4000 - Advisory Opinions
Applicability of FDIC Rules on Bank Discount Brokerage Affiliate Selling Mutual Funds and Unit Investment Trusts
June 16, 1987
Pamela E. F. LeCren, Senior Attorney
The following is in response to your request for an opinion on whether or not *** Discount Brokerage, Inc., ***, an affiliate of *** Bank, ***, will have to comply with the requirements set forth in section 337.4(c) of the FDIC's regulations (12 C.F.R. 337.4(c)) if *** engages in certain activities involving the sale of mutual funds and unit investment trusts.
According to your letter, *** plans to engage in business operations "similar to those described in the [Federal Reserve Board's June 27, 1986] Sovran Letter." That letter (signed by Michael Bradfield, General Counsel, Federal Reserve Board) responded to a request by Sovran Investment Corporation, a discount broker affiliated with Sovran Bank, N.A., for an opinion on whether or not it was permissible under section 225.25(b)(15) of the Federal Reserve Board's regulations for the discount broker to engage in certain activities involving the sale of shares in mutual funds (i.e., open end management investment companies) and unit investment trusts. The activities as described in the Sovran letter are substantially as follows.
The discount broker will execute purchase, sale and redemption orders for shares of load mutual funds, no load mutual funds, and unit investment trusts upon the order of, and for the account of, its customers. The broker will provide no investment advice or research services, will not exercise any investment discretion regarding the purchase, sale or redemption of shares, and will not purchase shares for its own account. The broker will enter into written agreements with the issuer, sponsor or principal underwriter of the mutual funds or unit investment trusts which generally provide that the broker will act as agent upon the order and for the account of the broker's customers. The issuer, sponsor or principal underwriter will execute transactions upon authorization from the broker and either confirm directly with the customer or with the broker who maintains customer accounts and who in turn will send a confirmation to the customer. The broker will have no authority to act as agent for the issuer, sponsor or principal underwriter nor any authority to make representations about the funds or unit investment trusts other than those contained in the then current prospectus.
The broker will receive an agent's commission as disclosed in the prospectus if the customer purchases shares of a unit investment trust or a load mutual fund. In the case of no load funds, the broker will enter into an additional set of agreements with the issuer, sponsor or principal underwriter under which the broker will provide certain administrative and customer services to the mutual fund and its shareholders such as handling installment purchases, maintaining records on each shareholder's account, posting dividends and reinvesting dividends in accordance with shareholder instructions, rendering periodic statements of account, entering changes of address and account registration, assisting shareholders in changing their instructions for the disposition of dividends, and transferring and receiving money by wire. The fund will compensate the broker for these services based on the average daily net asset value of all shares in the accounts for which the broker provides services. None of the agreements will in any way obligate the broker to sell or promote the mutual funds or unit investment trust shares nor will they restrict the broker from making other mutual funds or unit investment trusts available to its customers.
The broker will not advertise or promote any specific mutual fund or unit investment trust but will promote the availability of its services. The broker's employees will inform customers that the broker does not recommend any particular investment and brochures promoting the broker's services will caution customers to read the prospectus carefully prior to investing. Likewise, the brochures will indicate that the shares are not obligations of the broker's affiliated bank and are not insured by the FDIC. The broker will furnish a prospectus only upon customer request and will not make unsolicited mailings or other distributions of prospectuses or sales literature and will refer non-routine inquiries about a mutual fund or unit investment trust to the issuer, sponsor or principal underwriter. The broker's employees will not receive any compensation based upon the purchase, sale or redemption of mutual fund or unit investment trust shares. The broker will not receive a cumulative quantity discount on mutual fund or unit investment trust shares except upon behalf of its customers.
Your letter to *** of the Federal Reserve Board requesting approval under section 225.25(b)(15) for *** program characterizes *** plan as substantially identical to the program dealt with by the Federal Reserve Board in connection with the Sovran request. In addition, your letter sets forth the following details pertaining to *** program.
*** plans to make mutual fund and unit investment trust shares available to its customers through its clearing broker. *** will be paid a commission by its customers in connection with purchases, sales and redemptions of no load funds. *** will enter into "agent" or "seller's" agreements with the issuer, sponsor or principal underwriter of load funds pursuant to which *** "will participate in the load the customer pays." All purchases will be solely for the account of, and upon the order of *** customers. *** will not acquire any ownership interest in the mutual fund or unit investment trust shares.
*** clearing broker will handle approximately 600 mutual funds and unit investment trusts. As it would not be feasible to inventory prospectuses for all 600 funds, *** intends to keep on hand prospectuses for 40 to 50 funds. Prospectuses will be mailed out upon customer request only. *** will generally promote its services to its customers and will identify the names of the 40 to 50 funds the prospectuses of which are inventoried. Each security will be listed by classification and investment objective (e.g., bond, balance, common stock, growth, income, etc.). This information will be derived solely from prospectuses. No performance figures will be given to customers.
If a customer contacts *** indicating interest in making a purchase of mutual fund shares or unit investment trust shares but does not specify the specific fund or trust to be purchased, *** "will ascertain the generic type of security in which its customer is interested, based upon the customer's stated investment objective . . . advise the customer of the names of several [funds] having such characteristics, the prospectuses of which *** has on hand . . . [and] offer to review the names of the other [funds] which are available through its clearing broker within that category". No recommendation will be furnished with respect to the purchase of shares in any particular fund. The ultimate decision as to which if any security a customer will purchase will be made by the customer based solely upon information obtained from the prospectus and whatever other sources upon which the customer has chosen to rely.
Section 337.4 of the FDIC's regulations governs the securities activities of subsidiaries and affiliates of insured nonmember banks. Pursuant to that regulation, any affiliate of an insured nonmember bank that engages in securities activities prohibited to banks by section 21 of the Glass-Steagall Act must comply with the requirements of section 337.4(c) of the regulation which sets forth, among other things, restrictions on shared officers and employees, shared offices and the composition of the affiliated bank's board of directors. In order to respond to your question we must determine whether or not a bank could engage in the activities described above.
Section 21 of the Glass-Steagall Act (12 U.S.C. 378) provides in relevant part that it shall be unlawful for:
[A]ny person, firm, corporation, association, business trust, or other similar organization, engaged in the business of issuing, underwriting, selling, or distributing, at wholesale or retail, or through syndicate participation, stocks, bonds, debentures, notes or other securities, to engage at the same time to any extent whatever in the business of receiving deposits . . . . Provided, that the provisions of this paragraph shall not prohibit national banks or state banks or trust companies (whether or not members of the Federal Reserve System) . . . from dealing in, underwriting, purchasing, and selling investment securities to the extent permitted to national banking associations by the provisions of Section 24 of this title [Section 16 of the Glass-Steagall Act] . . . .
Section 16 of the Glass-Steagall Act (12 U.S.C. 24(seventh)) provides in relevant part that the business of dealing in securities and stock by a national bank shall be limited to purchasing and selling securities without recourse solely upon the order and for the account of customers and in no case for its own account. The section also specifically provides that a national bank shall not underwrite any issue of securities except for certain listed obligations none of which are relevant here.
For the reasons discussed below, we believe that the activities described above would fall within the language of section 16 of the Act and would not involve prohibited activities. We conclude therefore that *** will not be required to meet the requirements pertaining to affiliates in section 337.4(c) of the FDIC's regulations if it engages in activities involving the sale of mutual fund and unit investment trust shares in the manner described above.
Bankers Trust Decision
A recent opinion of the United States Court of Appeals for the District of Columbia (Securities Industry Association v. Board of Governors of the Federal Reserve System, 807 F.2d 1052 (D.C. Cir. 1986), "Bankers Trust II") considered the issue of whether certain agency activities by a bank on behalf of an issuer of securities constitutes underwriting and therefore are not permissible for a bank under the Glass-Steagall Act. The activities in question involved Bankers Trust Company acting as agent on behalf of an issuer in the private placement of commercial paper.1 The Court of Appeals overruled the lower court's decision that the selling activities constituted underwriting. (SIA v. Board of Governors, 627 F. Supp. 695 (D.D.C. 1986)). In particular the Court of Appeals found that the selling activities fell within the language of section 16 (i.e., were for the account of a customer without recourse against the bank) and that the activities did not constitute underwriting. The activities were therefore permissible for banks under the Glass-Steagall Act and the inquiry needed go no further.2 In the Court's view a private placement did not involve underwriting for the purposes of the Glass-Steagall Act as the term "underwriting" (as well as the term "distribution") only encompasses transactions involving a public offering.3 The Court left open the possibility, however, that other agency sales activities on behalf of an issuer occurring in the context of a public offering could constitute underwriting and thus would be banned by the Glass-Steagall Act.
We do not believe that Section 16 gives unlimited rein to banks in the performance of agency transactions, as Bankers Trust suggests. We instead read the restriction against underwriting contained in Section 16 as an independent restriction on the bank's securities operations that applies even to agency transactions. Bankers Trust II, at 1062 n. 3.
The Court did not elaborate on what those limits might be. To do so was unnecessary to the disposition of the case in view of the Court's earlier conclusion that the private placement activities involved there did not constitute underwriting.
Lastly, even though the Court questioned the need to conduct a hazards analysis with respect to the bank's private placement activities, the Court, nonetheless, reviewed whether those particular agency activities implicated the subtle hazards that the Glass-Steagall Act sought to eliminate.4 At the conclusion of its review, the Court found that the private placement activities did not, for the most part,5 create the type of subtle hazards with which the Glass-Steagall Act was concerned.
Application of Bankers Trust Decision to *** Program
The activities to be undertaken by *** clearly fall within the literal language of section 16. *** activities are undertaken solely as agent for *** customers and not on behalf of an issuer, sponsor or principal underwriter of securities. *** does not commit itself to sell securities behalf of any issuer, does not solicit purchasers, and does not promote the sale of any securities on behalf of any issuer. *** makes no purchases as principal. All purchases will be without recourse as agent for the account, and upon the order of, *** customers. The first half of section 16 is therefore met. As to the caveat in section 16 concerning underwriting, we do not feel that the *** program involves underwriting. Although the *** program involves securities issued in the primary market through a public offering (a fact situation which according to Bankers Trust II could involve underwriting), it does not appear that the agency transactions involved here constitute underwriting. Indeed, because *** does not commit itself as agent, or otherwise, to sell any securities, its activities do not constitute best efforts underwriting.6 [Even if we were to assume that agency transactions on behalf of an issuer in the primary market through a public offering (whether or not under a commitment to sell a certain amount of securities) involve underwriting for the purposes of the Glass-Steagall Act. *** activities do not fall within that category.] We therefore conclude that the second half of section 16 has been met, i.e., *** is not underwriting securities.
The Supreme Court in Investment Company Institute v. Camp, 401 U.S. 617, 630-633 (1971), reviewed and held invalid a regulation of the Comptroller of the Currency permitting national banks to establish and operate a certain type of collective investment fund. The Court discussed the legislative history of the Glass-Steagall Act and articulated several hazards associated with the direct and indirect involvement by banks in securities activities.
The temptations identified by the Supreme Court were: (1) the association of the affiliate and the bank in the public's mind could impair public confidence in the bank should the affiliate fare badly; (2) the temptation to shore up the affiliate through bad loans; (3) the temptation to make the bank's credit facilities readily available and make unsound loans to companies in whose stock the affiliate has invested; (4) loss of customer goodwill if a customer suffers loss after investing in a stock or security associated with a bank affiliate; (5) the promotional interest of investment banking might cause a bank to lend its reputation to the sale of particular stocks and thus risk the undercutting of its reputation; (6) the temptation to make loans for the purpose of acquiring stock or securities sold by the bank's affiliate; (7) the inherent conflict between a bank's promotional interest and its obligation to render impartial investment advice; and (8) the unloading of poor issues into the bank's trust department.
We have considered a number of these hazards in the context of the ** program and have concluded on balance that the subtle risks identified by Camp are not present.
Based upon the foregoing analysis we have concluded that *** need not comply with section 337.4(c) of the FDIC's regulations. This opinion is based solely upon the facts presented to the FDIC in your inquiry. We reserve the right to review this conclusion if there is any material change in the facts and circumstances from those set forth above.
1 The Court of Appeals decision in Bankers Trust II is relevant to the issue at hand as the activities in which *** wishes to engage could be characterized as agency sales activities on behalf of an issuer of securities. We do not feel that the Supreme Court's 1984 decision involving Charles Schwab & Company, SIA v. Board of Governors, 104 S. Ct. 3003 (1984) ("Schwab"), is controlling here. In that case the Supreme Court found that the affiliation of a member bank with a company principally engaged in retail brokerage in the secondary market as agent for the account of its customers did not violate section 20 of the Glass-Steagall Act (12 U.S.C. 377). (Section 20 prohibits the affiliation of a member bank with any corporation engaged principally in the issue, flotation, underwriting, public sale or distribution of securities.) While the Supreme Court in dicta indicated that the terms "underwriting" and "distribution" traditionally apply to activities distinctly different from those of a broker (Schwab, at 3010) and characterized an underwriter as one who buys as principal (Schwab, at 3010 n. 17), we do not feel that the decision is dispositive of this case. In Schwab, the Supreme Court considered securities activities that took place in the secondary market (i.e., involved the buying and selling of securities already in the market). The case specifically left open the possibility that agency transactions (i.e., best-efforts underwriting) can give rise to underwriting for the purposes of the Glass-Steagall Act. (Schwab, at 3010 n. 17). Transactions of the type at issue here involve the primary market (i.e., newly issued securities). Depending upon the actions involved, such activities could be viewed as assisting in the underwriting of such securities. Go back to Text
2 "Thus, if the Board reasonably found that section 16 permits Bankers Trust's activities, our inquiry ends there." Bankers Trust II, at 1058. Concerning the interplay of sections 16 and 21 the Court stated that, "Section 21 cannot be read to prohibit what Section 16 permits." Bankers Trust II, at 1057. The Court also stated that, ". . .any restriction on the activities of a commercial bank that may arise because of the prohibitions of Section 21 is relieved insofar as the activity is permitted by Section 16." Bankers Trust II, at 1058. Go back to Text
3 See pages 19 through 24 of the Court of Appeals opinion, where the Court discusses certain passages of the Act's legislative history as evidence that Congress was concerned about the promotional pressures that ensue when a bank establishes a retail network for the sale of securities. Go back to Text
4 The Court of Appeals noted that although the Supreme Court in Board of Governors v. Dimension Financial Corporation, 106 S. Ct. 681 (1986) rejected the invocation of broad legislative purpose to override the clear language of a statute, the Supreme Court has uniformly considered whether subtle hazards are associated with the securities activities in question whenever it has been asked to interpret the Glass-Steagall Act. Bankers Trust II, at 1066-1067. Go back to Text
5 "We believe, however, that despite the existence of this one subtle hazard' we must still affirm the Board. There are several reasons for that conclusion. First, the subtle hazards' addressed in Camp and returned to ICI, Schwab and SIA have never alone caused the Supreme Court to hold that Glass-Steagall permits or prohibits any particular banking practice. Rather, analysis of the hazards in those cases simply reinforced the Court's conclusion that, as a matter of statutory interpretation, Glass-Steagall permitted or prohibited the questioned practice. Moreover, the Court has concluded that subtle hazards counsel prohibition of a banking practice only when the practice gave rise to each and every one of the hazards." Bankers Trust II, at 1069. Go back to Text
6 "Underwriters also may distribute securities under a best efforts' agreement pursuant to which large blocks of specific issues of securities are offered to the public by the investment banker as agent for the issuer." Schwab, at 3010. Go back to Text