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4000 - Advisory Opinions
Applicability of FDIC Rules on Bank Discount
Brokerage Affiliate Selling Mutual Funds and Unit Investment Trusts
FDIC-87-6
June 16, 1987
Pamela E. F. LeCren, Senior Attorney
The following is in response to your request for an opinion on
whether or not *** Discount Brokerage, Inc., ***, an affiliate of ***
Bank, ***, will have to comply with the requirements set forth in
section 337.4(c) of the FDIC's regulations (12 C.F.R. 337.4(c)) if ***
engages in certain activities involving the sale of mutual funds and
unit investment trusts.
Background:
``Sovran Letter''
According to your letter, *** plans to engage in business operations
"similar to those described in the [Federal Reserve Board's June
27, 1986] Sovran Letter." That letter (signed by Michael Bradfield,
General Counsel, Federal Reserve Board) responded to a request by
Sovran Investment Corporation, a discount broker affiliated with Sovran
Bank, N.A., for an opinion on whether or not it was permissible under
section 225.25(b)(15) of the Federal Reserve Board's regulations for
the discount broker to engage in certain activities involving the sale
of shares in mutual funds (i.e., open end management
investment companies) and unit investment trusts. The activities as
described in the Sovran letter are substantially as follows.
The discount broker will execute purchase, sale and redemption
orders for shares of load mutual funds, no load mutual funds, and unit
investment trusts upon the order of, and for the account of, its
customers. The broker will provide no investment advice or research
services, will not exercise any investment discretion regarding the
purchase, sale or redemption of shares, and will not purchase shares
for its own account. The broker will enter into written agreements with
the issuer, sponsor or principal underwriter of the mutual funds or
unit investment trusts which generally provide that the broker will act
as agent upon the order and for the account of the broker's customers.
The issuer, sponsor or principal underwriter will execute transactions
upon authorization from the broker and either confirm directly with the
customer or with the broker who maintains customer accounts and who in
turn will send a confirmation to the customer. The broker will have no
authority to act as agent for the issuer, sponsor or principal
underwriter nor any authority to make representations about the funds
or unit investment trusts other than those contained in the then
current prospectus.
The broker will receive an agent's commission as disclosed in the
prospectus if the customer purchases shares of a unit investment trust
or a load mutual fund. In the case of no load funds, the broker will
enter into an additional set of agreements with the issuer, sponsor or
principal underwriter under which the broker will provide certain
administrative and customer services to the mutual fund and its
shareholders such as handling installment purchases, maintaining
records on each shareholder's account, posting dividends and
reinvesting dividends in accordance with shareholder instructions,
rendering periodic statements of account, entering changes of address
and account registration, assisting shareholders in changing their
instructions for the disposition of dividends, and transferring and
receiving money by wire. The fund will compensate the broker for these
services based on the average daily net asset value of all shares in
the accounts for which
{{4-28-89 p.4250}}the broker provides services. None of
the agreements will in any way obligate the broker to sell or promote
the mutual funds or unit investment trust shares nor will they restrict
the broker from making other mutual funds or unit investment trusts
available to its customers.
The broker will not advertise or promote any specific mutual fund or
unit investment trust but will promote the availability of its
services. The broker's employees will inform customers that the broker
does not recommend any particular investment and brochures promoting
the broker's services will caution customers to read the prospectus
carefully prior to investing. Likewise, the brochures will indicate
that the shares are not obligations of the broker's affiliated bank and
are not insured by the FDIC. The broker will furnish a prospectus only
upon customer request and will not make unsolicited mailings or other
distributions of prospectuses or sales literature and will refer
non-routine inquiries about a mutual fund or unit investment trust to
the issuer, sponsor or principal underwriter. The broker's employees
will not receive any compensation based upon the purchase, sale or
redemption of mutual fund or unit investment trust shares. The broker
will not receive a cumulative quantity discount on mutual fund or unit
investment trust shares except upon behalf of its customers.
*** Program
Your letter to *** of the Federal Reserve Board requesting approval
under section 225.25(b)(15) for *** program characterizes *** plan as
substantially identical to the program dealt with by the Federal
Reserve Board in connection with the Sovran request. In addition, your
letter sets forth the following details pertaining to *** program.
*** plans to make mutual fund and unit investment trust shares
available to its customers through its clearing broker. *** will be
paid a commission by its customers in connection with purchases, sales
and redemptions of no load funds. *** will enter into "agent" or
"seller's" agreements with the issuer, sponsor or principal
underwriter of load funds pursuant to which *** "will participate in
the load the customer pays." All purchases will be solely for the
account of, and upon the order of *** customers. *** will not acquire
any ownership interest in the mutual fund or unit investment trust
shares.
*** clearing broker will handle approximately 600 mutual funds and
unit investment trusts. As it would not be feasible to inventory
prospectuses for all 600 funds, *** intends to keep on hand
prospectuses for 40 to 50 funds. Prospectuses will be mailed out upon
customer request only. *** will generally promote its services to its
customers and will identify the names of the 40 to 50 funds the
prospectuses of which are inventoried. Each security will be listed by
classification and investment objective (e.g., bond,
balance, common stock, growth, income, etc.). This information will be
derived solely from prospectuses. No performance figures will be given
to customers.
If a customer contacts *** indicating interest in making a purchase
of mutual fund shares or unit investment trust shares but does not
specify the specific fund or trust to be purchased, *** "will
ascertain the generic type of security in which its customer is
interested, based upon the customer's stated investment objective
. . . advise the customer of the names of several [funds] having
such characteristics, the prospectuses of which *** has on hand . . .
[and] offer to review the names of the other [funds] which are
available through its clearing broker within that category". No
recommendation will be furnished with respect to the purchase of shares
in any particular fund. The ultimate decision as to which if any
security a customer will purchase will be made by the customer based
solely upon information obtained from the prospectus and whatever other
sources upon which the customer has chosen to rely.
Conclusion
Section 337.4 of the FDIC's regulations governs the securities
activities of subsidiaries and affiliates of insured nonmember banks.
Pursuant to that regulation, any affiliate of an insured nonmember bank
that engages in securities activities prohibited to banks by section 21
of the Glass-Steagall Act must comply with the requirements of section
337.4(c) of the regulation which sets forth, among other things,
restrictions on shared officers and
{{4-28-89 p.4251}}employees, shared offices and the
composition of the affiliated bank's board of directors. In order to
respond to your question we must determine whether or not a bank could
engage in the activities described above.
Section 21 of the Glass-Steagall Act (12 U.S.C. 378) provides in
relevant part that it shall be unlawful for:
[A]ny person, firm, corporation, association, business trust, or
other similar organization, engaged in the business of issuing,
underwriting, selling, or distributing, at wholesale or retail, or
through syndicate participation, stocks, bonds, debentures, notes or
other securities, to engage at the same time to any extent whatever in
the business of receiving deposits . . . . Provided,
that the provisions of this paragraph shall not prohibit national
banks or state banks or trust companies (whether or not members of the
Federal Reserve System) . . . from dealing in, underwriting,
purchasing, and selling investment securities to the extent permitted
to national banking associations by the provisions of Section 24 of
this title [Section 16 of the Glass-Steagall Act] . . . .
Section 16 of the Glass-Steagall Act (12 U.S.C. 24(seventh))
provides in relevant part that the business of dealing in securities
and stock by a national bank shall be limited to purchasing and selling
securities without recourse solely upon the order and for the account
of customers and in no case for its own account. The section also
specifically provides that a national bank shall not underwrite any
issue of securities except for certain listed obligations none of which
are relevant here.
For the reasons discussed below, we believe that the activities
described above would fall within the language of section 16 of the Act
and would not involve prohibited activities. We conclude therefore that
*** will not be required to meet the requirements pertaining to
affiliates in section 337.4(c) of the FDIC's regulations if it engages
in activities involving the sale of mutual fund and unit investment
trust shares in the manner described above.
Discussion
Bankers Trust Decision
A recent opinion of the United States Court of Appeals for the
District of Columbia (Securities Industry Association v. Board of
Governors of the Federal Reserve System, 807 F.2d 1052 (D.C. Cir.
1986), "Bankers Trust II") considered the issue of whether
certain agency activities by a bank on behalf of an issuer of
securities constitutes underwriting and therefore are not permissible
for a bank under the Glass-Steagall Act. The activities in question
involved Bankers Trust Company acting as agent on behalf of an issuer
in the private placement of commercial
paper. 1
The Court of Appeals overruled the lower court's decision that the
selling activities constituted underwriting. (SIA v. Board of
Governors, 627 F. Supp. 695 (D.D.C. 1986)). In particular the
Court of Appeals found that the selling
{{4-28-89 p.4252}}activities fell within the language of
section 16 (i.e., were for the account of a customer without
recourse against the bank) and that the activities did not constitute
underwriting. The activities were therefore permissible for banks under
the Glass-Steagall Act and the inquiry needed go no
further. 2
In the Court's view a private placement did not involve underwriting
for the purposes of the Glass-Steagall Act as the term
"underwriting" (as well as the term "distribution") only
encompasses transactions involving a public
offering. 3
The Court left open the possibility, however, that other agency sales
activities on behalf of an issuer occurring in the context of a public
offering could constitute underwriting and thus would be banned by the
Glass-Steagall Act.
We do not believe that Section 16 gives unlimited rein to banks
in the performance of agency transactions, as Bankers Trust suggests.
We instead read the restriction against underwriting contained in
Section 16 as an independent restriction on the bank's securities
operations that applies even to agency transactions. Bankers
Trust II, at 1062 n. 3.
The Court did not elaborate on what those limits might be. To do so
was unnecessary to the disposition of the case in view of the Court's
earlier conclusion that the private placement activities involved there
did not constitute underwriting.
Lastly, even though the Court questioned the need to conduct a
hazards analysis with respect to the bank's private placement
activities, the Court, nonetheless, reviewed whether those particular
agency activities implicated the subtle hazards that the Glass-Steagall
Act sought to eliminate. 4
At the conclusion of its review, the Court found that the private
placement activities did not, for the most
part, 5
create the type of subtle hazards with which the Glass-Steagall Act was
concerned.
Application of Bankers Trust Decision to *** Program
The activities to be undertaken by *** clearly fall within the
literal language of section 16. *** activities are undertaken solely as
agent for *** customers and not on behalf of an issuer, sponsor or
principal underwriter of securities. *** does not commit itself to sell
securities behalf of any issuer, does not solicit purchasers, and does
not promote the sale of any securities on behalf of any issuer. ***
makes no purchases as principal. All purchases will be without recourse
as agent for the account, and upon the order of, *** customers. The
first half of section 16 is therefore met. As to the caveat in section
16 concerning underwriting, we do not feel that the *** program
involves underwriting. Although the *** program involves securities
issued in the primary market through a public offering (a
fact
{{4-28-89 p.4253}}situation which according to
Bankers Trust II could involve underwriting), it does not
appear that the agency transactions involved here constitute
underwriting. Indeed, because *** does not commit itself as agent, or
otherwise, to sell any securities, its activities do not constitute
best efforts underwriting. 6
[Even if we were to assume that agency transactions on behalf of an
issuer in the primary market through a public offering (whether or not
under a commitment to sell a certain amount of securities) involve
underwriting for the purposes of the Glass-Steagall Act. *** activities
do not fall within that category.] We therefore conclude that the
second half of section 16 has been met, i.e., *** is not
underwriting securities.
Hazards Analysis
The Supreme Court in Investment Company Institute v. Camp,
401 U.S. 617, 630-633 (1971), reviewed and held invalid a
regulation of the Comptroller of the Currency permitting national banks
to establish and operate a certain type of collective investment fund.
The Court discussed the legislative history of the Glass-Steagall Act
and articulated several hazards associated with the direct and indirect
involvement by banks in securities activities.
The temptations identified by the Supreme Court were: (1) the
association of the affiliate and the bank in the public's mind could
impair public confidence in the bank should the affiliate fare badly;
(2) the temptation to shore up the affiliate through bad loans; (3) the
temptation to make the bank's credit facilities readily available and
make unsound loans to companies in whose stock the affiliate has
invested; (4) loss of customer goodwill if a customer suffers loss
after investing in a stock or security associated with a bank
affiliate; (5) the promotional interest of investment banking might
cause a bank to lend its reputation to the sale of particular stocks
and thus risk the undercutting of its reputation; (6) the temptation to
make loans for the purpose of acquiring stock or securities sold by the
bank's affiliate; (7) the inherent conflict between a bank's
promotional interest and its obligation to render impartial investment
advice; and (8) the unloading of poor issues into the bank's trust
department.
We have considered a number of these hazards in the context of the
** program and have concluded on balance that the subtle risks
identified by Camp are not present.
Based upon the foregoing analysis we have concluded that *** need
not comply with section 337.4(c) of the FDIC's regulations. This
opinion is based solely upon the facts presented to the FDIC in your
inquiry. We reserve the right to review this conclusion if there is any
material change in the facts and circumstances from those set forth
above.
1 The Court of Appeals decision in Bankers Trust II
is relevant to the issue at hand as the activities in which ***
wishes to engage could be characterized as agency sales activities on
behalf of an issuer of securities. We do not feel that the Supreme
Court's 1984 decision involving Charles Schwab & Company, SIA v.
Board of Governors, 104 S. Ct. 3003 (1984) ("Schwab"), is
controlling here. In that case the Supreme Court found that the
affiliation of a member bank with a company principally engaged in
retail brokerage in the secondary market as agent for the account of
its customers did not violate section 20 of the Glass-Steagall Act (12
U.S.C. 377). (Section 20 prohibits the affiliation of a member bank
with any corporation engaged principally in the issue, flotation,
underwriting, public sale or distribution of securities.) While the
Supreme Court in dicta indicated that the terms "underwriting"
and "distribution" traditionally apply to activities distinctly
different from those of a broker (Schwab, at 3010) and
characterized an underwriter as one who buys as principal
(Schwab, at 3010 n. 17), we do not feel that the decision is
dispositive of this case. In Schwab, the Supreme Court
considered securities activities that took place in the secondary
market (i.e., involved the buying and selling of securities
already in the market). The case specifically left open the possibility
that agency transactions (i.e., best-efforts underwriting)
can give rise to underwriting for the purposes of the Glass-Steagall
Act. (Schwab, at 3010 n. 17). Transactions of the type at
issue here involve the primary market (i.e., newly issued
securities). Depending upon the actions involved, such activities could
be viewed as assisting in the underwriting of such securities. Go Back to Text
2 "Thus, if the Board reasonably found that section 16
permits Bankers Trust's activities, our inquiry ends there."
Bankers Trust II, at 1058. Concerning the interplay of
sections 16 and 21 the Court stated that, "Section 21 cannot be read
to prohibit what Section 16 permits." Bankers Trust II,
at 1057. The Court also stated that, ". . .any restriction on
the activities of a commercial bank that may arise because of the
prohibitions of Section 21 is relieved insofar as the activity is
permitted by Section 16." Bankers Trust II, at 1058. Go Back to Text
3 See pages 19 through 24 of the Court of Appeals opinion,
where the Court discusses certain passages of the Act's legislative
history as evidence that Congress was concerned about the promotional
pressures that ensue when a bank establishes a retail network for the
sale of securities. Go Back to Text
4 The Court of Appeals noted that although the Supreme Court in
Board of Governors v. Dimension Financial Corporation, 106
S. Ct. 681 (1986) rejected the invocation of broad legislative purpose
to override the clear language of a statute, the Supreme Court has
uniformly considered whether subtle hazards are associated with the
securities activities in question whenever it has been asked to
interpret the Glass-Steagall Act. Bankers Trust II, at
1066-1067. Go Back to Text
5 "We believe, however, that despite the existence of this
one subtle hazard' we must still affirm the Board. There are several
reasons for that conclusion. First, the subtle hazards' addressed in
Camp and returned to ICI, Schwab and SIA
have never alone caused the Supreme Court to hold that
Glass-Steagall permits or prohibits any particular banking practice.
Rather, analysis of the hazards in those cases simply reinforced the
Court's conclusion that, as a matter of statutory interpretation,
Glass-Steagall permitted or prohibited the questioned practice.
Moreover, the Court has concluded that subtle hazards counsel
prohibition of a banking practice only when the practice gave rise to
each and every one of the hazards." Bankers Trust II, at
1069. Go Back to Text
6 "Underwriters also may distribute securities under a
best efforts' agreement pursuant to which large blocks of specific
issues of securities are offered to the public by the investment banker
as agent for the issuer." Schwab, at 3010. Go Back to Text
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