5500 - General Counsel's Opinions
THE LEGALITY OF DISCOUNT BROKERAGE SERVICES WHEN OFFERED BY INSURED NONMEMBER BANKS
General Counsel's Opinion No. 6
The FDIC has received numerous inquiries from insured nonmember banks and their counsel asking whether or not it is lawful for an insured nonmember bank to offer discount brokerage services to its customers. The inquiries primarily focus on the lawfulness of contractual arrangements between banks and unrelated discount brokers whereby the discount broker executes securities transactions for bank customers and the bank shares in the commissions generated by the transactions. A response to those questions necessarily involves an inquiry into the permissible scope of an insured nonmember bank's direct securities activities under the Banking Act of 1933 (popularly known as the Glass-Steagall Act and codified in several sections of the United States Code). The Glass-Steagall Act is generally recognized as separating the business of banking from that of investment banking (i.e., the securities business). Most of what is the Glass-Steagall Act applies solely to member banks of the Federal Reserve System. (See section 20 (prohibiting the affiliation of member banks and companies engaged principally in the issue, floatation, underwriting, public sale, or distribution of stocks, bonds, debentures, notes or other securities, 12 U.S.C. 377) and section 32 (prohibiting officers, directors, or employees of companies primarily engaged in the issue, floatation, underwriting, public sale, or distribution of stocks, bonds, or similar securities, or partners or employees of a partnership so engaged, from serving as directors, officers, or employees of member banks, 12 U.S.C. 78)).
Section 21 of the Glass-Steagall Act (12 U.S.C. 378) is applicable, however, to member and nonmember banks alike. Section 21 provides, in part, that it shall be unlawful for, any person, firm, corporation, association, business trust, or other similar organization, engaged in the business of issuing, underwriting, selling, or distributing *** stocks, bonds, debentures, notes or other securities, to engage at the same time to any extent whatever in the business of receiving deposits ***.
Section 21 further provides, however, that nothing therein should be read to prohibit "*** State banks *** whether or not members of the Federal Reserve System) *** from dealing, underwriting, purchasing, and selling investment securities to the extent permitted to national banking associations by the provisions of section 24 of this title." Section 24(7th) of title 12 of the United States Code (hereinafter referred to as section 16 of the Glass-Steagall Act) limits "the business of dealing in securities and stock *** to purchasing and selling such securities and stock without recourse, solely upon the order, and for the account of, customers ***." Section 16 ends with the proviso that a national banking association (and thus a nonmember bank) may purchase certain listed investment securities for its own account.
A nonmember bank may therefore, consistent with the Glass-Steagall Act, purchase and sell securities for the account of a customer if it is without recourse and solely upon the order of the customer. It is the opinion of the Legal Division of the FDIC, after reviewing the language of the statute, current case law interpreting the Glass-Steagall Act, and the Act's legislative history, that "discount brokerage" is a permissible activity falling within the language of section 16. By the term "discount brokerage" we are referring to the practice by a bank of executing securities transactions solely at the direction of a bank customer but not providing that customer with any investment advice.
As explained in the senate report accompanying the Glass-Steagall Act, section 16 would permit national banks "to purchase and sell investment securities for their customers to the same extent as heretofore ***." S. Rep. No. 77, 73rd Cong., 1st Sess. 16 (1933). National banks were engaged in brokerage type activities prior to the enactment of the Glass-Steagall Act and their involvement in such activities had been judicially recognized. ( See Blakley v. Brinson, 286 U.S. 254 (1932); McNair v. Davis, 68 F.2d 935 (5th Cir.), cert. denied 292 U.S. 647 (1934); and Block v. Pennsylvania Exchange Bank, 253 N.Y. 227, 170 N.E. 900 (1930)). Bank trust departments also had traditionally performed brokerage functions with regard to trust accounts administered by banks. Therefore in our opinion both the legislative history of section 16 and the historical involvement of banks in brokerage activities support the conclusion that a nonmember bank is not prohibited from engaging in discount brokerage activities as defined above.
Further support for the opinion that discount brokerage activities are a permissible activity for banks can be found in court decisions construing the Glass-Steagall Act. As early as 1947 the Supreme Court, in determining whether a securities firm was "primarily engaged" in securities activities covered by section 32 of the Glass-Steagall Act, did not give any weight to the firm's substantial brokerage activities. Board of Governors of the Federal Reserve System v. Agnew, 329 U.S. 441 (1947). Implicit in that decision, and the later observations of the Court concerning section 16, is the premise that the Glass-Steagall Act is not concerned with activities in which banks traditionally engaged which do not raise the types of hazards sought to be addressed by the Glass-Steagall Act.
As recognized by the Supreme Court in Investment Company Institute v. Camp, 401 U.S. 617, 630-634 (1971), the legislative history of the Glass-Steagall Act reflects concern that a bank might be harmed by its direct or indirect involvement in certain securities activities. Those hazards included the possibility that: (1) The association of the bank with a securities company affiliate could impair public confidence in the bank if the latter performed poorly; (2) the bank might be tempted to make unsound loans to its securities affiliate or to companies whose securities the bank's affiliate was underwriting; (3) bank customer goodwill could suffer if any customer suffered losses after investing in a security associated with the bank; (4) the bank may make unsound "purpose loans" (loans obtained for the purpose of acquiring securities) in order to facilitate the sale of securities in which the bank or its securities affiliate dealt; (5) the bank's affiliate could dump poor issues into the bank's trust department; and (6) the bank's promotional interest in the securities would be in direct conflict with its obligation to render impartial investment advice.
The above hazards have been found not to be present in the case of discount brokerage. The U.S. District Court for the District of Columbia, for example, found automatic investment services ("AIS") by banks not to violate the Glass-Steagall Act. New York Stock Exchange v. Smith, 404 F. Supp. 1091 (D.D.C. 1975), vacated on other grounds sub nom. New York Stock Exchange v. Bloom, 562 F.2d 736 (D.C. Cir 1977) cert. denied, 435 U.S. 942 (1978). Under an AIS program, a bank periodically makes purchases of equity stocks for bank customers from among a list of corporations provided by the bank and debits the customer's account accordingly, i.e., the service is essentially a discount brokerage program. As stated by the lower court in New York Stock Exchange v. Smith.
Banks offering AIS do not have a salesman's interest in the securities performances. Since the banks do not manage the customers' investments, they need not prove that they perform better than anyone else. This is quite different from the situation in Investment Company Institute, where banks were compelled to outperform mutual funds. Under AIS, banks are in competition with investment brokers only in terms of convenience, costs, and dependability. This sort of competition does not engender the threat to banks' solvency which concerned the drafters of the Glass-Steagall Act because it is independent of any investment decision. 404 F. Supp. at 1099-1100.
Based on the foregoing, it is the opinion of the Legal Division that discount brokerage services offered by a nonmember bank are permissible under the Glass-Steagall Act. The legality of any particular brokerage activity may, however, vary from circumstance to circumstance. Discount brokerage can function in as many ways as there are discount brokers or banks. A bank may merely introduce its customers to the broker/dealer services of a discount broker with the bank's subsequent involvement in any securities transaction being limited to debiting or crediting the customer's bank account after each securities transaction ( i.e., the customer directly contacts the broker/dealer to initiate transactions and the broker/dealer confirms all transactions directly with the customer). A bank's involvement may typically increase along a continuum. For example, the bank customer may contact the bank for price quotations, for the placing of buy and sell orders, etc. The bank may act as a conduit of information to the broker/dealer, with the bank confirming transactions with the customer; the bank transmitting funds and securities from the customer to the broker/dealer; and the bank possibly acting as custodian for the customers' securities. In either case the bank would receive a portion of the broker's commission generated by each transactions.
While we obviously cannot comment on all discount brokerage programs as the facts may vary in each, we will observe that generally speaking the Legal Division would not cite as a violation of the Glass-Steagall Act a program in which: (1) The bank clearly acted solely at the customer's direction; (2) the transactions are for the account of the customer and not the account of the bank; (3) the transactions are without recourse; (4) the bank makes no warranty as to the performance or quality of any security; and (5) the bank did not advise the customer to make any particular investment decision. (Trust and agency accounts with regard to which the bank has investment discretion are not subject to this restriction.) Item (5) is in keeping with the traditional role played by banks with respect to investment advice. The Legal Division is of the opinion that investment advice to bank customers is appropriately confined to the administration of trust accounts and should not be done on the commercial side of the bank. This separation plays a significant role in avoiding conflicts of interest and avoiding loss of confidence in the bank due to the performance of a particular securities investment and thus is significant in determining that discount brokerage services do not violate the Glass-Steagall Act.
It is further the Legal Division's opinion that the bank may lawfully promote the discount brokerage service. The bank should assure itself, however, that its promotional literature does not mischaracterize the bank's role in providing the discount brokerage service. This will serve to prevent public misconception about the bank's function with regard to the securities investment. If the bank intends to utilize the contractual arrangement with the broker/deal for transactions executed in connection with trust department accounts, the bank should not receive any additional compensation with regard to those transactions from the broker/dealer, i.e., the bank trust department should not share in any commission associated with the transaction. To do so would raise possibilities of a breach of fiduciary obligation toward the bank's trust account customers.
If a bank's discount brokerage activities are anything more involved than merely introducing bank customers to a broker/dealer pursuant to a contractual arrangement, the bank is advised to review and comply with Part 344 of FDIC's regulations to the extent that they are applicable. (12 CFR Part 344) Part 344 sets forth recordkeeping and confirmation requirements for securities transactions. Nonmember banks are also reminded that any margin lending engaged in with regard to the discount brokerage services must comply with Part 221 of the Federal Reserve Board's regulations (12 CFR Part 221) and should fully comport with sound banking practices.
Lastly, we reiterate that while we are generally of the opinion that discount brokerage comports with the Glass-Steagall Act whether or not the broker/dealer through whom the transaction is executed is an affiliate or a subsidiary of the bank, the FDIC will have to judge each particular program on a case-by-case basis. Any discount brokerage activities on the part of a nonmember bank must fully comport with State law and be consistent with the powers and authorities of any State nonmember bank as defined by State law. This opinion is not intended to address the issue of whether or not discount brokerage presents any conflicts of interests or any safety or soundness concerns. That issue and others are presently being studied by the FDIC in connection with the agency's proposed rulemaking concerning the need, if any, to condition, restrict or prohibit securities activities of subsidiaries of nonmember banks and the need for regulations to govern the relationship between a nonmember bank and its securities affiliates.
[Source: 48 Fed. Reg. 22989, May 23, 1983]