[Federal Register: March 19, 1997 (Volume 62, Number 53)]
[Rules and Regulations]
[Page 13275-13288]
From the Federal Register Online via GPO Access [wais.access.gpo.gov]
[DOCID:fr19mr97-11]
[[Page 13275]]
_______________________________________________________________________
Part VI
Department of the Treasury
Office of the Comptroller of the Currency
12 CFR Part 13
Federal Reserve System
12 CFR Part 208 and 211
Federal Deposit Insurance Corporation
12 CFR Part 368
_______________________________________________________________________
Government Securities Sales Practices; Final Rule
[[Page 13276]]
DEPARTMENT OF THE TREASURY
Office of the Comptroller of the Currency
12 CFR Part 13
[Docket No. 97-05]
RIN 1557-AB52
FEDERAL RESERVE SYSTEM
12 CFR Parts 208 and 211
[Regulations H and K, Docket No. R-0921]
FEDERAL DEPOSIT INSURANCE CORPORATION
12 CFR Part 368
RIN 3064-AB66
Government Securities Sales Practices
AGENCIES: Office of the Comptroller of the Currency, Treasury; Board of
Governors of the Federal Reserve System; Federal Deposit Insurance
Corporation.
ACTION: Joint final rule.
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SUMMARY: The Office of the Comptroller of the Currency (OCC), Board of
Governors of the Federal Reserve System (Board), and Federal Deposit
Insurance Corporation (FDIC) (collectively, the agencies) are issuing
rules regarding sales practices concerning government securities by
depository institutions within their respective jurisdictions. The
agencies are adopting the final rules in light of recent statutory
changes authorizing the agencies to adopt rules governing transactions
in government securities in order to provide consistent treatment for
government securities customers. The final rules minimize regulatory
burdens to the extent feasible, consistent with the goal of providing
purchasers of government securities with consistent treatment
regardless of whether they engage in transactions in government
securities with banks or nonbank government securities brokers and
dealers.
EFFECTIVE DATE: This joint rule is effective July 1, 1997.
FOR FURTHER INFORMATION, CONTACT: OCC: Ellen Broadman, Director, or
Elizabeth Malone, Senior Attorney, Securities & Corporate Practices
Division (202/874-5210); Joseph W. Malott, National Bank Examiner,
Capital Markets (202/874-5070); or Mark J. Tenhundfeld, Assistant
Director, Legislative and Regulatory Activities (202/874-5090), 250 E
Street, SW, Washington, DC 20219.
Board: Oliver Ireland, Associate General Counsel (202/452-3625), or
Lawranne Stewart, Senior Attorney (202/452-3513), Legal Division, Board
of Governors of the Federal Reserve System, 20th and C Streets, NW,
Washington, DC 20551. For the hearing impaired only, Telecommunication
Device for Deaf (TDD), Ernestine Hill or Dorothea Thompson (202/452-
3544).
FDIC: William A. Stark, Assistant Director (202/898-6972), Keith
Ligon, Chief (202/898-3618), Kenton Fox, Senior Capital Markets
Specialist (202/898-7119), Division of Supervision; or Karen L. Main,
Senior Attorney (202/898-8838), Legal Division, Federal Deposit
Insurance Corporation, 550 17th Street, NW, Washington, DC 20429.
SUPPLEMENTARY INFORMATION:
The Government Securities Act Amendments of 1993
The Government Securities Act Amendments of 1993 (Amendments)
(Pub.L. 103-202), codified at section 15C(b)(3) of the Securities
Exchange Act of 1934 (Exchange Act) (15 U.S.C. 78o-5(b)(3)), authorize
the agencies to adopt rules and regulations governing transactions in
government securities as may be necessary to prevent fraudulent and
manipulative acts and practices and to promote just and equitable
principles of trade. Id. section 15C(b)(3)(A). Rules adopted pursuant
to the Amendments apply to transactions in government securities by
banks that have filed, or are required to file, notice as government
securities brokers or dealers.
The Amendments require the banking agencies to consider the
sufficiency and appropriateness of existing laws and rules applicable
to government securities brokers or dealers and associated persons
before promulgating rules governing transactions in government
securities. Id. section 15C(b)(3)(C). In determining whether existing
laws are sufficient, the agencies may consider rules that expressly
apply to government securities activities of financial institutions and
other sales practice rules that do not expressly apply to these
activities but that are used by examiners and bankers as guidance for
transactions in government securities. S. Rep. No. 109, 103d Cong., 1st
Sess. at 14. The agencies also may consider the extent to which
additional rules are necessary to establish consistent treatment for
bank customers engaged in transactions involving government securities.
The Amendments also eliminated the statutory limitations on the
National Association of Securities Dealers (NASD) authority to apply
sales practice rules to transactions in government securities by
government securities broker-dealers that are members of the NASD. See
section 106 of the Amendments (15 U.S.C. 78o-3). To implement this
expanded sales practice authority, the NASD proposed, and the SEC
approved August 20, 1996 (see SEC Release No. 34-37588), the
application of the NASD Conduct Rules (formerly, the Rules of Fair
Practice) to transactions in government securities. The NASD Conduct
Rules include a Business Conduct Rule and a Suitability Rule, as well
as a Suitability Interpretation. The rules and the interpretation that
the agencies promulgated in both the proposed and final rules (see text
that follows) are substantially identical to the NASD Business Conduct
and Suitability Rules and the NASD Suitability Interpretation.
The Proposal
On April 25, 1996 (61 FR 18470), the agencies requested comment on
whether they should require a bank that is a government securities
broker or dealer to comply with rules that are substantively identical
to the NASD Business Conduct and Suitability Rules and the NASD
Suitability Interpretation. The proposal defined ``bank that is a
government securities broker or dealer'' as a bank that has filed
notice, or is required to file notice, as a government securities
broker or dealer under the provisions of the Government Securities Act
(15 U.S.C. 78o-5(a)) and applicable Treasury rules (17 CFR 400.1(d) and
401).
The proposal required a bank that is a government securities broker
or dealer and its associated persons: (a) To 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 (b) to have reasonable grounds for believing that recommendations
are suitable for a customer based on the facts, if any, disclosed by a
customer regarding his, her, or its other securities holdings and
financial situation and needs. The proposal provided that, if a bank is
doing business with a non-institutional 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 transaction it recommended to the customer. The suitability
rule contained in the proposal, like the Suitability Rule of the NASD,
applies only in situations where a bank makes a ``recommendation'' to
its customer.
[[Page 13277]]
The proposal also set out a suitability interpretation that
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 identified:
(a) the customer's capability to evaluate investment risk
independently; and (b) the extent to which the customer is exercising
independent judgement 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. The suitability
interpretation provided that 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 judgement in evaluating a
recommendation.
The proposed suitability interpretation set 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, advisors, 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 stressed 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
noted 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 proposed suitability interpretation further provided that a
determination that an institutional customer is making an independent
investment decision depends 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 proposed suitability interpretation stated that these
factors would 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 stated 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.
Final Rules and Comments Received
The final rules adopt the business conduct and suitability rules
and the suitability interpretation as proposed, excepting only the
addition of a definition of ``government security'' in the final rules
and minor modifications of the suitability interpretation to conform
that interpretation to the NASD's Suitability Interpretation. As
discussed in greater detail below, the agencies continue to believe
that banks and their customers will benefit significantly from a
consistent set of rules applied to banks engaged in transactions in
government securities.
The agencies received a total of 18 comments. Of these, eight were
from trade organizations representing interests ranging from the banks
and the securities companies to state governments and retired persons.
Seven other comments were from insured depository institutions or their
affiliates, two were from State governments, and the remaining comment
was from a securities dealer. The comments were fairly evenly split,
with banks and securities companies and their respective trade
organizations generally opposing the proposal and the rest of the
commenters favoring it.
Commenters typically responded to some or all of the specific
questions set out in the proposal. Below is a summary of the comments,
along with the agencies' responses, that follows the order of questions
presented for comment in the proposal.
Issue 1. Adoption of rules substantially similar to the NASD Business
Conduct and Suitability Rules
Eight commenters opposed adoption of these rules for banks while
seven favored adoption of the rules.
(a) Comments supporting adoption of the proposed rules. Commenters
representing purchasers of government securities stated that certain
government securities, such as collateralized mortgage obligations,
carry considerable risk and are unsuitable for certain investors. The
purchasers' representatives stated further that customers need to be
protected from potential misconduct in the sale of government
securities. They believe that banks should be held to the same
standards as apply to other entities that engage in government
securities transactions and that the existence of customer protections
should not depend on the type of entity selling the security. Several
of the commenters also stated their support for the suitability
interpretation, with one commenter stating that a suitability
determination must be made on a case-by-case basis and another stating
that banks should be required to ask for specific information about an
investor before making a recommendation.
(b) Comments opposing adoption of the proposed rules. Those
opposing the application of these rules to banks advanced several
arguments to support their conclusion that the rule is unnecessary.
Their arguments fall into the following eight broad categories.
(i) There have been no significant sales practice abuses.
(ii) The Amendments and the legislative history indicate that the
banking agencies are not required to adopt sales practice rules.
(iii) There are sufficient market incentives to ensure that the
good relations that exist between banks and their customers would
likely discourage banks from making unsuitable recommendations of
government securities.
(iv) A suitability obligation is particularly inappropriate in the
case of institutional investors, because institutional investors need
less protection than do retail customers and because a bank will lack
adequate information needed to detect anomalies between an
institutional customer's investment objectives and the type of trade.
(v) The rules will impose significant additional burdens on banks,
in part because the rules are too ambiguous.
(vi) The rules could have unintended adverse consequences by
discouraging investors from performing their own research in order to
shift responsibility (and, therefore, liability) for making appropriate
investments to the bank that makes a recommendation.
(vii) Case law and other issuances, such as the Interagency
Statement on Retail Sales of Nondeposit Investment Products (the
Interagency Statement), OCC Banking Circular 277--Risk Management of
Financial Derivatives, the Board's Trading Activities Manual (March
1994) and SR 93-69 (FIS) (Dec. 20, 1993), and the Rules of the
Municipal Securities Rulemaking Board
[[Page 13278]]
(MSRB), provide sufficient guidance to banks and bank examiners on
appropriate sales practices.
(viii) The agencies should consider alternatives to adopting the
rules as proposed, such as adopting guidelines or amending the proposal
to include a statement that compliance with certain requirements
creates a safe harbor.
(c) Analysis of Issue 1. After carefully considering all the
arguments advanced by the commenters, the agencies continue to believe
that the benefits of the rules in question significantly outweigh the
burdens and, therefore, are adopting the rules substantially as
proposed. The agencies believe that adoption of final rules
substantially in the form proposed is appropriate to provide consistent
treatment for government securities customers. Although bank and
nonbank government securities dealers will continue to be subject to
different regulatory structures, adoption of business conduct and
suitability rules that are consistent with the NASD rules will ensure
that customers of both bank and nonbank government securities broker-
dealers receive consistent treatment in their government securities
transactions. The agencies agree with those who stated that certain
government securities can carry considerable risk and that the rules
appropriately focus the banking industry's attention on the issue of
suitability in recommending these securities. An analysis of the
comments opposing adoption of the rules follows.
(i) Lack of evidence of abuses. Opponents of the rules are correct
that sales practice abuses have not been found to be a significant
problem in financial institutions engaged in government securities
transactions. However, losses stemming from unsuitable transactions in
government securities can create reputational risk for banks. The
agencies believe that banking practices that comport with the final
rules will help minimize this risk to banks due to losses incurred by
their customers.
(ii) Rules not required by statute. Opponents of the rules also
correctly noted that the Amendments and the legislative history do not
require the bank regulatory agencies to adopt sales practice rules.
However, the Amendments authorize the agencies to adopt rules as may be
necessary to promote, among other things, just and equitable principles
of trade. The final rules accomplish this by providing guidance to
banks about the extent of their obligations when recommending a
government security to a customer. They also enable a customer to
receive consistent treatment, regardless of whether the customer
conducts business with a bank or nonbank government securities broker-
dealer.
(iii) Sufficient market alternatives. The agencies intend for the
rules to facilitate the good relations noted by many commenters that
exist between banks and their customers. In addition to codifying the
business conduct and suitability rules, the final rules provide banks
with guidance concerning those factors that a bank may find relevant
when determining its suitability obligations to an institutional
customer. This guidance is provided to assist banks in identifying when
an institutional customer is capable of evaluating investment risk
independently and is exercising independent judgement in evaluating the
bank's recommendation.
(iv) Suitability obligation inappropriate for institutional
customers. The agencies agree with the commenters who stated that any
suitability rule should reflect the differences between institutional
and non-institutional customers. Banks frequently will have knowledge
about an investment and its risks that are not possessed or easily
obtained by the non-institutional customer. A more sophisticated
institutional customer, on the other hand, may have both the
understanding of how a particular securities issue could perform and a
desire to make investment decisions without relying on a bank's
recommendation.
The final rules recognize the wide variety of customer profiles,
even among institutional customers, and provides guidance intended to
assist a bank in determining the nature of its suitability obligations
to a customer. Under the final rules, the nature of a suitability
determination changes, depending on the type of customer. For a
comparatively unsophisticated customer, the determination will need to
focus more on whether a particular investment is appropriate for that
customer after a review of the customer's financial condition and
objectives. For a more sophisticated customer, the focus of the
suitability determination shifts initially to the question of whether
the customer is capable of evaluating risk and the bank's
recommendation. The suitability interpretation provides illustrative
factors that are intended to help a bank determine how to fulfill its
suitability obligation for a given institutional customer. As noted in
the interpretation, these factors are not intended to be requirements
or the only factors to be considered but are offered merely as guidance
in determining the scope of a bank's suitability obligations.
(v) Increased burden. The agencies believe that the sales practice
rules will not subject banks to a material increase in regulatory
burden. Almost all banks that are government securities broker-dealers
also are municipal securities broker-dealers or sell other securities
for which they are required to comply with business conduct and
suitability rules. As a consequence, banks frequently will have
obtained the information needed to comply with the business conduct and
suitability rules from customers in the course of other securities
transactions, and will have implemented policies and procedures that
can be applied to transactions involving government securities.
(vi) Unintended adverse consequences. The agencies disagree with
the commenters who suggested that the rules will discourage customers
from consulting with their own internal or external advisors before
making an investment. These commenters are concerned that the rules
will shift liability to banks by creating disincentives for a customer
to undertake research that is independent of that conducted by a bank.
As noted in the proposal, the suitability and business conduct rules
and suitability interpretation do not provide a basis for a private
right of action against a bank by a customer based on a violation of
these rules or interpretation. Thus, a customer will have every
incentive after the rules are adopted that it had before adoption to
undertake whatever due diligence it thinks is appropriate in evaluating
an investment recommendation.
(vii) Existing guidance adequate. While those opposed to the rules
are correct that there are banking agency issuances that address sales
practices in other areas of securities sales, these issuances do not
provide customers who engage in government securities transactions with
banks with treatment that is consistent with that provided under the
NASD Business Conduct or Suitability Rules or the NASD Suitability
Interpretation. Moreover, existing guidance does not address government
securities sales practices for all types of customers. The final rules
will provide a framework that will be consistent throughout the banking
industry for analyzing the obligations of a bank engaged in government
securities transactions.
(viii) Suggested alternatives. One bank commenter recommended that
the agencies adopt guidelines instead of the proposed sales practice
rules. Another suggested that the agencies adopt an
[[Page 13279]]
``appropriateness'' standard pursuant to which a bank would focus on
the customer's ability to understand the nature of, and risks inherent
in, a given transaction. Two commenters suggested that the final rules
contain an assurance that compliance with the interpretive guidance
will create, at a minimum, a rebuttable presumption that a bank's
suitability obligations with respect to institutional customers have
been satisfied. Finally, another commenter suggested that banks be
insulated from liability if an institutional customer has retained a
third party professional investment advisor or if the bank executes a
transaction that is consistent with an institutional account's
specifically enumerated authorized investment guidelines.
The agencies have concluded, however, that adopting the rules in
the form of a regulation will provide consistent treatment of
customers, regardless of whether they conduct business with a bank or a
nonbank government securities broker-dealer. The agencies also have
decided not to create any safe harbors whereby a bank would be presumed
to have fulfilled its suitability obligation. The creation of such a
presumption would be acceptable only if a definable class of
institutional customers could be identified that would not benefit from
the suitability rule under any conceivable circumstance.
``Institutional customers'' include, among others, colleges, churches,
charities, and governments. Given the wide diversity of characteristics
that such entities present, the agencies have concluded that it is more
appropriate for a bank to determine suitability on a case-by-case
basis. Furthermore, nonbank broker-dealers do not have safe harbors
whereby compliance with the suitability obligation is presumed. To
create a safe harbor for banks would reduce the benefits of consistent
treatment of customers.
Issue 2. Benefits of Consistency Among Government Securities Brokers
and Dealers
Of the seven commenters responding to this issue, five stated that
there are benefits of consistent treatment by government securities
broker-dealers while two stated that consistency would not provide
significant benefits.
(a) Comments favoring consistency. Several commenters stated that
customers are more likely to receive equal treatment if the agencies
impose rules similar to those imposed by the NASD. One commenter noted
that the substance of the rules applied by the banking agencies should
be as uniform as possible with those applied by the NASD to minimize
the extent to which there are gaps in the existing regulatory
framework. Another commenter stated that a customer should not have to
bear the burden of determining which set of rules apply to different
dealers who are performing exactly the same functions concerning
exactly the same types of investments. In this commenter's view, the
agencies'' role in maintaining the safety and soundness of banks
includes protecting customers. A third commenter observed that
fragmentation of the market is likely if different rules apply.
(b) Comments opposing consistency. A trade association representing
both bank and nonbank interests stated that a majority of its members
believes that adopting the final rules is not justified because the
level playing field already exists in the form of remedial and
enforcement authority that the agencies may exercise. Another commenter
noted that there are significant differences between bank and nonbank
government securities broker-dealers, and concluded that these
differences justify using different standards. This commenter believes
that the different standards continue to result in the same level of
customer protection, thus obviating the need to adopt the rules set out
in the proposal.
(c) Analysis of Issue 2. The agencies believe that the final rules
will provide consistent treatment to customers engaging in government
securities transactions, regardless of whether the customer receives a
recommendation from a bank or nonbank government securities broker-
dealer. The existing regulatory and common law does not provide this
consistent treatment. The final rules avoid requiring customers to
ascertain which rules apply to which institution. Moreover, the
agencies expect that the final rules, by focusing banks' attentions on
suitability concerns, will minimize the disputes between banks and
their customers concerning the suitability of a given recommendation.
Issue 3. Sufficiency of the Standard Provided in the Business Conduct
Rule
Five commenters responded to this issue. Four commenters believe
that the business conduct rule is sufficiently clear, while one
commenter believes that additional interpretation is necessary.
(a) Comments finding business conduct rule clear. One commenter
stated that the business conduct rule, taken together with the
suitability rule, is sufficiently clear. In this commenter's opinion, a
rule of this nature should provide a general code of conduct that
protects the integrity of the profession by setting a baseline of good
conduct. Another commenter suggested that more specific guidelines may
be too restrictive and not benefit the customer or bank. A third
commenter restated its request for changes in the examination
procedures to ensure compliance with the final rule but suggested that
banks should have less latitude in the types of information requested
from a customer. The fourth commenter stated its general agreement that
the business conduct rule is clear.
(b) Comments finding the business conduct rule unclear. The one
comment finding the business conduct rule unclear stated that the rule
does not delineate proper conduct for sales practices. This commenter
stated that it views the NASD guidance related to the business conduct
rule as providing appropriate additional clarification.
(c) Analysis of Issue 3. The agencies believe that the business
conduct rule set out in the proposal is sufficiently clear. As noted by
one commenter, the rule establishes a baseline of appropriate behavior
in the industry. A bank then has the flexibility to comply with this
standard in ways that it finds appropriate and effective. Attempts at
additional clarification in this area are likely to provide little
additional meaningful guidance without becoming so detailed as to be
overly burdensome and restrictive. The agencies also are concerned that
additional clarification in the business conduct rule would detract
from the objective of ensuring consistent treatment for customers of
bank and nonbank government securities broker-dealers. The agencies
note that the NASD is continuing to consider issues concerning the
application of certain interpretations of their Business Conduct Rule
to the government securities markets.
Issue 4. Definition of ``Recommendation''
The issue of whether to define ``recommendation'' or provide
guidance as to what is and is not a recommendation generated responses
from seven commenters, four of whom requested additional guidance or a
definition and three of whom stated that no additional guidance or
definition is needed.
(a) Comments favoring defining ``recommendation.'' A point
consistently made by those requesting additional guidance is that the
rules should clarify that a recommendation does not include providing
routine market information, such as market observations, forecasts
about the general
[[Page 13280]]
direction of interest rates, and price quotations. One commenter also
stated that the rules should not treat subjective analyses of market
information as a recommendation, because to do so would discourage
banks from providing this information. This commenter suggested that
the rules exclude from the definition of ``recommendation'' the
providing of several investment alternatives for an investor's
consideration. Two commenters proposed definitions that would include,
generally speaking, an unconditional affirmative statement by one party
urging another to enter into a particular transaction, an explicit
identification of the statement as a recommendation, and/or a
requirement that information be given to the bank expressly for the
purpose of enabling the bank to make a recommendation. One of these
commenters stated that reliance should not be considered reasonable
unless an institutional customer has provided information regarding its
portfolio, its liabilities, and the range of investment opportunities
available to the customer. Another commenter concluded that the
definition is so vague that the commenter will have to assume, despite
the fact that it makes no recommendations, that all current sales
activities constitute making a recommendation and then build systems
and increase staff to evaluate and document the suitability of each
customer purchase. Another commenter suggested that a definition should
not include trade or hedging ideas unless there is a written agreement
between the parties or unless applicable law expressly imposes
affirmative obligations to the contrary. This commenter noted that this
approach would be consistent with the ``impersonal advisory services''
rule proposed by the SEC in 1994.
(b) Comments opposing defining ``recommendation.'' Commenters
opposing defining ``recommendation'' expressed concern that a
definition would create a safe harbor protecting banks against
liability and stated that individual facts and circumstances must be
reviewed to determine whether a recommendation has been made. One
commenter stated further that the line of when a bank is recommending a
product is clear, namely, when the bank provides information to explain
why a customer should purchase a particular product. This commenter
suggested that once a customer expresses an interest in a particular
product, the suitability obligation should be triggered even if no
explicit recommendation is made.
(c) Analysis of Issue 4. The agencies have decided not to define
``recommendation,'' for several reasons. First, a determination of
whether a recommendation has been made necessarily depends on the facts
of a given situation. The agencies believe that a definition would not
change the need to review the entire circumstances of a transaction,
and, therefore, do not believe that a definition would provide a
significant benefit. Second, the agencies are concerned that a
definition might be misinterpreted as a safe harbor whereby a
government securities broker-dealer effectively recommends an
investment but argues that it had no suitability obligation because the
advice technically was not a recommendation according to the literal
terms of a definition. Third, the agencies believe that there is no
need to define the term, because bankers and examiners already are
accustomed to the use of the term in the municipal securities area
where similar rules currently exist. Finally, for the reasons
previously stated, the agencies believe that government securities
customers will benefit from rules that are consistent for both bank and
nonbank government securities broker-dealers. Given that the NASD and
SEC recently decided not to define ``recommendation,'' a decision to do
so in the banking agencies'' rule could result in a material difference
that could undermine the benefits of consistency and could lead to
confusion concerning what effect the definition would have on the other
rules.
While the agencies do not believe it is appropriate to define the
term ``recommendation,'' they note that they would not view the
provision of general market information, including market observations,
forecasts about interest rates, and price quotations, as making a
recommendation under the rule, absent other conduct.
Issue 5. Adoption of Additional Rules
Of the four commenters addressing the need to adopt rules similar
to other sections of the Rules of Fair Practice or interpretations
similar to other NASD interpretations, all four supported adopting
additional rules and interpretations.
(a) Comments supporting additional rules. One commenter suggested
that the agencies adopt those parts of the NASD Rules of Fair Practice
that require the establishment of a system to supervise personnel
involved in government securities transactions. Another commenter
stated that the rules should be extended to those practices that
adversely affect transactions, such as markups, churning, and
frontrunning. A third commenter suggested that the agencies adopt rules
concerning the supervision of employees, the establishment of written
procedures, and the requirement of internal inspections. This commenter
noted that the banking industry and its customers would benefit from
additional uniformity with nonbank government securities dealers. The
final commenter suggested that the agencies adopt additional rules
similar to those applicable to bank municipal securities dealers.
(b) Comments opposing additional rules. While no commenter
specifically opposed adopting additional rules, several noted their
general opposition to the agencies adopting any rules in this area. The
arguments advanced by these commenters are summarized in the discussion
of the first issue.
(c) Analysis of Issue 5. The agencies have decided not to adopt
rules other than the Suitability and Business Conduct Rules and
Suitability Interpretation at this time. In some cases, the NASD Rules
overlap with safety and soundness standards that already apply to banks
(see, e.g., Rule 3010 of the NASD's Conduct Rules, which requires each
member to establish and maintain a system of supervision that is
reasonably designed to achieve compliance with applicable securities
laws and regulations). Other NASD Rules appear to codify existing
duties and principles to which bank employees acting in a fiduciary
capacity must adhere (see, e.g., Rule 2330 of the NASD's Conduct Rules,
which prohibits members and associated persons from making improper use
of a customer's securities or funds). While the agencies believe that
the business conduct rule is sufficiently broad to address much of the
conduct proscribed by other NASD Rules, the agencies will consider
whether there is a need to adopt additional rules as the agencies
examine banks for compliance with the rules and interpretation adopted
herein. Banks should determine the adequacy and appropriateness of
their policies, procedures, and internal controls with respect to the
final rules.
Issue 6. Ability to contract out of the rules
Four of the six commenters addressing this issue favor allowing a
bank and its customers to establish standards by contract that would
govern that relationship, while two opposed this option.
(a) Comments favoring allowing parties to contract out of the
rules. One commenter suggested that the agencies look to the Principles
and Practices for
[[Page 13281]]
Wholesale Financial Market Transactions, prepared in 1995 under the
coordination of the Federal Reserve Bank of New York, for guidance on
the appropriate set of governing assumptions regarding institutional
relationships. This commenter noted that the Amendments contain no
limitation on the agencies'' ability to permit this flexibility. While
this commenter opposed adoption of the rules in general, the commenter
stated that, if the agencies adopt the rules, they should clarify that
a bank would be insulated from liability to the extent that the bank
and customer contractually limit liability. Another commenter opined
that a written contract should control on the question of suitability
and that the agencies should provide guidance on when an oral agreement
will suffice (such as, for instance, allowing oral agreements to
control if they are entered into on a recorded line). A third commenter
stated that banks should be encouraged to clarify the nature of the
relationship with their customers, including providing disclaimers
about the nature of the information given if appropriate. The fourth
commenter expressed its support for allowing parties to contract out of
the rules but then suggested that the presence or absence of a contract
should be one of the factors considered if a bank's compliance with its
suitability obligation is in dispute.
(b) Comments opposing allowing parties to contract out of the
rules. Those commenters who opposed allowing banks to contract out of
the rules expressed concern that an agreement should not be used to
protect banks that make unsuitable recommendations. One commenter noted
that a contract should be only one factor to consider when determining
whether a suitability obligation has been satisfied. The other
commenter opposed to contractually limiting liability stated that, if
parties are allowed to do so, the final rules should require periodic
review of the contract. According to this commenter, the changing
nature of financial markets may render a contract inappropriate over
time.
(c) Analysis of Issue 6. The agencies believe that a contract
establishing the nature of the relationship can be helpful in
determining the relationship between the bank and its customer, but
that such a contract will not be determinative of whether the bank has
fulfilled its obligation under the rules. The agencies also believe
that the benefits to be gained by both the banking industry and its
customers from having uniform suitability rules and interpretations
would be significantly undermined if banks were permitted to establish
by contract a safe harbor from their obligations under the rules.
Accordingly, the final rules do not go beyond the proposed
interpretation, which provides that written and oral agreements will be
considered as one of several factors that may be relevant in
determining whether the bank has fulfilled its obligations under the
suitability rule. Additionally, the agencies note that because the
rules do not create a private right of action, there is no need to
provide a mechanism in the rule for a bank to insulate itself from
liability to customers arising from a violation of the rules.
Issue 7. Definition of ``Institutional Customer''
Eight commenters addressed the issue of how to define an
``institutional customer.'' Of these, four opposed using $50 million in
total assets as the measure by which institutional customers are judged
while one favored using this cutoff. Five commenters expressed support
for a test based on assets under management as the appropriate measure,
and one opposed any test based on asset size, portfolio size, or
revenue.
(a) Comment favoring use of $50 million in total assets. The one
commenter favoring the use of $50 million in assets as the threshold
for determining who is an institutional customer stated that the level
of assets usually is a good determinant of whether the customer is
sophisticated. This commenter also noted that customers above that size
can afford to hire a professional manager, and suggested that there is
no reason to shift to the dealer the responsibility for ensuring that
investments are suitable. The commenter suggested further that an
appropriate benchmark for governmental entities is whether a
government's budget is at least $50 million. Finally, this commenter
opined that a customer should be considered ``institutional'' if it is
registered as an investment adviser under either U.S. or foreign law
and that the definition should clarify that a bank, savings
association, or insurance company may be domestic or foreign.
(b) Comments opposing use of $50 million in total assets. All of
the commenters opposed to defining ``institutional customer'' by using
total assets stated that asset size is not a good proxy for
sophistication. One commenter maintained that a rule that does not
apply to all registered investment companies will result in banks being
less willing to make recommendations to small investment companies
because the suitability obligations to the small companies will be more
onerous. Another commenter stated that this test will only place more
burdens and risks on banks. The commenter opposed to any test based on
asset size, portfolio size, or revenue stated that the tests are
inaccurate and arbitrary. Concerning an asset size test, this commenter
noted that all but the smallest local governments have assets of at
least $50 million, although most of these assets are in the form of
buildings, land, sewage facilities, and so on. This commenter opposed a
revenue test because the cyclical nature of tax receipts will
temporarily swell the amounts available for investment by a government,
thereby resulting in many small governments being deemed
``institutional customers'' even though they need the protections
afforded by the suitability rule. Finally, this commenter believes that
portfolio size is problematic because it is unclear which governmental
entity's portfolio should be considered. To illustrate this problem,
this commenter asked whether investments of a state government and
local governments within that state should be considered as held in one
portfolio and whether pension funds invested by a city are part of the
city's portfolio. Two other commenters stated their general opposition
to an asset size test set at $50 million.
(c) Comments favoring portfolio size as the appropriate test. Of
the four commenters favoring a test based on portfolio size, one agreed
that $10 million was the appropriate cutoff. Two others stated that,
while portfolio size is a better measure of sophistication than is
asset size, $10 million is too high a threshold. Finally, one commenter
stated that portfolio size should be considered, but that it should be
only one of several factors looked at.
(d) Analysis of Issue 7. The agencies have decided to adopt a
definition of ``institutional customer'' that is consistent with the
NASD's definition. As a result, all customers will receive consistent
treatment under the suitability rule. Moreover, transactions with all
customers other than natural persons will be covered by the suitability
interpretation, although the factors identified in the interpretation
will be most appropriate for a customer with at least $10 million
invested in securities in the aggregate in its portfolio and/or under
management. If an entity has less than $50 million in total assets, a
bank making a recommendation to that entity must make a reasonable
effort to obtain information about the customer's financial and tax
status, investment
[[Page 13282]]
objectives, and other information used or considered reasonable by the
bank in making a recommendation.
The agencies believe that if a different measure were used, the
inconsistencies between their rule and the NASD's Suitability Rule
would make the agencies' rule more difficult to apply. Also, examiners,
auditors, and compliance officers likely would encounter difficulties
determining compliance with suitability requirements if the measure for
an institutional customer varies, as some commenters suggested,
depending on the type of entity and security involved.
The agencies believe that some commenters may have misinterpreted
the significance of the tests for determining when an investor is an
``institutional customer.'' All customers, whether institutional or
not, are covered by the suitability rule. In all cases, a bank must
have reasonable grounds for believing that a recommendation is suitable
based on the facts, if any, disclosed by a customer concerning the
customer's other security holdings and financial situation and needs.
Moreover, in all cases, a bank must make a determination based on the
facts of a particular situation whether it has fulfilled its
suitability obligation. The thresholds identified in the regulation and
interpretation are provided solely for the purpose of assisting a bank
in identifying the type of information that may be relevant in deciding
if the suitability obligation is met in a given case. For all entities
other than natural persons (but particularly for entities with at least
$10 million invested in securities in the aggregate in its portfolio
and/or under management), a bank should consider the factors identified
in the suitability interpretation in deciding whether a customer is
capable of evaluating investment risk independently and whether the
customer is exercising independent judgement in evaluating a bank's
recommendation. For entities (including natural persons) with less than
$50 million in total assets, a bank is required to make reasonable
efforts to obtain the additional information listed in the section
captioned ``Customer information'' (12 CFR 13.5, 208.25(e), and 368.5,
respectively). This information will be in addition to whatever other
information the bank obtains in its effort to determine whether it has
met its suitability obligation.
Issue 8: Other Suggestions
One commenter stated that the factors listed in the suitability
interpretation concerning a customer's ability to evaluate risk are
reasonable but do not require banks to provide information the customer
needs in order to make an informed investment decision. This commenter
suggested that the interpretation should require banks to provide
certain types of transaction-specific information, such as valuation
information, an instrument's behavior under a stress test, and the
types of risks incurred.
The agencies agree that this information may be useful to a
customer in many cases. However, a comparatively unsophisticated
customer likely will rely on the bank to evaluate this information
before making a recommendation, while a more sophisticated customer
will, in many cases, request this information from the bank or obtain
this information on its own. Accordingly, the agencies have decided not
to require the information suggested by the commenter.
This commenter also identified what it believes are shortcomings in
each of the considerations listed in the suitability interpretation.
Many of the shortcomings cited focus on the inapplicability or
inappropriateness of a certain factor in a given set of circumstances.
The agencies acknowledge that not all of the factors identified will be
helpful in every case. However, the interpretation is not presented as
a checklist of required information. The factors listed neither create
nor reduce a bank's suitability obligation. Their relevance will vary,
depending on the circumstances of a given situation. The agencies
believe that the factors will be helpful in assisting a bank's
determination of whether it has met its suitability obligation.
Therefore, the agencies are adopting the suitability interpretation as
proposed, making only the modifications to the proposed interpretation
that are necessary to conform the agencies' suitability interpretation
to that of the NASD.
Two commenters requested that the agencies clarify that the final
rules do not apply to institutions that are subject to NASD
jurisdiction. The agencies recognize that many banks conduct a
significant portion of their securities activities through subsidiaries
or affiliates that are registered broker-dealers. The agencies confirm
that securities activities conducted in registered broker-dealers that
are NASD members are subject to the NASD rules and will not be subject
to the agencies' final rules.
Another commenter requested that the agencies add a cross-reference
in the final rules to the definition of ``government securities'' used
in the Securities Exchange Act (15 U.S.C. 78c(a)(42)) in order to
assist bankers working with the rules. The agencies agree that a
reference to this definition would be helpful, and have amended the
final rules accordingly.
Finally, one commenter asserted that the Regulatory Flexibility Act
certification contained in the proposal is flawed because it fails to
focus on the 300 domestic banks that are covered by the proposal.1
The agencies note that they did focus on these banks in determining the
impact that the rules would have on small entities. See 61 FR 18472
(``As an initial matter, the proposed rule would apply only to those
banks that have given notice or are required to give notice that they
are government securities brokers or dealers under section 15C of the
Securities Exchange Act of 1934 (15 U.S.C. 78o-5) and applicable
Treasury rules under section 15C (17 CFR 400.1(d) and 401), including
approximately 300 domestic banks and branches of foreign banks.''). The
Regulatory Flexibility Act certification in these final rules also
focuses on these banks as the appropriate pool to consider when
evaluating the rules' impact on small entities. See discussion of the
Regulatory Flexibility Act that follows.
---------------------------------------------------------------------------
\1\ Data obtained since the proposal was published show that
this figure is approximately 160 banks covered by the rule. See
discussion of the Regulatory Flexibility Act for additional analysis
of the number of institutions covered.
---------------------------------------------------------------------------
Regulatory Flexibility Act
Under section 605(b) of the Regulatory Flexibility Act (RFA) (5
U.S.C. 605(b)), the regulatory flexibility analysis otherwise required
under section 604 of the RFA (5 U.S.C. 604) is not required if the head
of the agency certifies that the rule will not have a significant
economic impact on a substantial number of small entities and the
agency publishes such certification and a statement providing the
factual basis for such certification in the Federal Register along with
the final rule.
Pursuant to section 605(b) of the RFA, the OCC, Board, and the FDIC
each individually certifies that these final rules will not have a
significant economic impact on a substantial number of small entities.
As noted in the proposal and in the preamble to the final rules, the
rules will apply only to those banks that have given notice or are
required to give notice that they are government securities brokers or
dealers under section 15C of the Securities Exchange Act of 1934 (15
U.S.C. 78o-5) and applicable Treasury rules under section 15C (17 CFR
400.1(d) and 401).
[[Page 13283]]
Most small banking institutions are not required to give notice under
section 15C, as Treasury rules provide exemptions for financial
institutions that engage in fewer than 500 government securities
brokerage transactions per year and for financial institutions with
government securities dealing activities limited to sales and purchases
in a fiduciary capacity. See 17 CFR 401.3 and 401.4. Other exemptions
from the notice requirements also are available. See 17 CFR Part 401.
Additionally, the agencies note that many banks conduct a significant
portion of their securities activities through subsidiaries or
affiliates that are registered broker-dealers. Securities activities
conducted in registered broker-dealers that are NASD members are
subject to the NASD Rules and would not be subject to the agencies'
final rules. As a consequence, currently there are only approximately
160 banks that are registered as a government securities broker-dealer.
Of these, only 7 are ``small entities'' for purposes of the Regulatory
Flexibility Act. See 13 C.F.R. 121.601.
Paperwork Reduction Act
In accordance with section 3506 of the Paperwork Reduction Act of
1995 (44 U.S.C. 3506; see also 5 CFR 1320 Appendix a.1), the agencies
have reviewed the final rules and have determined that no collections
of information pursuant to the Paperwork Reduction Act are contained in
the rules.
OCC Executive Order 12866 Statement
The Office of Management and Budget has concurred with the OCC's
determination that these final rules are not a significant regulatory
action under Executive Order 12866.
OCC Unfunded Mandates Act of 1995 Statement
Section 202 of the Unfunded Mandates Reform Act of 1995, Public Law
104-4 (Unfunded Mandates Act), requires that the agency prepare a
budgetary impact statement before promulgating a rule that includes a
Federal mandate that may result in the expenditure by State, local, and
tribal governments, in the aggregate, or by the private sector, of $100
million or more in any one year. If a budgetary impact statement is
required, section 205 of the Unfunded Mandates Act also requires the
agency to identify and consider a reasonable number of regulatory
alternatives before promulgating a rule. As discussed in the preamble,
the final rules set forth sales practice responsibilities of banks that
are government securities brokers or dealers. The OCC has determined
that the final rules will not result in expenditures by State, local,
or tribal governments or by the private sector of more than $100
million. Accordingly, the OCC has not prepared a budgetary impact
statement or addressed specifically the regulatory alternatives
considered.
Small Business Regulatory Enforcement Fairness Act
The Small Business Regulatory Enforcement Fairness Act of 1996
(Pub. L. 104-121, 104th Cong., 2d Sess. (1996)) provides generally for
agencies to report rules to Congress and for Congress to review the
rules. The reporting requirement is triggered in instances where the
agency in question issues a final rule as defined by the Administrative
Procedure Act at 5 U.S.C. 551. The agencies will file the appropriate
reports pursuant to the statute concerning their final rules.
The Office of Management and Budget has determined that these final
rules do not constitute ``major'' rules as defined by the statute.
List of Subjects
12 CFR Part 13
Banks, banking, Government securities, National banks, Securities
12 CFR Part 208
Accounting, Agriculture, Banks, banking, Confidential business
information, Crime, Currency, Federal Reserve System, Flood insurance,
Mortgages, Reporting and recordkeeping requirements, Securities.
12 CFR Part 211
Exports, Federal Reserve System, Foreign banking, Holding
companies, Investments, Reporting and recordkeeping requirements.
12 CFR Part 368
Banks, banking, Securities.
Office of the Comptroller of the Currency
12 CFR CHAPTER I
Authority and Issuance
For the reasons set out in the preamble, a new part 13 is added to
chapter I of title 12 of the Code of Federal Regulations to read as
follows:
PART 13--GOVERNMENT SECURITIES SALES PRACTICES
Sec.
13.1 Scope.
13.2 Definitions.
13.3 Business conduct.
13.4 Recommendations to customers.
13.5 Customer information.
Interpretations
13.100 Obligations concerning institutional customers.
Authority: 12 U.S.C. 1 et seq., and 93a; 15 U.S.C. 78o-5.
Sec. 13.1 Scope.
This part applies to national banks that have filed notice as, or
are required to file notice as, government securities brokers or
dealers pursuant to section 15C of the Securities Exchange Act (15
U.S.C. 78o-5) and Department of the Treasury rules under section 15C
(17 CFR 400.1(d) and part 401).
Sec. 13.2 Definitions.
(a) Bank that is a government securities broker or dealer means a
national bank that has filed notice, or is required to file notice, as
a government securities broker or dealer pursuant to section 15C of the
Securities Exchange Act (15 U.S.C. 78o-5) and Department of the
Treasury rules under section 15C (17 CFR 400.1(d) and part 401).
(b) Customer does not include a broker or dealer or a government
securities broker or dealer.
(c) Government security has the same meaning as this term has in
section 3(a)(42) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(42)).
(d) Non-institutional customer means any customer other than:
(1) A bank, savings association, insurance company, or registered
investment company;
(2) An investment adviser registered under section 203 of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-3); or
(3) Any entity (whether a natural person, corporation, partnership,
trust, or otherwise) with total assets of at least $50 million.
Sec. 13.3 Business conduct.
A bank that is a government securities broker or dealer shall
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.
Sec. 13.4 Recommendations to customers.
In recommending to a customer the purchase, sale or exchange of a
government security, a bank that is a government securities broker or
dealer shall have reasonable grounds for believing that the
recommendation is suitable for the customer upon the basis of the
facts, if any, disclosed by the customer as to the customer's other
security holdings and as to the
[[Page 13284]]
customer's financial situation and needs.
Sec. 13.5 Customer information.
Prior to the execution of a transaction recommended to a non-
institutional customer, a bank that is a government securities broker
or dealer shall make reasonable efforts to obtain information
concerning:
(a) The customer's financial status;
(b) The customer's tax status;
(c) The customer's investment objectives; and
(d) Such other information used or considered to be reasonable by
the bank in making recommendations to the customer.
Interpretations
Sec. 13.100 Obligations concerning institutional customers.
(a) As a result of broadened authority provided by the Government
Securities Act Amendments of 1993 (15 U.S.C. 78o-3 and 78o-5), the OCC
is adopting sales practice rules for the government securities market,
a market with a particularly broad institutional component.
Accordingly, the OCC believes it is appropriate to provide further
guidance to banks on their suitability obligations when making
recommendations to institutional customers.
(b) The OCC's suitability rule (Sec. 13.4) is fundamental to fair
dealing and is intended to promote ethical sales practices and high
standards of professional conduct. Banks' responsibilities include
having a reasonable basis for recommending a particular security or
strategy, as well as having reasonable grounds for believing the
recommendation is suitable for the customer to whom it is made. Banks
are expected to meet the same high standards of competence,
professionalism, and good faith regardless of the financial
circumstances of the customer.
(c) In recommending to a customer the purchase, sale, or exchange
of any government security, the bank shall have reasonable grounds for
believing that the recommendation is suitable for the customer upon the
basis of the facts, if any, disclosed by the customer as to the
customer's other security holdings and financial situation and needs.
(d) The interpretation in this section concerns only the manner in
which a bank determines that a recommendation is suitable for a
particular institutional customer. The manner in which a bank fulfills
this suitability obligation will vary, depending on the nature of the
customer and the specific transaction. Accordingly, the interpretation
in this section deals only with guidance regarding how a bank may
fulfill customer-specific suitability obligations under
Sec. 13.4.1
---------------------------------------------------------------------------
\1\ The interpretation in this section does not address the
obligation related to suitability that requires that a bank have ``*
* * a `reasonable basis' to believe that the recommendation could be
suitable for at least some customers.'' In the Matter of the
Application of F.J. Kaufman and Company of Virginia and Frederick J.
Kaufman, Jr., 50 SEC 164 (1989).
---------------------------------------------------------------------------
(e) While it is difficult to define in advance the scope of a
bank's suitability obligation with respect to a specific institutional
customer transaction recommended by a bank, the OCC has identified
certain factors that may be relevant when considering compliance with
Sec. 13.4. These factors are not intended to be requirements or the
only factors to be considered but are offered merely as guidance in
determining the scope of a bank's suitability obligations.
(f) The two most important considerations in determining the scope
of a bank's suitability obligations in making recommendations to an
institutional customer are the customer's capability to evaluate
investment risk independently and the extent to which the customer is
exercising independent judgement in evaluating a bank's recommendation.
A bank must determine, based on the information available to it, the
customer's capability to evaluate investment risk. In some cases, the
bank may conclude that the customer is not capable of making
independent investment decisions in general. In other cases, the
institutional customer may have general capability, but may not be able
to understand a particular type of instrument or its risk. This is more
likely to arise with relatively new types of instruments, or those with
significantly different risk or volatility characteristics than other
investments generally made by the institution. If a customer is either
generally not capable of evaluating investment risk or lacks sufficient
capability to evaluate the particular product, the scope of a bank's
customer-specific obligations under Sec. 13.4 would not be diminished
by the fact that the bank was dealing with an institutional customer.
On the other hand, the fact that a customer initially needed help
understanding a potential investment need not necessarily imply that
the customer did not ultimately develop an understanding and make an
independent investment decision.
(g) A bank may conclude that a customer is exercising independent
judgement if the customer's investment decision will be based on its
own independent assessment of the opportunities and risks presented by
a potential investment, market factors and other investment
considerations. Where the bank has reasonable grounds for concluding
that the institutional customer is making independent investment
decisions and is capable of independently evaluating investment risk,
then a bank's obligations under Sec. 13.4 for a particular customer are
fulfilled.2 Where a customer has delegated decision-making
authority to an agent, such as an investment advisor or a bank trust
department, the interpretation in this section shall be applied to the
agent.
---------------------------------------------------------------------------
\2\ See footnote 1 in paragraph (d) of this section.
---------------------------------------------------------------------------
(h) A determination of capability to evaluate investment risk
independently will depend on an examination of the customer's
capability to make its own investment decisions, including the
resources available to the customer to make informed decisions.
Relevant considerations could include:
(1) The use of one or more consultants, investment advisers, or
bank trust departments;
(2) The general level of experience of the institutional customer
in financial markets and specific experience with the type of
instruments under consideration;
(3) The customer's ability to understand the economic features of
the security involved;
(4) The customer's ability to independently evaluate how market
developments would affect the security; and
(5) The complexity of the security or securities involved.
(i) A determination that a customer is making independent
investment decisions will depend on the nature of the relationship that
exists between the bank and the customer.
Relevant considerations could include:
(1) Any written or oral understanding that exists between the bank
and the customer regarding the nature of the relationship between the
bank and the customer and the services to be rendered by the bank;
(2) The presence or absence of a pattern of acceptance of the
bank's recommendations;
(3) The use by the customer of ideas, suggestions, market views and
information obtained from other government securities brokers or
dealers or market professionals, particularly those relating to the
same type of securities; and
(4) The extent to which the bank has received from the customer
current comprehensive portfolio information in
[[Page 13285]]
connection with discussing recommended transactions or has not been
provided important information regarding its portfolio or investment
objectives.
(j) Banks are reminded that these factors are merely guidelines
that will be utilized to determine whether a bank has fulfilled its
suitability obligation with respect to a specific institutional
customer transaction and that the inclusion or absence of any of these
factors is not dispositive of the determination of suitability. Such a
determination can only be made on a case-by-case basis taking into
consideration all the facts and circumstances of a particular bank/
customer relationship, assessed in the context of a particular
transaction.
(k) For purposes of the interpretation in this section, an
institutional customer shall be any entity other than a natural person.
In determining the applicability of the interpretation in this section
to an institutional customer, the OCC will consider the dollar value of
the securities that the institutional customer has in its portfolio
and/or under management. While the interpretation in this section is
potentially applicable to any institutional customer, the guidance
contained in this section is more appropriately applied to an
institutional customer with at least $10 million invested in securities
in the aggregate in its portfolio and/or under management.
Dated: February 18, 1997.
Eugene A. Ludwig,
Comptroller of the Currency.
Federal Reserve System
12 CFR CHAPTER II
Authority and Issuance
For the reasons set forth in the joint preamble, parts 208 and 211
of chapter II of title 12 of the Code of Federal Regulations are
amended as follows:
PART 208--MEMBERSHIP OF STATE BANKING INSTITUTIONS IN THE FEDERAL
RESERVE SYSTEM (REGULATION H)
1. The authority citation for Part 208 is revised to read as
follows:
Authority: 12 U.S.C. 36, 248(a), 248(c), 321-338a, 371d, 461,
481-486, 601, 611, 1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,
3310, 3331-3351 and 3906-3909; 15 U.S.C. 78b, 781(b), 781(g),
781(i), 78o-4(c)(5), 78o-5, 78q, 78q-1, and 78w: 31 U.S.C. 5318; 42
U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.
2. A new Sec. 208.25 is added to subpart A to read as follows:
Sec. 208.25 Government securities sales practices.
(a) Scope. This subpart is applicable to state member banks that
have filed notice as, or are required to file notice as, government
securities brokers or dealers pursuant to section 15C of the Securities
Exchange Act (15 U.S.C. 78o-5) and Department of the Treasury rules
under section 15C (17 CFR 400.1(d) and part 401).
(b) Definitions--(1) Bank that is a government securities broker or
dealer means a state member bank that has filed notice, or is required
to file notice, as a government securities broker or dealer pursuant to
section 15C of the Securities Exchange Act (15 U.S.C. 78o-5) and
Department of the Treasury rules under section 15C (17 CFR 400.1(d) and
part 401).
(2) Customer does not include a broker or dealer or a government
securities broker or dealer.
(3) Government security has the same meaning as this term has in
section 3(a)(42) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(42)).
(4) Non-institutional customer means any customer other than:
(i) A bank, savings association, insurance company, or registered
investment company;
(ii) An investment adviser registered under section 203 of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-3); or
(iii) Any entity (whether a natural person, corporation,
partnership, trust, or otherwise) with total assets of at least $50
million.
(c) Business conduct. A bank that is a government securities broker
or dealer shall 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.
(d) Recommendations to customers. In recommending to a customer the
purchase, sale or exchange of a government security, a bank that is a
government securities broker or dealer shall have reasonable grounds
for believing that the recommendation is suitable for the customer upon
the basis of the facts, if any, disclosed by the customer as to the
customer's other security holdings and as to the customer's financial
situation and needs.
(e) Customer information. Prior to the execution of a transaction
recommended to a non-institutional customer, a bank that is a
government securities broker or dealer shall make reasonable efforts to
obtain information concerning:
(1) The customer's financial status;
(2) The customer's tax status;
(3) The customer's investment objectives; and
(4) Such other information used or considered to be reasonable by
the bank in making recommendations to the customer.
3. A new Sec. 208.129 is added to subpart B to read as follows:
Sec. 208.129 Obligations concerning institutional customers.
(a) As a result of broadened authority provided by the Government
Securities Act Amendments of 1993 (15 U.S.C. 78o-3 and 78o-5), the
Board is adopting sales practice rules for the government securities
market, a market with a particularly broad institutional component.
Accordingly, the Board believes it is appropriate to provide further
guidance to banks on their suitability obligations when making
recommendations to institutional customers.
(b) The Board's Suitability Rule, Sec. 208.25(b), is fundamental to
fair dealing and is intended to promote ethical sales practices and
high standards of professional conduct. Banks'' responsibilities
include having a reasonable basis for recommending a particular
security or strategy, as well as having reasonable grounds for
believing the recommendation is suitable for the customer to whom it is
made. Banks are expected to meet the same high standards of competence,
professionalism, and good faith regardless of the financial
circumstances of the customer.
(c) In recommending to a customer the purchase, sale, or exchange
of any government security, the bank shall have reasonable grounds for
believing that the recommendation is suitable for the customer upon the
basis of the facts, if any, disclosed by the customer as to the
customer's other security holdings and financial situation and needs.
(d) The interpretation in this section concerns only the manner in
which a bank determines that a recommendation is suitable for a
particular institutional customer. The manner in which a bank fulfills
this suitability obligation will vary, depending on the nature of the
customer and the specific transaction. Accordingly, the interpretation
in this section deals only with guidance regarding how a bank may
fulfill customer-specific suitability obligations under
Sec. 208.25(d).1
---------------------------------------------------------------------------
\1\ The interpretation in this section does not address the
obligation related to suitability that requires that a bank have ``*
* * a `reasonable basis' to believe that the recommendation could be
suitable for at least some customers.'' In the Matter of the
Application of F.J. Kaufman and Company of Virginia and Frederick J.
Kaufman, Jr., 50 SEC 164 (1989).
---------------------------------------------------------------------------
[[Page 13286]]
(e) While it is difficult to define in advance the scope of a
bank's suitability obligation with respect to a specific institutional
customer transaction recommended by a bank, the Board has identified
certain factors that may be relevant when considering compliance with
Sec. 208.25(d). These factors are not intended to be requirements or
the only factors to be considered but are offered merely as guidance in
determining the scope of a bank's suitability obligations.
(f) The two most important considerations in determining the scope
of a bank's suitability obligations in making recommendations to an
institutional customer are the customer's capability to evaluate
investment risk independently and the extent to which the customer is
exercising independent judgement in evaluating a bank's recommendation.
A bank must determine, based on the information available to it, the
customer's capability to evaluate investment risk. In some cases, the
bank may conclude that the customer is not capable of making
independent investment decisions in general. In other cases, the
institutional customer may have general capability, but may not be able
to understand a particular type of instrument or its risk. This is more
likely to arise with relatively new types of instruments, or those with
significantly different risk or volatility characteristics than other
investments generally made by the institution. If a customer is either
generally not capable of evaluating investment risk or lacks sufficient
capability to evaluate the particular product, the scope of a bank's
customer-specific obligations under Sec. 208.25(d) would not be
diminished by the fact that the bank was dealing with an institutional
customer. On the other hand, the fact that a customer initially needed
help understanding a potential investment need not necessarily imply
that the customer did not ultimately develop an understanding and make
an independent investment decision.
(g) A bank may conclude that a customer is exercising independent
judgement if the customer's investment decision will be based on its
own independent assessment of the opportunities and risks presented by
a potential investment, market factors and other investment
considerations. Where the bank has reasonable grounds for concluding
that the institutional customer is making independent investment
decisions and is capable of independently evaluating investment risk,
then a bank's obligations under Sec. 208.25(d) for a particular
customer are fulfilled.2 Where a customer has delegated decision-
making authority to an agent, such as an investment advisor or a bank
trust department, the interpretation in this section shall be applied
to the agent.
---------------------------------------------------------------------------
\2\ See footnote 1 in paragraph (d) of this section.
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(h) A determination of capability to evaluate investment risk
independently will depend on an examination of the customer's
capability to make its own investment decisions, including the
resources available to the customer to make informed decisions.
Relevant considerations could include:
(1) The use of one or more consultants, investment advisers, or
bank trust departments;
(2) The general level of experience of the institutional customer
in financial markets and specific experience with the type of
instruments under consideration;
(3) The customer's ability to understand the economic features of
the security involved;
(4) The customer's ability to independently evaluate how market
developments would affect the security; and
(5) The complexity of the security or securities involved.
(i) A determination that a customer is making independent
investment decisions will depend on the nature of the relationship that
exists between the bank and the customer. Relevant considerations could
include:
(1) Any written or oral understanding that exists between the bank
and the customer regarding the nature of the relationship between the
bank and the customer and the services to be rendered by the bank;
(2) The presence or absence of a pattern of acceptance of the
bank's recommendations;
(3) The use by the customer of ideas, suggestions, market views and
information obtained from other government securities brokers or
dealers or market professionals, particularly those relating to the
same type of securities; and
(4) The extent to which the bank has received from the customer
current comprehensive portfolio information in connection with
discussing recommended transactions or has not been provided important
information regarding its portfolio or investment objectives.
(j) Banks are reminded that these factors are merely guidelines
that will be utilized to determine whether a bank has fulfilled its
suitability obligation with respect to a specific institutional
customer transaction and that the inclusion or absence of any of these
factors is not dispositive of the determination of suitability. Such a
determination can only be made on a case-by-case basis taking into
consideration all the facts and circumstances of a particular bank/
customer relationship, assessed in the context of a particular
transaction.
(k) For purposes of the interpretation in this section, an
institutional customer shall be any entity other than a natural person.
In determining the applicability of the interpretation in this section
to an institutional customer, the Board will consider the dollar value
of the securities that the institutional customer has in its portfolio
and/or under management. While the interpretation in this section is
potentially applicable to any institutional customer, the guidance
contained in this section is more appropriately applied to an
institutional customer with at least $10 million invested in securities
in the aggregate in its portfolio and/or under management.
PART 211--INTERNATIONAL BANKING OPERATIONS (REGULATION K)
1. The authority citation for Part 211 is revised to read as
follows:
Authority: 12 U.S.C. 221 et seq., 1818, 1841 et seq., 3101 et
seq., 3109 et seq.; 15 U.S.C. 78o-5.
2. Section 211.24 is amended by revising the section heading and
adding a new paragraph (h) to read as follows:
Sec. 211.24 Approval of offices of foreign banks; procedures for
applications; standards for approval; representative-office activities
and standards for approval; preservation of existing authority; reports
of crimes and suspected crimes; government securities sales practices.
* * * * *
(h) Government securities sales practices. An uninsured state-
licensed branch or agency of a foreign bank that is required to give
notice to the Board under section 15C of the Securities Exchange Act of
1934 (15 U.S.C. 78o-5) and the Department of the Treasury rules under
section 15C (17 CFR 400.1(d) and part 401) shall be subject to the
provisions of 12 CFR 208.25 to the same extent as a state member bank
that is required to give such notice.
[[Page 13287]]
By order of the Board of Governors of the Federal Reserve Board,
March 11, 1997.
Jennifer J. Johnson,
Deputy Secretary of the Board.
Federal Deposit Insurance Corporation
12 CFR CHAPTER III
Authority and Issuance
For the reasons set out in the preamble, a new part 368 is added to
chapter III of title 12 of the Code of Federal Regulations to read as
follows:
PART 368--GOVERNMENT SECURITIES SALES PRACTICES
Sec.
368.1 Scope.
368.2 Definitions.
368.3 Business conduct.
368.4 Recommendations to customers.
368.5 Customer information.
368.100 Obligations concerning institutional customers.
Authority: 15 U.S.C. 78o-5.
Sec. 368.1 Scope.
This part is applicable to state nonmember banks and insured state
branches of foreign banks that have filed notice as, or are required to
file notice as, government securities brokers or dealers pursuant to
section 15C of the Securities Exchange Act (15 U.S.C. 78o-5) and
Department of the Treasury rules under section 15C (17 CFR 400.1(d) and
part 401).
Sec. 368.2 Definitions.
(a) Bank that is a government securities broker or dealer means a
state nonmember bank or an insured state branch of a foreign bank that
has filed notice, or is required to file notice, as a government
securities broker or dealer pursuant to section 15C of the Securities
Exchange Act (15 U.S.C. 78o-5) and Department of the Treasury rules
under section 15C (17 CFR 400.1(d) and part 401).
(b) Customer does not include a broker or dealer or a government
securities broker or dealer.
(c) Government security has the same meaning as this term has in
section 3(a)(42) of the Securities Exchange Act of 1934 (15 U.S.C.
78c(a)(42)).
(d) Non-institutional customer means any customer other than:
(1) A bank, savings association, insurance company, or registered
investment company;
(2) An investment adviser registered under section 203 of the
Investment Advisers Act of 1940 (15 U.S.C. 80b-3); or
(3) Any entity (whether a natural person, corporation, partnership,
trust, or otherwise) with total assets of at least $50 million.
Sec. 368.3 Business conduct.
A bank that is a government securities broker or dealer shall
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.
Sec. 368.4 Recommendations to customers.
In recommending to a customer the purchase, sale or exchange of a
government security, a bank that is a government securities broker or
dealer shall have reasonable grounds for believing that the
recommendation is suitable for the customer upon the basis of the
facts, if any, disclosed by the customer as to the customer's other
security holdings and as to the customer's financial situation and
needs.
Sec. 368.5 Customer information.
Prior to the execution of a transaction recommended to a non-
institutional customer, a bank that is a government securities broker
or dealer shall make reasonable efforts to obtain information
concerning:
(a) The customer's financial status;
(b) The customer's tax status;
(c) The customer's investment objectives; and
(d) Such other information used or considered to be reasonable by
such bank in making recommendations to the customer.
Sec. 368.100 Obligations concerning institutional customers.
(a) As a result of broadened authority provided by the Government
Securities Act Amendments of 1993 (15 U.S.C. 78o-3 and 78o-5), the FDIC
is adopting sales practice rules for the government securities market,
a market with a particularly broad institutional component.
Accordingly, the FDIC believes it is appropriate to provide further
guidance to banks on their suitability obligations when making
recommendations to institutional customers.
(b) The FDIC's suitability rule (Sec. 368.4) is fundamental to fair
dealing and is intended to promote ethical sales practices and high
standards of professional conduct. Banks' responsibilities include
having a reasonable basis for recommending a particular security or
strategy, as well as having reasonable grounds for believing the
recommendation is suitable for the customer to whom it is made. Banks
are expected to meet the same high standards of competence,
professionalism, and good faith regardless of the financial
circumstances of the customer.
(c) In recommending to a customer the purchase, sale, or exchange
of any government security, the bank shall have reasonable grounds for
believing that the recommendation is suitable for the customer upon the
basis of the facts, if any, disclosed by the customer as to the
customer's other security holdings and financial situation and needs.
(d) The interpretation in this section concerns only the manner in
which a bank determines that a recommendation is suitable for a
particular institutional customer. The manner in which a bank fulfills
this suitability obligation will vary, depending on the nature of the
customer and the specific transaction. Accordingly, the interpretation
in this section deals only with guidance regarding how a bank may
fulfill customer-specific suitability obligations under Sec. 368.4.
1
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1 The interpretation in this section does not address the
obligation related to suitability that requires that a bank have ``
* * * a `reasonable basis' to believe that the recommendation could
be suitable for at least some customers.'' In the Matter of the
Application of F.J. Kaufman and Company of Virginia and Frederick J.
Kaufman, Jr., 50 SEC 164 (1989).
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(e) While it is difficult to define in advance the scope of a
bank's suitability obligation with respect to a specific institutional
customer transaction recommended by a bank, the FDIC has identified
certain factors that may be relevant when considering compliance with
Sec. 368.4. These factors are not intended to be requirements or the
only factors to be considered but are offered merely as guidance in
determining the scope of a bank's suitability obligations.
(f) The two most important considerations in determining the scope
of a bank's suitability obligations in making recommendations to an
institutional customer are the customer's capability to evaluate
investment risk independently and the extent to which the customer is
exercising independent judgement in evaluating a bank's recommendation.
A bank must determine, based on the information available to it, the
customer's capability to evaluate investment risk. In some cases, the
bank may conclude that the customer is not capable of making
independent investment decisions in general. In other cases, the
institutional customer may have general capability, but may not be able
to understand a particular type of instrument or its risk. This is more
likely to arise with relatively new types of instruments, or those with
significantly different risk or volatility characteristics than other
investments generally made by the institution. If a customer is either
generally not capable
[[Page 13288]]
of evaluating investment risk or lacks sufficient capability to
evaluate the particular product, the scope of a bank's customer-
specific obligations under Sec. 368.4 would not be diminished by the
fact that the bank was dealing with an institutional customer. On the
other hand, the fact that a customer initially needed help
understanding a potential investment need not necessarily imply that
the customer did not ultimately develop an understanding and make an
independent investment decision.
(g) A bank may conclude that a customer is exercising independent
judgement if the customer's investment decision will be based on its
own independent assessment of the opportunities and risks presented by
a potential investment, market factors and other investment
considerations. Where the bank has reasonable grounds for concluding
that the institutional customer is making independent investment
decisions and is capable of independently evaluating investment risk,
then a bank's obligations under Sec. 368.4 for a particular customer
are fulfilled. 2 Where a customer has delegated decision-making
authority to an agent, such as an investment advisor or a bank trust
department, the interpretation in this section shall be applied to the
agent.
---------------------------------------------------------------------------
2 See footnote 1 in paragraph (d) of this section.
---------------------------------------------------------------------------
(h) A determination of capability to evaluate investment risk
independently will depend on an examination of the customer's
capability to make its own investment decisions, including the
resources available to the customer to make informed decisions.
Relevant considerations could include:
(1) The use of one or more consultants, investment advisers, or
bank trust departments;
(2) The general level of experience of the institutional customer
in financial markets and specific experience with the type of
instruments under consideration;
(3) The customer's ability to understand the economic features of
the security involved;
(4) The customer's ability to independently evaluate how market
developments would affect the security; and
(5) The complexity of the security or securities involved.
(i) A determination that a customer is making independent
investment decisions will depend on the nature of the relationship that
exists between the bank and the customer. Relevant considerations could
include:
(1) Any written or oral understanding that exists between the bank
and the customer regarding the nature of the relationship between the
bank and the customer and the services to be rendered by the bank;
(2) The presence or absence of a pattern of acceptance of the
bank's recommendations;
(3) The use by the customer of ideas, suggestions, market views and
information obtained from other government securities brokers or
dealers or market professionals, particularly those relating to the
same type of securities; and
(4) The extent to which the bank has received from the customer
current comprehensive portfolio information in connection with
discussing recommended transactions or has not been provided important
information regarding its portfolio or investment objectives.
(j) Banks are reminded that these factors are merely guidelines
that will be utilized to determine whether a bank has fulfilled its
suitability obligation with respect to a specific institutional
customer transaction and that the inclusion or absence of any of these
factors is not dispositive of the determination of suitability. Such a
determination can only be made on a case-by-case basis taking into
consideration all the facts and circumstances of a particular bank/
customer relationship, assessed in the context of a particular
transaction.
(k) For purposes of the interpretation in this section, an
institutional customer shall be any entity other than a natural person.
In determining the applicability of the interpretation in this section
to an institutional customer, the FDIC will consider the dollar value
of the securities that the institutional customer has in its portfolio
and/or under management. While the interpretation in this section is
potentially applicable to any institutional customer, the guidance
contained in this section is more appropriately applied to an
institutional customer with at least $10 million invested in securities
in the aggregate in its portfolio and/or under management.
By order of the Board of Directors, dated at Washington, D.C.,
this 11th day of March, 1997.
Federal Deposit Insurance Corporation
Robert E. Feldman,
Deputy Executive Secretary.
[FR Doc. 97-6803 Filed 3-18-97; 8:45 am]
BILLING CODES: 4810-33-P, 6210-01-P, 6714-01-P
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