Rule G-13, 95 MSRB Rule G-14, 95 MSRB Rule G-15, 95–96 MSRB Rule G-17, 96 MSRB Rule G-18, 96 MSRB Rule G-19, 92, 97 MSRB Rule G-20, 92, 97 MSRB Rule G-21, 98 MSRB Rule G-22, 98 MSRB Rule G-23, 98 MSRB Rule G-24, 99 MSRB Rule G-25, 99 MSRB Rule G-26, 99 MSRB Rule G-27, 99 MSRB Rule G-28, 100 MSRB Rule G-29, 100 MSRB Rule G-30, 100 MSRB Rule G-31, 100–101 MSRB Rule G-32, 101 MSRB Rule G-33, 101 MSRB Rule G-34, 101 MSRB Rule G-35, 101 MSRB Rule G-36, 101–102 MSRB Rule G-37, 92, 102 MSRB Rule G-38, 92, 102 MSRB Rule G-39, 102 Multilateral netting, 46–47 Municipal revenue bonds, 75, 83

Municipal securities, 51, 75 advertising, 98 churning, 97 control relationships, 98 customer confirmations, 95–96 financial advisers to issuers, 98 Municipal Securities Rulemaking Board Regulations, 88–89 other MSRB rules, 99–102 professional qualification standards, 89–91 quotations and reports of sales and purchases, 95 recordkeeping rules, 91–93 separately identifiable department, 89 standards of fair practice, 96–97 underwriting syndicates, 93–94 uniform processing, clearance, and settlement practices, 94 Municipal Securities Laws, 12 Municipal securities principal, 89–90 Municipal securities representative, 90 Municipal Securities Rulemaking Board (MSRB), 12, 88–89; see also specific MSRB rule Mutual fund activities, 18 administrative services for, 128–129 bank and bank holding company permissible activities, 125 custodianship of, 130–131 FHC subsidiaries and financial subsidiaries, 124–125 investment advisers and, 123–124, 126–127 names for, 59–60, 127–128 organizing and sponsoring of, 125 overview of, 122–123 references, 131 transfer agents for, 130

N National Association of Securities Dealers (NASD), 10, 55, 66, 103, 111 National Association of Securities Dealers Regulation (NASDR), 55 National bank operating subsidiaries, 88 Nationally Recognized Securities Rating Organization (NRSRO), 18 Net asset value (NAV), 122–123 Netting contracts bilateral, 46 multilateral, 46–47

Index 151 Networking arrangement, 105 Nondeposit investment products (NDIP), 53, 55–63 advertising, 60 compensation, 62 compliance, 62–63 disclosures, 57–59 names of mutual funds, 59–60 program management, 57 qualifications and training, 61 reference, 63 retail sales, 56–57 sales guidelines, 55–63 scope of guidelines, 56 setting and circumstances, 60–61 suitability and sales practices, 61–62

O Office of the Comptroller of the Currency (OCC), 7, 15, 17, 18, 125 bilateral netting, 46 financial subsidiaries, 79–80 Investment Securities Regulation (12 CFR 1), 14 mutual funds, 59–60, 125–127 administrative services for, 128–129 recordkeeping requirements, 63 Open-end fund, 122–123 Operating standard financial holding companies, 78 Section 20 subsidiaries, 84–87 Operating risks, derivatives defined, 41 documentation, 46 duty separation, 45 personnel quality, 45 systems quality, 45 valuation issues, 46 Options, 34–35 Overseas securities activities debt-for-equity conversions, 142–143 board approval, 143 ownership restrictions, 143 investments, 137–138 FRB approval of, 138 member bank direct investments, 137 U.S. activities, 137–138 joint ventures, 139 operating structures, 135 overseas branches, 135–137

Overseas securities activities (continued) branch subsidiaries, 136–137 investments, 136 other activities, 137 repurchase agreements, 137 underwriting, 135–136 overseas subsidiaries, 140–142 investments, 140 other permissible activities, 142 underwriting, 140–141 overview of, 134 portfolio investments, 139 references, 144 statutes and regulations for, 134–135 Bank Holding Company Act, 134 Federal Reserve Act, 134 Regulation K, 135

P “Pair offs,” 28 Permissible securities, 51 Personnel brokerage operations, qualifications and training, 61 derivatives, 45 Physical commodity transactions, 47 Political contributions, 102 Portfolio company, 117 Portfolio investments, 139 Presettlement risk, 43–44 Price risk, 14 Private equity funds, merchant banking, 116 Private placements, 17–18, 76, 87 Program management, nondeposit investment products, 57 Prohibited Transaction Exemption (PTE), 25 “Push out” rule, 50, 74–75

Q Quantitative and qualitative disclosures, 39–40 Quotations, 95

R Recordkeeping brokerage activities, 63–64 government securities, 105–106 municipal securities, 91–93 securities lending, 22

152 The Securities Regulatory Handbook Reference credit, 36 Registered persons, 91 Registered sales representative, 61 Regulation K, 8, 115, 134–135, 138, 140–142 Regulation Y, 8, 127 Report of the Committee on Interbank Netting Schemes of the Central Bank of the Group of 10 Countries, 47 Reporting Section 20 operating standard, 87 securities transactions, 26–27 Repurchase agreements, 19–20, 28 overseas branches, 137 overview of, 19 regulatory guidelines, 19–20 Reputation risk, 14 Restricted lists, 69 Retail sales, nondeposit investment products, 56–57 Risk management, derivatives capital adequacy, 47 counterparty credit risk, 40–41, 43–44 credit authorization, 43 monitoring of, 44 presettlement, 43–44 settlement, 44 legal risk, 46–47 bilateral netting, 46 multilateral netting, 46–47 physical commodity transactions, 47 liquidity risk, 41, 44–45 cash flow and funding, 45 market and product, 44 monitoring of, 45 market risk, 41–43 dealers and active position-takers, 42–43 limited end-users, 43 operating risk, 41, 45–46 documentation, 46 duty separation, 45 personnel quality, 45 systems quality, 45 valuation issues, 46 senior management supervision audit coverage, 42 risk responsibility, 42 written policies and procedures, 41–42 settlement risk, 41 Risk management, merchant banking investments, 117–118 Risk management systems, 42

Riskless principal transactions, 96–97 Rule 10b-5, 68 Rule 15c2-12, 101–102 Rule 17j-1, 70 Rule 144A, 17–18

S Safe harbor, 40, 117 Safekeeping disclosures, 66, 107–108 Sales practices, nondeposit investment products, 61–62 Section 4(c)(6), 114 Section 4(c)(7), 114 Section 4(c)(8), 8 Section 4(c)(13), 8, 115, 134 Section 10b, 68 Section 16, 7 Section 17A, 130 Section 20 subsidiaries, 7, 82–87 adequate capital, 84 commercial paper, 83 consumer receivable-related securities, 83 customer disclosure, 85–86 foreign banks, 87 interlocks restrictions, 85 internal controls, 84 intra-day credit, 86 mortgage-related securities, 83 municipal revenue bonds, 83 operating standard #1: capital, 84 operating standard #2: internal controls, 84 operating standard #3: interlocks restrictions, 85 operating standard #4: customer disclosure, 85–86 operating standard #5 intra-day credit, 86 operating standard #6: underwriting period restrictions, 86 operating standard #7: reporting requirement, 87 operating standard #8: foreign banks, 87 private placements, 87 reporting requirements, 87 securities affiliate, 16–17 underwriting period restrictions, 86 Section 21, 7 Section 23A, 9, 78, 81, 84, 87, 118 Section 23B, 9, 78, 81, 84, 87, 118 Section 25A, 115 Section 25, 115, 134 Section 32, 7 Securities Act (1933), 10–11, 40, 87

Index 153 Securities Acts Amendments (1975), 12 Securities dealer selection overview of, 30 regulatory guidelines for board responsibility, 30 control of securities, 31 minimum considerations, 30 Securities Exchange Act (1934), 10, 40, 50, 75, 130 Antifraud Provisions, 68 broker-dealer registration, 54–55 Rule 17j-1, 70 Section 10b, 68 Securities and Exchange Commission (SEC) examination programs, 69 municipal securities activities, 88–89 mutual fund names, 59–60, 127–128 Rule 144A, 17–18 Securities lending, 20–26 administrative procedures, 22 collateral management, 23–24 credit analysis, 22–23 credit and concentration limits, 23 employee benefit plans, 25 FFIEC policy statement, 21–22 indemnification, 25–26 introduction, 20–21 recordkeeping, 22 use of finders, 24–25 written agreements, 24 Securities trading adjusted trading, 29 corporate or extended settlements, 28 covered calls, 29 discretionary authority, 29 gains trading, 28 “pair offs,” 28 repositioning repurchase agreements, 28 short sales, 29 “when issued,” 28 Securities transactions available-for-sale, 27 general, 26–27 held-to-maturity, 26–27 trading securities, 27 Self Regulatory Organization (SRO), 67 Senior management, derivative activities, 41–42 Separately identifiable department (SID), 12, 89, 124, 126 Settlements corporate and extended, 28

Settlements (continued) risks in, 41, 44 securities transactions, 66 Short sales, 29 Small Business Investment Corporations (SBICs), 114 Soft dollar arrangements, 126 Standards of fair practice, municipal securities, 96–97 State nonmember banks equity investments, 18–19 subsidiaries, 82 State securities laws, 12 Strategic risk, 14 Suitability rule, 111–112 Supervision, brokerage operation, 66–67 Swaps, 34, 51, 76 credit default, 36 total rate of return (TROR), 36–37 Syndicates, municipal securities, 93–94

T Telemarketing, 102 Tennessee Valley Authority, 15 Third-party networking, brokerage activities, 53–54 Tier I capital, 115, 117, 136, 138–141, 143 Tier I powers, 83–84 Tier II capital, 141 Tier II powers, 83–84 Total rate of return (TROR) swaps, 36–37 Trading vs. dealing, 74 Transaction risk, 14 Transfer agents, 52, 130 Type I securities, 14–16 Type II securities, 14–16 Type III securities, 14, 16 Type IV securities, 14, 16, 17 Type V securities, 14, 17

U Underwriting period restrictions, Section 20 operating standard, 86 Underwriting syndicates, 93–94 Underwriting and dealing activities dealing, defined, 74 dealing activities, 75–76 financial holding companies (FHCs), 76–77 operating standards, 77–78 financial subsidiaries of national and state member

154 The Securities Regulatory Handbook Underwriting and dealing activities (continued) banks, 78–81 bank qualifications, 79 notice, 79–81 requirements and restrictions, 81 Government Securities Act (GSA), 102–112 broker-dealer registration requirements, 103–104 custodial holding requirements, 106–108 exemptions, 104–105 hold-in-custody repurchase agreements, 108–110 overview of, 102–103 recordkeeping requirements, 105–106 sales practices, 110–112 municipal securities advertising, 98 churning, 97 control relationships, 98 customer confirmations, 95–96 financial advisers to issuers, 98 Municipal Securities Rulemaking Board Regulations, 88–89 other MSRB rules, 99–102 professional qualification standards, 89–91 quotations and reports of sales and purchases, 95 recordkeeping rules, 91–93 separately identifiable department, 89 standards of fair practice, 96–97 underwriting syndicates, 93–94 uniform processing, clearance, and settlement practices, 94 national bank operating subsidiaries, 88 private placements, 76

Underwriting and dealing activities (continued) references, 88, 102, 112 Section 20 subsidiaries, 82–87 adequate capital, 84 commercial paper, 83 consumer receivable-related securities, 83 customer disclosure, 85–86 foreign banks, 87 interlocks restrictions, 85 internal controls, 84 intra-day credit, 86 mortgage-related securities, 83 municipal revenue bonds, 83 operating standards, 84–87 private placements, 87 reporting requirements, 87 underwriting period restrictions, 86 state nonmember bank subsidiaries, 82 trading versus dealing, 74 underwriting, defined, 74 U.S. Department of Labor (DOL), 25 U.S. Department of the Treasury, 9, 79, 103, 108, 117

V Valuation issues, 46

W Watch lists, 69 “When issued” securities trading, 28 World Bank, 15 Written agreements, securities lending, 24 Written policies and procedures, derivatives, 41–42

Securities Regulatory Handbook: 2001-2002 (Pricewaterhousecoopers Regulatory Handbooks)

The Consumer Banking Regulatory Handbook: 2001-2002 (Pricewaterhousecoopers Regulatory Handbooks)

The Commercial Banking Regulatory Handbook (Pricewaterhousecoopers Regulatory Handbooks)

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Regulatory RNAs

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Handbook for Evaluating Infrastructure Regulatory Systems

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Oecd Reviews of Regulatory Reform (OECD Reviews of Regulatory Reform)

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