[Federal Register: October 3, 2007 (Volume 72, Number 191)]
[Rules and Regulations]
[Page 56513-56562]
[DOCID:fr03oc07-15]

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Part III

Federal Reserve System

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Securities and Exchange Commission

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12 CFR Part 218 and 17 CFR Parts 240 and 247

Definitions of Terms and Exemptions Relating to the ``Broker''
Exceptions for Banks and Exemptions for Banks Under Section 3(a)(5) of
the Securities Exchange Act of 1934 and Related Rules; Final Rules

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FEDERAL RESERVE SYSTEM

12 CFR Part 218

[Regulation R; Docket No. R-1274]

SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 240 and 247

[Release No. 34-56501; File No. S7-22-06]
RIN 3235-AJ74

Definitions of Terms and Exemptions Relating to the ``Broker''
Exceptions for Banks

AGENCIES: Board of Governors of the Federal Reserve System (``Board'')
and Securities and Exchange Commission (``SEC'' or ``Commission'')
(collectively, the Agencies).

ACTION: Final rule.

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SUMMARY: The Board and the Commission jointly are adopting a single set
of final rules that implement certain of the exceptions for banks from
the definition of the term ``broker'' under Section 3(a)(4) of the
Securities Exchange Act of 1934 (``Exchange Act''), as amended by the
Gramm-Leach-Bliley Act (``GLBA''). The rules define terms used in these
statutory exceptions and include certain related exemptions. In
developing these rules, the Agencies have consulted with, and sought
the concurrence of, the Office of the Comptroller of the Currency
(``OCC''), the Federal Deposit Insurance Corporation (``FDIC'') and the
Office of Thrift Supervision (``OTS''), and have taken into
consideration all comments received on the proposed rules issued in
December 2006. The rules are intended, among other things, to
facilitate banks' compliance with the Exchange Act and the GLBA.

DATES: Effective dates: The addition of parts 12 CFR 218 and 17 CFR 247
is effective September 28, 2007. Regulations at 12 CFR 218.781 and 17
CFR 247.781 (collectively ``Rule 781'') are effective on September 28,
2007. Regulations at 12 CFR 218.100 through 218.780 and 17 CFR 247.100
through 247.780 are effective December 3, 2007. Amendments affecting
Part 240 of Title 17 are effective December 3, 2007.
    Compliance date: Banks are exempt from complying with the rules and
the ``broker'' exceptions in Section 3(a)(4)(B) of the Exchange Act
until the first day of their first fiscal year that commences after
September 30, 2008.

FOR FURTHER INFORMATION CONTACT:
    BOARD: Kieran J. Fallon, Assistant General Counsel,<PHONE_NUMBER>,
Andrea Tokheim, Counsel,<PHONE_NUMBER>, or Brian Knestout, Attorney,
(202) 452-2249, Legal Division, Board of Governors of the Federal
Reserve System, 20th Street and Constitution Avenue, NW., Washington,
DC 20551. Users of Telecommunication Device for Deaf (TDD) only, call
(202) 263-4869.
    SEC: Catherine McGuire, Chief Counsel, Linda Stamp Sundberg, Senior
Special Counsel, Joshua Kans, Senior Special Counsel, John J. Fahey,
Branch Chief, or Elizabeth MacDonald, Special Counsel, at (202) 551-
5550, Office of the Chief Counsel, Division of Market Regulation,
Securities and Exchange Commission, 100 F Street, NE., Washington, DC
20549.

SUPPLEMENTARY INFORMATION:

Table of Contents

I. Introduction
    A. Background
    B. Overview of Comments
    C. Final Rules and Related Matters
II. Networking Arrangements
    A. Overview of Proposed Rules and Comments
    B. Rule 700: Definition of Terms Used in Networking Exception
    1. Definition of ``Nominal One-Time Cash Fee of a Fixed Dollar
Amount''
    2. Definition of ``Referral''
    3. Definition of ``Contingent on Whether the Referral Results in
a Transaction''
    4. Definition of ``Incentive Compensation''
    a. Exception for Discretionary, Multi-Factor Bonus Plans
    b. Safe Harbor for Plans Based on Overall Profitability or
Revenue
    C. Rule 701: Exemption for Referrals Involving Institutional
Customers and High Net Worth Customers
    1. Definitions of ``Institutional Customer'' and ``High Net
Worth Customer''
    2. Determining that a Customer Meets the Relevant Thresholds
    3. Conditions Relating to Disclosures
    4. Suitability or Sophistication Analysis by Broker-Dealer
    5. Conditions Relating to Bank Employees
    6. Good Faith Compliance and Corrections by Banks
    7. Referral Fees Permitted Under the Exemption
    8. Permissible Bonus Compensation Not Restricted
III. Trust and Fiduciary Activities
    A. Trust and Fiduciary Exception and Proposed Rules
    B. Joint Final Rules
    1. ``Chiefly Compensated'' Test and Bank-Wide Exemption Based on
Two-Year Rolling Averages
    2. ``Relationship Compensation''
    3. Excluded Compensation
    4. Trust or Fiduciary Accounts
    5. Exemptions for Special Accounts, Foreign Branches,
Transferred Accounts, and a De Minimis Number of Accounts
    6. Advertising Restrictions
IV. Sweep Accounts and Transactions in Money Market Funds
    A. Rule 740: Definition of Terms Used in Sweep Exception
    B. Exemption Regarding Money Market Fund Transactions
V. Safekeeping and Custody
    A. Background
    B. Rule 760: Custody Exemption
    1. Order-Taking for Employee Benefit Plan Accounts and
Individual Retirement or Similar Accounts
    a. Employee Compensation Restrictions
    b. Advertisements and Sales Literature
    c. Other Conditions
    2. Order-Taking as an Accommodation for Other Types of Accounts
    a. Accommodation Basis
    b. Employee Compensation Restrictions
    c. Limitations on Bank Fees
    d. Advertising and Sales Literature Restrictions
    e. Investment Advice or Recommendations
    3. Other Conditions Applicable to Order-Taking for All Custody
Accounts
    a. Directed Trustees
    b. Broker Execution Requirement
    c. Carrying Broker Provisions
    4. Custodians, Subcustodians, and Administrators/Recordkeepers
    a. ``Account for Which a Bank Acts as a Custodian''
    b. Administrators/Recordkeepers and Subcustodians
    5. Evasions
VI. Other Exemptions
    A. Exemption for Regulation S Transactions With Non-U.S. Persons
and Broker-Dealers
    B. Exemption for Non-Custodial Securities Lending Transactions
    C. Exemption for Banks Effecting Certain Excepted or Exempted
Transactions in Investment Company Securities and Variable Insurance
Products
    D. Exemption for Certain Transactions involving a Company's
Securities for Its Employee Benefit Plans and Participants
    E. Temporary and Permanent Exemption for Contracts Entered Into
by Banks From Being Considered Void or Voidable
    F. Extension of Time and Transition Period
VII. Finding That the Exemptions Are Appropriate and in the Public
Interest and Consistent With the Protection of Investors
VIII. Withdrawal of Proposed Regulation B and Removal of Exchange
Act Rules 3a4-2-3a4-6, and 3b-17
IX. Administrative Law Matters
    A. Paperwork Reduction Act Analysis
    B. Consideration of Benefits and Costs
    C. Consideration of Burden on Competition, and on Promotion of
Efficiency, Competition, and Capital Formation
    D. Consideration of Impact on the Economy
    E. Regulatory Flexibility Analysis
    F. Plain Language
X. Statutory Authority
XI. Text of Rules and Rule Amendment

I. Introduction

A. Background

    The GLBA amended several federal statutes governing the activities
and supervision of banks, bank holding

companies, and their affiliates.\1\ Among other things, it lowered
barriers between the banking and securities industries erected by the
Banking Act of 1933 (``Glass-Steagall Act'').\2\ It also altered the
way in which the supervisory responsibilities over the banking,
securities, and insurance industries are allocated among financial
regulators. Among other things, the GLBA repealed most of the
separation of investment and commercial banking imposed by the Glass-
Steagall Act. The GLBA also revised the provisions of the Exchange Act
that had completely excluded banks from broker-dealer registration
requirements.
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    \1\ Pub. L. No. 106-102, 113 Stat. 1338 (1999).
    \2\ Pub. L. No. 73-66, ch. 89, 48 Stat. 162 (1933) (as codified
in various Sections of 12 U.S.C.).
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    In enacting the GLBA, Congress adopted functional regulation for
bank securities activities, with certain exceptions from Commission
oversight for specified securities activities. With respect to the
definition of ``broker,'' the GLBA amended the Exchange Act to provide
eleven specific exceptions for banks.\3\ Each of these exceptions
permits a bank to act as a broker or agent in securities transactions
that meet specific statutory conditions.
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    \3\ 15 U.S.C. 78c(a)(4).
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    In particular, Section 3(a)(4)(B) of the Exchange Act as amended by
the GLBA provides conditional exceptions from the definition of broker
for banks that engage in certain securities activities in connection
with third-party brokerage arrangements; \4\ trust and fiduciary
activities; \5\ permissible securities transactions; \6\ certain stock
purchase plans; \7\ sweep accounts; \8\ affiliate transactions; \9\
private securities offerings; \10\ safekeeping and custody activities;
\11\ identified banking products; \12\ municipal securities; \13\ and a
de minimis number of other securities transactions.\14\
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    \4\ Exchange Act Section 3(a)(4)(B)(i). This exception permits
banks to enter into third-party brokerage, or ``networking''
arrangements with brokers under specific conditions.
    \5\ Exchange Act Section 3(a)(4)(B)(ii). This exception permits
banks to effect transactions as trustees or fiduciaries for
securities customers under specific conditions.
    \6\ Exchange Act Section 3(a)(4)(B)(iii). This exception permits
banks to buy and sell commercial paper, bankers' acceptances,
commercial bills, exempted securities, certain Canadian government
obligations, and Brady bonds.
    \7\ Exchange Act Section 3(a)(4)(B)(iv). This exception permits
banks, as part of their transfer agency activities, to effect
transactions for certain issuer plans.
    \8\ Exchange Act Section 3(a)(4)(B)(v). This exception permits
banks to sweep funds into no-load money market funds.
    \9\ Exchange Act Section 3(a)(4)(B)(vi). This exception permits
banks to effect transactions for affiliates, other than broker-
dealers.
    \10\ Exchange Act Section 3(a)(4)(B)(vii). This exception
permits certain banks to effect transactions in certain privately
placed securities, under certain conditions.
    \11\ Exchange Act Section 3(a)(4)(B)(viii). This exception
permits banks to engage in certain enumerated safekeeping or custody
activities, including stock lending as custodian.
    \12\ Exchange Act Section 3(a)(4)(B)(ix). This exception permits
banks to buy and sell certain ``identified banking products,'' as
defined in Section 206 of the GLBA.
    \13\ Exchange Act Section 3(a)(4)(B)(x). This exception permits
banks to effect transactions in municipal securities.
    \14\ Exchange Act Section 3(a)(4)(B)(xi). This exception permits
banks to effect up to 500 transactions in securities in any calendar
year in addition to transactions referred to in the other
exceptions.
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    In October 2006, the Financial Services Regulatory Relief Act of
2006 (``Regulatory Relief Act'') became effective.\15\ Among other
things, the Regulatory Relief Act requires that the SEC and the Board
jointly adopt a single set of rules to implement the bank broker
exceptions in Section 3(a)(4) of the Exchange Act.\16\ In addition, it
required that the Agencies issue a single set of proposed rules to
implement these exceptions not later than 180 days after enactment of
the Regulatory Relief Act (April 11, 2007).
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    \15\ Public Law No. 109-351, 120 Stat. 1966 (2006).
    \16\ See Exchange Act Section 3(a)(4)(F), as added by Section
101 of the Regulatory Relief Act.
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    In December 2006, the Agencies jointly issued, and requested public
comment on, a single set of proposed rules to implement the broker
exceptions for banks relating to third-party networking arrangements,
trust and fiduciary activities, sweep activities, and safekeeping and
custody activities.\17\ The proposed rules included certain exemptions
related to these activities, as well as exemptions related to foreign
securities transactions, securities lending transactions conducted in
an agency capacity, the execution of transactions involving mutual fund
shares, and the potential liability of banks under Section 29 of the
Exchange Act. In developing the proposed rules, the Agencies
considered, among other things, the language and legislative history of
the ``broker'' exceptions for banks adopted in the GLBA, the rules
previously issued or proposed by the Commission relating to these
exceptions, and the comments received in connection with those prior
rulemakings.
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    \17\ See 71 FR 77522, December 26, 2006.
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    The Agencies requested comment on all aspects of the proposed
rules. In addition, the Agencies requested comment on whether it would
be useful or appropriate for the Agencies to adopt rules implementing
the other bank ``broker'' exceptions in Section 3(a)(4)(B) of the
Exchange Act that were not addressed in the proposal.

B. Overview of Comments

    The Agencies received comments from 58 organizations and
individuals on the proposed rules. Commenters included 22 trade
associations, 20 banking organizations, 7 other organizations in the
financial services industry, 3 community and nonprofit groups, two
credit unions, one state government, one self-regulatory organization,
one association of state securities administrators, and one individual.
Many commenters supported the proposed rules as a general matter. For
example, commenters asserted that the proposed rules would provide
banks considerable flexibility in providing securities services to
their customers, would avoid disrupting bank activities and customer
relationships, or were a significant improvement over earlier
proposals.\18\ In addition, many commenters supported the general
approaches (including related exemptions) taken by the proposed rules
to implement the networking, trust and fiduciary, sweep, and
safekeeping and custody exceptions. Several commenters, however,
contended that the proposed rules did not adequately protect investors,
and particularly retail investors.\19\ Some of these commenters argued
that that the Agencies should withdraw the proposed rules and issue new
rules based on those issued in 2001\20\ or 2004.\21\
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    \18\ See, e.g., Citigroup Letter, Independent Community Bankers
Ass'n (``ICBA'') Letter, American Bankers Ass'n (``ABA'') Letter,
JPMorgan Chase & Co. (``JP Morgan'') Letter, Financial Services
Roundtable (``Roundtable'') Letter.
    \19\ See, e.g., Massachusetts Securities Division Letter, Pace
Investors Rights Project (``Pace Project'') Letter, Boyd Financial
Letter.
    \20\ Exchange Act Release No. 44291 (May 11, 2001), 66 FR 27760
(May 18, 2001).
    \21\ Exchange Act Release No. 49879 (June 17, 2004), 69 FR 39682
(June 30, 2004). See, e.g., North American Securities Administrators
Association (``NASAA'') Letter.
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    Most commenters also recommended that the Agencies modify specific
provisions of the proposed rules to, among other things, reduce
administrative burden, better protect bank customers or investors, or
clarify the scope or effect of the rules. The comments received on the
proposed rules are discussed in greater detail in the following
sections of this SUPPLEMENTARY INFORMATION.

C. Final Rules and Related Matters

    After carefully considering the comments, the Agencies have adopted

final rules to implement the broker exceptions for banks relating to
third-party networking arrangements, trust and fiduciary activities,
sweep activities, and custody and safekeeping activities.\22\ The Board
and SEC have consulted extensively with, and sought the concurrence of,
the OCC, FDIC and OTS in developing these final rules.
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    \22\ Commenters generally did not request that the Agencies
adopt rules to implement the other broker exceptions for banks at
this time or stated that no additional guidance was needed at this
time with respect to these exceptions. See ABA Letter.
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    Like the proposal, the final rules include certain exemptions
related to these activities, as well as exemptions related to foreign
securities transactions, securities lending transactions conducted in
an agency capacity, the execution of transactions other than through a
broker-dealer, the potential liability of banks under Section 29 of the
Exchange Act, and the date on which the GLB Act's ``broker'' exceptions
for banks will go into effect.
    As discussed in the following sections, the Agencies have modified
the rules in numerous respects in light of the comments received. These
changes include, among other things, modifications to the examples of
``relationship compensation'' in Rule 721 to clarify the scope of the
term for purposes of the rules relating to trust and fiduciary
activities; the custody exemption in Rule 760 to permit banks acting as
a directed trustee to accept orders under the exemption; and Rule 781
to extend the compliance date for a bank until the first day of its
first fiscal year commencing after September 30, 2008. The Agencies
also have adopted new exemptions relating to trust or fiduciary
accounts held in a foreign branch of a bank,\23\ and to permit a bank
to effect, under certain conditions and without using a broker-dealer,
transactions in a fiduciary or custodial capacity for an employee
benefit plan in the stock of the plan's sponsor.\24\
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    \23\ See Rule 723(c).
    \24\ See Rule 776.
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    The final rules are designed to accommodate the business practices
of banks and protect investors. If more than one broker exception or
exemption is available to a bank under the statute or rules for a
securities transaction, the bank may choose the exception or exemption
on which it relies to effect the transaction without registering as a
broker-dealer. For example, if the bank effects a transaction in a
security sold in an offshore transaction for a custody account that is
permissible under either the Regulation S exemption in Rule 771 or the
custody exemption in Rule 760, the bank may choose which exemption to
rely on and comply with in effecting the transaction. Similarly, if a
bank effects no more than 500 securities transactions as agent for its
customers in a calendar year, the bank may rely on the de minimis
exception in Section 3(a)(4)(B)(xi) of the Exchange Act in lieu of any
other available exception or exemption for such transactions. The bank,
of course, must comply with all of the requirements contained in the
exception or exemption on which it relies.\25\
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    \25\ An employee of a bank that operates in accordance with the
exceptions in Section 3(a)(4)(B) of the Exchange Act and, where
applicable, the rules is not required to register as a ``broker'' to
the extent that the employee's activities are covered by the
relevant exception or rule.
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    Section 401 of the Regulatory Relief Act amended the definition of
``bank'' in Section 3(a)(6) of the Exchange Act to include any Federal
savings association or other savings association the deposits of which
are insured by the FDIC. Accordingly, as used in the final rules, the
term ``bank'' includes any savings association that qualifies as a
``bank'' under Section 3(a)(6) of the Exchange Act, as amended.\26\
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    \26\ Several commenters asked the Agencies, or the Commission
independently, to adopt rules that would extend to federal or state-
chartered credit unions some or all of the ``broker'' exceptions or
exemptions provided banks under Section 3(a)(4)(B) of the Exchange
Act or the final rules. See, e.g., Credit Union Nat'l Ass'n Letter,
Nat'l Ass'n of Credit Union Service Organizations Letter, Nat'l
Ass'n of Fed. Credit Unions Letter, Navy Fed. Credit Union Letter,
and XCU Corp. Letter. While the GLBA's ``bank'' exceptions do not by
their terms apply to credit unions, these requests are under
consideration by the Commission, which is the agency with authority
to address these matters. The Commission notes the existence of SEC
staff positions with regard to networking relationships between a
credit union and a broker-dealer and is not addressing this issue at
this time. See, e.g., Chubb Securities Corp., 1993 SEC No-Act. LEXIS
1204 (Nov. 24, 1993).
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    Identical sets of the final rules are being adopted by the Board
and SEC and will be published by the Board in Title 12 of the Code of
Federal Regulations and by the SEC in Title 17 of the Code of Federal
Regulations.\27\ Pursuant to the Regulatory Relief Act, this single set
of final rules supersedes any and all other proposed or final rules
issued by the Commission on or after the date of enactment of the GLBA
with regard to the definition of ``broker'' under Section 3(a)(4) of
the Exchange Act.\28\
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    \27\ The final rules adopted by the Board and the SEC within
their respective titles of the Code of Federal Regulation (12 CFR
part 218 for the Board and 17 CFR part 247 for the SEC) are
identically numbered from Sec.  ------.100 to Sec.  ------.781. For
ease of reference, the single set of final rules adopted by each
Agency are referred to in this release as Rule ------, excluding
title and part designations. A similar format is used to refer to
the single set of proposed rules issued by the Agencies.
    \28\ Pub. L. No. 109-351, Sec.  101(a)(3), 120 Stat. 1966, 1968
(2006).
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    Any additions or changes to these rules that may be appropriate to
implement Section 3(a)(4)(B) of the Exchange Act will be adopted
jointly by the SEC and Board in accordance with the consultation
provisions in Section 101(b) of the Regulatory Relief Act. In addition,
if any rules (including exemptions) are proposed or adopted in the
future related to the other bank ``broker'' exceptions in Section
3(a)(4)(B) of the Exchange Act that are not addressed in the final
rules now being adopted by the SEC and the Board, they would be
proposed and adopted jointly by the SEC and Board.\29\
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    \29\ A few commenters requested that the Commission delegate
authority to act on future exemptive requests from banks to the
Director of its Division of Market Regulation. See America Community
Bankers Ass'n (``ACB'') Letter, Roma Bank Letter. Because particular
banks may have individual situations that may be appropriate for
additional relief, the Commission delegated authority to the
Director of the Division of Market Regulation to consider, on a
case-by-case basis, individual requests for exemptive relief from
banks. To facilitate the processing of these requests, the
Commission delegated this exemptive authority within its Rules of
Organization and Program Management in Rule 30-3(a)(70) (17 CFR
200.30-3(a)(70)). The Commission continues to expect the staff to
submit novel and complex requests for exemptions to the Commission.
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    As required by the GLBA, the Board, OCC, FDIC, and OTS
(collectively, the Banking Agencies) will develop, and request public
comment on, recordkeeping rules for banks that operate under the
``broker'' exceptions in Section 3(a)(4) of the Exchange Act.\30\ These
rules, which will be developed in consultation with the SEC, will
establish recordkeeping requirements to enable banks to demonstrate
compliance with the terms of the statutory exceptions and the final
rules and will be designed to facilitate compliance with the statutory
exceptions and the rules.
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    \30\ See 12 U.S.C. 1828(t)(1).
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    Several commenters urged the Agencies also to cooperate in
providing interpretations or guidance (such as staff no-action letters)
concerning the final rules or the broker exceptions for banks in
Section 3(a)(4)(B) of the Exchange Act or in taking enforcement action
to enforce compliance with these rules or exceptions.\31\ In addition,
a number of commenters urged the Agencies to work

with the Financial Industry Regulatory Authority (``FINRA'') \32\ to
modify promptly its Rule 3040 as it applies to persons that are
employees of both a bank and a broker-dealer (so-called ``dual
employees'').\33\
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    \31\ See, e.g., ABA Letter, Clearing House Ass'n Letter,
Citigroup Letter, The PNC Financial Services Group, Inc. (``PNC'')
Letter. One commenter, however, expressed concern that coordination
among the Agencies might result in slower responses to requests for
guidance. See American Bar Ass'n Section of Business Law Letter
(``Business Law Section Letter'').
    \32\ On July 26, 2007, the Commission approved a proposed rule
change filed by NASD to amend NASD's Certificate of Incorporation to
reflect its name change to Financial Industry Regulatory Authority
Inc., or FINRA, in connection with the consolidation of member firm
regulatory functions of NASD and NYSE Regulation, Inc. See
Securities Exchange Act Release No. 56146 (July 26, 2007). FINRA's
Rules currently consist of the rules adopted by the NASD and
effective on the date of the consolidation (which include NASD Rule
3040), as well as certain rules of the NYSE that FINRA has
incorporated into its own rules.
    \33\ See, e.g., ABA Letter, Clearing House Ass'n Letter, Harris
Bank Letter, HSBC Bank, N.A. (``HSBC Bank'') Letter, HSBC Securities
(USA) Inc. (``HSBC Securities'') Letter, Roundtable Letter. These
commenters asserted that it was important for the requested
modifications to FINRA's Rule 3040 to be made prior to the date on
which banks would first have to comply with the new ``broker''
exceptions in the GLBA.
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    In light of the joint nature of the final rules and the Agencies'
joint rule-writing authority for the bank broker exceptions in Section
3(a)(4)(B),\34\ the Agencies will jointly issue any interpretations and
responses to requests for no-action letters or other interpretive
guidance concerning the scope or terms of the exceptions and rules, and
will consult and, to the extent appropriate, coordinate with each other
and the appropriate federal banking agency for a bank concerning any
formal enforcement actions proposed to be taken against a bank for
violations of the exceptions or rules.
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    \34\ Rapaport v. U.S. Department of Treasury, 59 F. 3d 212, 216-
217 (D.C. Cir. 1995), cert. denied 116 S.Ct. 775 (1996).
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    The Agencies already consult with and coordinate with each other
and the other federal banking agencies in a variety of areas, and the
Agencies and the other federal banking agencies are in the process of
supplementing their existing policies and procedures to facilitate
coordination with respect to the broker exceptions and rules. Banks or
others that seek an interpretation of, or a no-action letter or other
staff guidance concerning, the rules or the exceptions should submit
their request to both Agencies. The Agencies also expect to continue
their dialogue with FINRA concerning potential modifications to that
authority's Rule 3040.

II. Networking Arrangements

    The third-party brokerage exception (``networking exception'') in
Section 3(a)(4)(B)(i) of the Exchange Act permits a bank to avoid being
considered a broker if, under certain conditions, it enters into a
contractual or other written arrangement with a registered broker-
dealer under which the broker-dealer offers brokerage services to bank
customers.\35\ The networking exception does not address the type or
amount of compensation that a bank may receive from its broker-dealer
partner under a networking arrangement. However, the networking
exception provides that a bank may not pay its unregistered employees
\36\ incentive compensation for brokerage transactions. Nevertheless,
the statutory exception does permit a bank employee to receive a
``nominal one-time cash fee of a fixed dollar amount'' for referring
bank customers to the broker-dealer if payment of the referral fee is
not ``contingent on whether the referral results in a transaction.''
\37\ Congress included this general prohibition on, and limited
exception to, incentive compensation to reduce concerns regarding the
securities sales practice of unregistered bank employees.
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    \35\ 15 U.S.C. 78c(a)(4)(B)(i).
    \36\ An unregistered bank employee is an employee that is not
registered or approved, or otherwise required to be registered or
approved, in accordance with the qualification standards established
by the rules of any self-regulatory organization.
    \37\ 15 U.S.C. 78c(a)(4)(B)(i)(VI).
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A. Overview of Proposed Rules and Comments

    Proposed Rule 700 defined certain key terms related to referral
fees and incentive compensation used in the networking exception. For
example, the proposed rule provided that a referral fee would be
considered ``nominal'' if it met any of four standards included in the
rule. The proposed rule also defined when a referral fee would be
``contingent on whether a referral results in a transaction,'' what
constitutes ``incentive compensation,'' and what types of bank bonus
plans would not be considered incentive compensation under the
networking exception. Proposed Rule 701 included an exemption that
permitted bank employees, subject to certain conditions, to receive
higher-than-nominal, contingent referral fees for referring
institutional customers and high net worth customers to a broker-
dealer.
    Many commenters supported the general approach of Proposed Rules
700 and 701, including the range of alternatives provided for
determining if a referral fee is nominal and the adoption of an
exemption for referrals involving high net worth or institutional
customers.\38\ Some commenters, however. suggested that the proposed
rules would harm investors by giving bank employees undue incentives to
direct unsophisticated customers into potentially unsuitable investment
products.\39\
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    \38\ See, e.g. ABA Letter, Roundtable Letter, Citigroup Letter,
Union Bank of California (``Union Bank'') Letter.
    \39\ See, e.g., Pace Project Letter.
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B. Rule 700: Definition of Terms Used in Networking Exception

1. Definition of ``Nominal One-Time Cash Fee of a Fixed Dollar Amount''
    Proposed Rule 700 defined the term ``nominal one-time cash fee of a
fixed dollar amount'' to mean a cash payment for a referral in an
amount that meets any one of four alternative standards: the first
based on twice the average hourly base wage established by the bank for
the employee's job family; the second based on 1/1000th of the average
annual base salary established by the bank for the employee's job
family; the third based on twice the employee's actual base hourly
wage; and the fourth based on a specified dollar amount ($25), indexed
for inflation.\40\
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    \40\ Proposed Rule 700(c).
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    Many commenters generally supported the flexibility that this range
of alternatives would afford in determining whether a referral fee is
``nominal.'' \41\ Some commenters expressed concern that the proposed
rule placed greater limits on permissible payments under networking
arrangements than exist currently under applicable federal banking
agency guidance or questioned the need for a definition of ``nominal''
to be established by rule at all.\42\ A few commenters contended that
the specific dollar amount in the proposed rule ($25) was too low.\43\
A number of commenters, however, believed that the alternatives would
result in the payment of fees that are higher than nominal and would
create incentives for bank employees to make securities referrals even
when not appropriate for the customer. These commenters questioned, for
example, whether twice an employee's hourly wage was truly nominal and
whether the Agencies had sufficient basis for selecting that measure of
``nominal.'' \44\
---------------------------------------------------------------------------

    \41\ See, e.g., Roundtable Letter, ACB Letter.
    \42\ See, e.g., Bank Insurance & Securities Ass'n (``BISA'')
Letter, Wisconsin Bankers Ass'n (``WBA'') Letter.
    \43\ See, e.g., Clearing House Ass'n Letter and ICBA Letter.
    \44\ See, e.g., Boyd Financial Letter, NASAA Letter, Pace
Project Letter, and University of Cincinnati Corp. Law Ctr. Letter.

---------------------------------------------------------------------------

    After carefully reviewing the comments, the Agencies have
determined to adopt the ``nominal'' definition substantially as
proposed. Including a definition of ``nominal'' in the rule will
provide banks with certainty as to the Agencies'' interpretation of
that standard and should facilitate compliance. The Agencies believe
that each of the alternatives for defining ``nominal'' is consistent
with the statutory networking exception, which provides that a bank
employee may receive compensation for each referral if the compensation
for that referral is ``nominal'' and meets the other requirements of
the statute. Under each of the alternatives established, the amount of
compensation a bank employee may receive for each referral will be
small in relation to the employee's overall compensation and therefore
unlikely to create undue incentives for the bank employee to engage in
activities, such as ``pre-selling'' specific securities to the customer
involved in violation of the networking exception,\45\ which would
raise sales practice concerns. As discussed below, the multiple
alternatives are designed to provide flexibility for banks of all sizes
and locations to use different business models and to take into account
economic differences around the country and among their employees in
assessing how best to structure their program(s) for paying ``nominal''
cash referral fees under the networking exception. The alternatives
also were designed to allow for roughly equivalent treatment of bank
employees at different base or hourly compensation levels within a
bank.
---------------------------------------------------------------------------

    \45\ See Exchange Act Section 3(a)(4)(B)(i)(V).
---------------------------------------------------------------------------

    Rule 700(c) provides that a referral fee paid to any bank employee
will be considered ``nominal'' if it does not exceed $25.\46\ This
dollar amount will be adjusted for inflation on April 1, 2012, and
every five years thereafter, to reflect any changes in the value of the
Employment Cost Index For Wages and Salaries, Private Industry Workers
(or any successor index thereto), as published by the Bureau of Labor
Statistics, from December 31, 2006.\47\ The Agencies selected this
index because it is a widely used and broad indicator of increases in
the wages of private industry workers, which includes bank employees.
Available data indicate that the $25 amount is consistent with the
level of referral fees generally paid to tellers and other bank
employees engaged in making referrals of retail customers under
existing Banking Agency guidance, which also includes a ``nominal''
standard.\48\
---------------------------------------------------------------------------

    \46\ Rule 700(c)(3).
    \47\ Each adjustment would be rounded to the nearest multiple of
$1. Rule 700(f).
    \48\ See ABA Securities Ass'n., 2003/2004 National Survey of
Bank Retail Investment Services, Vol. I, at 60 (survey data
demonstrate that 20 percent of banks pay retail referral fees of $20
or more); Banking Agencies' Interagency Statement on Retail Sales of
Nondeposit Investment Products (Feb. 15, 1994).
---------------------------------------------------------------------------

    As under the proposal, a referral fee also will be considered
``nominal'' under Rule 700(c) if the payment does not exceed (1) twice
the employee's actual base hourly wage; (2) twice the average of the
minimum and maximum hourly wage established by the bank for the current
or prior year for the job family that includes the employee; or (3) 1/
1000th of the average of the minimum and maximum annual base salary
established by the bank for the current or prior year for the job
family that includes the employee.\49\
---------------------------------------------------------------------------

    \49\ Rule 700(c)(1) and (2).
---------------------------------------------------------------------------

    In developing these alternatives to the fixed $25 fee, the Agencies
considered data on the average hourly wages of bank tellers, which are
the class of bank employees most typically engaged in making referrals
of retail customers. These data indicate that the national mean hourly
wage in 2005 for tellers was $10.59.\50\ Accordingly, the $25 amount is
slightly more than twice the national mean hourly wage for tellers in
2005, and slightly more than 1/1000th of the annualized salary of an
employee that makes $12.50 per hour (or $25 every two hours) based on a
40 hour work week.\51\ Thus, the alternatives based on twice the
employee's hourly base wage or 1/1000th of the employee's base annual
salary, at current pay rates, are designed to allow bank employees to
receive referral fees that are roughly equivalent to those that may be
received by bank tellers under the flat dollar option.
---------------------------------------------------------------------------

    \50\ Occupational Employment and Wages, May 2005, (Tellers),
U.S. Department of Labor, Bureau of Statistics.
    \51\ Specifically, twice the hourly wage for an employee who
earns an annual base salary of $25,000 (1,000 x $25) would be
$24.04, based on a 40 hour per week (or 1080 hours per year) work
schedule.
---------------------------------------------------------------------------

    The options based on the employee's job family use these same
measurements but allow comparisons to the average of the minimum and
maximum hourly base wage or base salary of the employee's job family.
These options are designed to reduce administrative burden while also
ensuring that referral fees remain nominal in amount. To provide
comparability between the alternative based on an employee's actual
compensation and those based on the compensation established for the
employee's job family, the Agencies have modified the final rule to
provide that a referral fee also will be considered nominal if it does
not exceed 1/1000th of the employee's actual base annual salary.\52\
Under the final rules, a bank may use a different ``nominal''
methodology in its different business lines or operating units and may
alter the methodology it uses within a given year.
---------------------------------------------------------------------------

    \52\ Rule 700(c)(2).
---------------------------------------------------------------------------

    One commenter suggested that the term ``job family'' was ambiguous
and could allow banks to include all employees in a single job family,
which would result in payments to employees with salaries at the lower
end of the job family that may be well in excess of twice their hourly
wage.\53\ Rule 700 defines a ``job family'' as a group of jobs or
positions involving similar responsibilities, or requiring similar
skills, education or training, that a bank, or a separate unit, branch
or department of a bank, has established and uses in the ordinary
course of its business to distinguish among its employees for purposes
of hiring, promotion, and compensation.\54\ The requirements that a job
family include jobs or positions with similar responsibilities, or that
require similar skills, education and training, and be used by the bank
in the ordinary course of its business for hiring, promotion and
compensation purposes are designed to prevent a bank from establishing
special job family classifications to evade the ``nominal'' standard. A
bank may not deviate from its ordinary classification of jobs for
purposes of determining whether a referral fee is nominal under this
standard, and the Banking Agencies will monitor the job family
classifications used by banks for ``nominal'' determination as part of
the risk-focused examination process. Depending on a bank's internal
employee classification system, examples of a job family may include
tellers, loan officers, or branch managers. The Agencies note,
moreover, that other provisions of the networking exception also
provide significant protection to customers. For example, the
networking exception provides that unregistered bank employees may
perform only clerical or ministerial functions in connection with
brokerage transactions.\55\ Accordingly, bank employees referring a
customer to a broker-dealer under the exception may not provide
investment advice concerning securities or make specific

securities recommendations to the customer.\56\
---------------------------------------------------------------------------

    \53\ See Pace Project Letter.
    \54\ Proposed Rule 700(d).
    \55\ See 15 U.S.C. 78c(a)(4)(B)(i)(V).
    \56\ A bank employee, however, may describe in general terms the
types of investment vehicles available from the bank and the broker-
dealer under the arrangement. See id.
---------------------------------------------------------------------------

    A few commenters suggested that, by defining ``nominal'' by
reference to hourly wages and annual base salary, the rule treats
unfairly employees who receive a considerable portion of their
compensation through bonuses tied to sales of non-securities
products.\57\ Because the five alternatives included in the final rule
are based on a set dollar amount or the hourly wage or annual base
salary established by a bank for the employee or the employee's job
family, the alternatives help ensure that a referral fee will be
nominal in relation to the employee's compensation in the year it is
paid. Bonuses, however, typically are discretionary, vary significantly
from year-to-year and, as noted by commenters, may constitute a
significant portion of the compensation of certain types of bank
employees in particular years. Permitting referral fees to be based in
part on the size of a bonus paid in a previous year (or projected to be
paid in the current year) could allow bank employees to receive a
referral fee that is not nominal in relation to the employee's
compensation, or the average compensation paid to employees within the
relevant job family, in the year in which the fee is paid and, thus,
could increase the potential for sales practice concerns.
---------------------------------------------------------------------------

    \57\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, Harris Bank Letter, Roundtable Letter, PNC Letter, U.S.
Trust Company, N.A. (``U.S. Trust'') Letter, and WBA Letter.
---------------------------------------------------------------------------

    Commenters also asserted that more than one employee should be able
to receive a fee for a single referral and also requested clarification
as to whether officers and directors of a bank may receive referral
fees under the exception.\58\ The Agencies believe that the networking
exception permits a bank employee who personally participated in a
referral to receive a referral fee for the referral.\59\ Accordingly,
the Agencies have modified Rule 700(c) to clarify this position. Thus,
for example, a supervisory employee may receive a separate, nominal
one-time cash fee for a referral made by another individual supervised
by the employee only if the supervisory employee personally
participated in the referral. A supervisory employee may not, however,
receive a referral fee merely for supervising the employee making the
referral or administering the referral process. An officer or director
of a bank who makes or personally participates in making a referral may
receive a nominal fee for the referral as a bank employee.
---------------------------------------------------------------------------

    \58\ See, e.g., Consumer Bankers Ass'n (``CBA'') Letter, BISA
Letter.
    \59\ See Section 3(a)(4)(B)(i)(VI) of the Exchange Act
(permitting ``the bank employee [to] receive compensation for the
referral of any customer'' in accordance with the exception).
---------------------------------------------------------------------------

    The proposed rule permitted a nominal referral fee to be paid only
in cash. Many commenters requested that banks be given the flexibility
to pay referral fees in non-cash forms.\60\ The terms of the networking
exception, however, provide for a ``nominal, one-time cash fee of a
fixed dollar amount'' \61\ and, accordingly, the final rule continues
to require that referral fees paid under the exception be paid in cash.
A bank, therefore, may not pay referral fees in non-cash forms, such as
vacation packages, stock grants, annual leave, or consumer goods. The
final rules do not, however, prevent a bank from paying an employee on
a quarterly or more frequent periodic basis the total amount of
nominal, fixed cash fees the employee earned during the period. For
example, if a bank employee is entitled to receive a $25 referral fee
for each securities referral and the employee makes three qualifying
referrals in a given quarter, the bank may pay the employee $75 at the
end of the quarter instead of three individual payments of $25. A bank
also may use a ``points'' system to keep track of the number of
qualifying securities referrals made by the employee during a quarterly
or more frequent period and the total amount of nominal, fixed cash
fees that the employee is entitled to receive at the end of the period.
In all cases, however, points must translate into cash payments on a
uniform basis and the cash amount that an employee will receive for a
qualifying securities referral (e.g., twice the employee's actual base
hourly wage) must be fixed before the referral is made and may not be
contingent or vary based on whether an employee makes a specified
number or type of securities referrals during a quarterly or more
frequent period.\62\
---------------------------------------------------------------------------

    \60\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, and JP Morgan Letter.
    \61\ See Exchange Act Section 3(a)(4)(B)(i)(VI).
    \62\ The exception and the final rules also do not prohibit a
bank from providing its employees non-cash items, such as pizza or
coffee mugs, in connection with programs to familiarize bank
employees with new types of investment vehicles offered by the bank
or the broker-dealer through the arrangement, provided that the
programs or items given to employees do not reward or compensate an
employee for making a referral to a broker-dealer. Thus, for
example, a ``pizza party'' that is made available only to those
employees that have made one or more referrals to a broker-dealer
would not be permissible.
---------------------------------------------------------------------------

2. Definition of ``Referral''
    The statutory networking exception permits bank employees to
receive a nominal one-time cash fee of a fixed dollar amount for the
``referral'' of a customer to a broker-dealer. Rule 700(e) defines a
referral as an action taken by one or more bank employees to direct a
customer of the bank to a broker-dealer for the purchase or sale of
securities for the customer's account.\63\ For purposes of the
networking exception and Rules 700 and 701, the term ``customer''
includes both existing and potential customers of the bank.
---------------------------------------------------------------------------

    \63\ Rule 700(e).
---------------------------------------------------------------------------

    As proposed, a bank employee may receive a referral fee under the
networking exception and Rule 700 for each referral made to a broker-
dealer, including separate referrals of the same individual or entity.
In addition, nothing in the statutory networking exception or the final
rules limits or restricts the ability of a bank employee to refer
customers to other departments or divisions of the bank itself,
including, for example, the bank's trust, fiduciary or custodial
department. Likewise, the networking exception and the rules do not
apply to referrals of retail, institutional or high net worth customers
to a broker-dealer or other third party solely for transactions not
involving securities, such as loans, futures contracts (other than a
security future), foreign currency, or over-the-counter commodities, or
solely for transactions in securities (such as U.S. Government
obligations) that would not require the other party to register under
section 15 of the Exchange Act.\64\
---------------------------------------------------------------------------

    \64\ A bank that acts as a government securities broker (as
defined in Section 3(a)(43) of the Exchange Act) is not exempt from
and must comply with the notification and other applicable
requirements of section 15C of the Exchange Act.
---------------------------------------------------------------------------

3. Definition of ``Contingent on Whether the Referral Results in a
Transaction''
    Under the statutory networking exception, a nominal fee paid to an
unregistered bank employee for referring a customer to a broker-dealer
may not be contingent on whether the referral results in a transaction.
This limitation is designed to allow banks to reward bank employees for
introducing customers to a broker-dealer without giving unregistered
bank employees a direct financial interest in any resulting securities
transaction at the broker-dealer.
    The final rule, like the proposed rule, provides that a referral
fee will be considered ``contingent on whether the referral results in
a transaction'' if payment of the fee is dependent on

whether the referral results in a purchase or sale of a security;
whether an account is opened with a broker-dealer; whether the referral
results in a transaction involving a particular type of security; or
whether the referral results in multiple securities transactions.\65\
The final rule expressly provides that a referral fee may be contingent
on whether a customer (1) contacts or keeps an appointment with a
broker-dealer as a result of the referral; or (2) meets any objective,
base-line qualification criteria established by the bank or broker-
dealer for customer referrals, including such criteria as minimum
assets, net worth, income, or marginal federal or state income tax
rate, or any requirement for citizenship or residency that the broker-
dealer, or the bank, may have established generally for referrals for
securities brokerage accounts.\66\ A bank or broker-dealer may
establish and use different objective, base-line qualification criteria
(including citizenship or residency requirements) for different classes
of customers or for different business lines, divisions or units of the
bank or broker-dealer.
---------------------------------------------------------------------------

    \65\ Rule 700(a).
    \66\ Rule 700(a).
---------------------------------------------------------------------------

    Commenters generally supported these permissible contingencies.
Some commenters contended that the rule also should allow payment of a
nominal referral fee to be contingent on other events, such as the
opening of an account at the broker-dealer or on the opening of an
account that may be used to conduct only securities transactions that
the bank itself could effect without registering as a broker under the
exceptions for banks in Sections 3(a)(4)(B) of the Exchange Act.\67\
Opening a securities account at the broker-dealer, however, is a
necessary first step to executing securities transactions and one that
a customer is unlikely to take unless the customer anticipates engaging
in securities transactions with the broker-dealer. In light of this
close link between opening an account and executing securities
transactions, the Agencies have not modified the rule as requested and
the final rule continues to provide that payment of a referral fee may
not be contingent on whether the customer opens an account (other than
the types of accounts described in Part B.2 supra.) at the broker-
dealer. Other contingencies not specified in the rule may be
permissible if they are not based on whether the referral results in a
securities transaction at the broker-dealer.
---------------------------------------------------------------------------

    \67\ See, e.g., BISA Letter, Clearing House Ass'n Letter, and
U.S. Trust Letter.
---------------------------------------------------------------------------

    In addition, the ``broker'' exceptions in Sections 3(a)(4)(B) of
the Exchange Act are available only to banks. Accordingly, a referral
to a broker-dealer for a securities transaction within the scope of
section 15 of the Exchange Act still involves a ``broker'' transaction
at the broker-dealer even if a bank could conduct the transaction
itself without registering as a broker, and a referral fee may not be
contingent on the occurrence of such a transaction (or the opening of
an account to engage in such transactions).\68\
---------------------------------------------------------------------------

    \68\ For similar reasons, a referral to a broker-dealer for such
a transaction is a ``referral'' for purposes of the networking
exception and Rule 700.
---------------------------------------------------------------------------

4. Definition of ``Incentive Compensation''
    The networking exception prohibits an unregistered employee of a
bank that refers a customer to a broker-dealer under the exception from
receiving ``incentive compensation'' for the referral or any securities
transaction conducted by the customer at the broker-dealer other than a
nominal, non-contingent referral fee. To provide banks and their
employees additional guidance in this area, Proposed Rule 700(b)
defined ``incentive compensation'' as compensation that is intended to
encourage a bank employee to refer potential customers to a broker-
dealer or give a bank employee an interest in the success of a
securities transaction at a broker-dealer.
    The proposed rule also excluded certain types of bonus compensation
from the definition of ``incentive compensation.'' Proposed Rule
700(b)(1) excluded compensation paid by a bank under a bonus or similar
plan if such compensation is paid on a discretionary basis; based on
multiple factors or variables; such factors or variables include
significant factors or variables that are not related to securities
transactions at the broker-dealer; and a referral made by the employee
or any other person is not a factor or variable in determining the
employee's compensation under the plan.
    In addition, Proposed Rule 700(b)(2) provided that the definition
of incentive compensation did not prevent a bank from compensating its
employees on the basis of any measure of the overall profitability of
(1) the bank, either on a stand-alone or consolidated basis; (2) any of
the bank's affiliates (other than a broker-dealer) or operating units;
or (3) a broker-dealer if such profitability is only one of multiple
factors or variables used to determine the compensation of the officer,
director, or employee and those factors or variables include
significant factors or variables that are not related to the
profitability of the broker-dealer. The Agencies specifically requested
comment on whether existing bank bonus programs would fit, or could
easily be adjusted to fit, within these proposed exclusions.
    Many commenters indicated that the proposed bonus provisions worked
well and would not interfere with bank bonus plans generally. One
commenter, however, opposed the proposed bonus provisions arguing that
permitting bonuses to be based even in part on revenues generated by
activity conducted at a broker-dealer would encourage bank employees to
make referrals regardless of the appropriateness of the referral in
order to increase their compensation under the bonus plan.\69\ In
addition, a number of commenters requested that the Agencies either
confirm that bonus programs structured in particular ways identified by
the commenter would not fall within the definition of ``incentive
compensation'' or modify the terms of the exclusions to encompass plans
with these features. For example, several commenters asked the Agencies
to confirm that the rules would not prohibit a bank from basing an
employee's bonus on the assets, revenues or profits brought to the bank
and its partner broker-dealer by that employee. Other commenters asked
that the Agencies provide that all ``traditional'' bank bonus programs
are protected under the rule.
---------------------------------------------------------------------------

    \69\ See NASAA Letter.
---------------------------------------------------------------------------

    A number of commenters also raised specific issues with one or more
aspects of the exception in Rule 700(b)(1) for discretionary, multi-
factor bonus plans or the safe harbor in Rule 700(b)(2) for plans based
on overall profitability. For example, some commenters requested
clarification of the ``discretionary'' requirement in paragraph (b)(1)
and asserted that a bonus plan should be considered ``discretionary''
if employees do not have an enforceable right to compensation under the
plan until it is paid.\70\ One commenter also argued that Proposed Rule
700(b)(1) should not prohibit the number of referrals made by an
employee from playing a role in the employee's compensation under a
bonus plan.\71\
---------------------------------------------------------------------------

    \70\ See, e.g., U.S. Trust Letter and Union Bank Letter.
    \71\ See TD Banknorth, N.A. (``TD Banknorth'') Letter.
---------------------------------------------------------------------------

    Several commenters also asserted that the safe harbor in paragraph
(b)(2) should be clarified or expanded to cover

bonus programs based on any measure of the financial performance, and
not just the ``overall profitability,'' of a bank, affiliate, operating
unit or broker-dealer.\72\ Commenters indicated that bank bonus
programs may be based on a wide variety of measures or metrics related
to the operations or performance of the bank, an affiliate or operating
unit.\73\ Some commenters also requested that the safe harbor be
revised to clarify that a bonus program may be based on the overall
profitability of an operating unit of an affiliate of a bank (other
than a broker-dealer), or be expanded to allow bonus programs to be
based on the financial performance of a branch, division, or
geographical or operational unit of a broker-dealer.\74\
---------------------------------------------------------------------------

    \72\ See, e.g., ABA Letter, Clearing House Ass'n Letter.
    \73\ See, e.g., Clearing House Ass'n Letter, Harris Bank Letter,
U.S. Trust Letter.
    \74\ See, e.g., ABA Letter, Clearing House Ass'n Letter, HSBC
Bank Letter, PNC Letter, and Union Bank Letter.
---------------------------------------------------------------------------

    The purpose of the exception and exclusion in paragraph (b) is to
recognize that certain types of bonus plans are not likely to give
unregistered bank employees a promotional interest in the brokerage
services offered by the broker-dealers with which the bank networks and
to avoid affecting bonus plans of banks generally. As described below,
the Agencies have made several revisions to the exception and exclusion
to help clarify the types of bonus plans that fall outside of the scope
of ``incentive compensation'' and to ensure that excepted or excluded
plans are not likely to give bank employees an impermissible
promotional interest in the broker-dealer's activities. These
exceptions and exclusions are crafted to accommodate existing types of
bank bonus programs in general. Nevertheless, a plan's longevity or the
number of banks that utilize similar plans are not factors in
determining whether a plan constitutes ``incentive compensation'' under
this definition. Accordingly, banks that have networking arrangements
with a broker-dealer should review their existing bonus programs in
light of the standards set forth in the rule to evaluate whether they
may constitute impermissible incentive compensation.
a. Exception for Discretionary, Multi-Factor Bonus Plans
    Under Rule 700(b)(1) of the final rules, compensation paid by a
bank under a bonus or similar plan is specifically excepted from
``incentive compensation'' if it is paid on a discretionary basis and
based on multiple factors or variables, provided that (1) those factors
or variables include multiple, significant factors or variables that
are not related to securities transactions at the broker-dealer; (2) a
referral made by the employee is not a factor or variable in
determining the employee's compensation under the plan; and (3) the
employee's compensation under the plan is not determined by reference
to referrals made by any other person.\75\ The Agencies have modified
the rule to make clear that, to be excluded under Rule 700(b)(1), a
multi-factor plan must include multiple, significant factors or
variables that are not related to securities transactions at the
broker-dealer.\76\ The proposed rule already required that there be
``significant factors or variables'' and the addition of ``multiple''
highlights the plural nature of these terms.
---------------------------------------------------------------------------

    \75\ Rule 700(b)(1). The requirement that an employee's
compensation not be based on a ``referral'' made by the employee or
another person means that the employee's compensation under the
bonus or similar plan may not vary based on the fact that the
employee or other person made a referral to a broker-dealer or the
number of securities referrals made by the employee or other person
to a broker-dealer.
    \76\ A similar change has been made to the corresponding
language in Rule 700(b)(2).
---------------------------------------------------------------------------

    Each factor or variable unrelated to securities transactions at the
broker-dealer will be considered ``significant'' for purpose of Rule
700(b) if it plays a material role in determining an employee's
compensation under the bonus or similar plan, i.e., the amount of the
employee's bonus could be reduced or increased by a material amount
based on the non-securities factor or variable. This clarification will
give banks greater certainty and will allow them to more readily
identify the types of factors or variables not related to securities
transactions that must be included within a discretionary, multi-factor
bonus plan under paragraph (b)(1) of the Rule. Thus, under paragraph
(b)(1), a bank's bonus program may take account of the full range of
banking, securities or other business of one or more customers brought
to the bank and its partner broker-dealer by an employee so long as the
bonus is paid on a discretionary basis, the banking and other factors
or variables not related to securities transactions at the broker-
dealer are significant factors or variables under the bonus program,
and a referral or number of referrals made by the employee or others is
not a factor or variable under the program. In this way, the rule is
designed to accommodate discretionary bank bonus programs that are
based on general measures of the business or performance of a bank or a
particular customer, branch or other unit of the bank, that are not
based on referrals made by one or more bank employees and that include
some inputs based on securities transactions at a broker-dealer as well
as multiple significant factors or variables that are unrelated to
securities transactions at the broker-dealer.
    A bank may not establish or maintain one or more ``sham'' non-
securities factors or variables in its bonus or similar plan for the
purpose of evading the restrictions in Rule 700(b) and the Banking
Agencies will continue to review the bonus and similar plans of banks
participating in networking arrangements as part of the risk-focused
supervisory process. In considering if a bonus program at a bank
contains sufficient banking or other factors unrelated to securities
transactions at a broker-dealer, the agencies will consider, among
other things, whether such factors or variables relate to banking or
other non-broker-dealer business(es) actually being conducted by the
bank or its employees, the resources devoted by the bank to such
business(es), and whether such business(es) materially contributes to
the payments made under the plan over time. It is not expected that the
actual payments made under a bank's bonus or similar plan would, over
time, be based predominantly on securities transactions conducted at a
broker-dealer. If such a situation were to occur, the bank would be
expected to make appropriate modifications to its bonus or similar plan
going forward.
    A bonus or similar plan will be considered ``discretionary'' under
the final rule if the amount an employee may receive under the plan is
not fixed in advance and the employee does not have an enforceable
right to payments under the plan until the amount of any payments are
established and declared by the bank. A plan may, however, include
targets or metrics that must be met in order for any bonus to be paid,
provided the plan is otherwise a ``discretionary'' plan.
    The Agencies have not modified the rule to allow a bonus plan to be
based on the fact of a referral or the number of referrals made by one
or more bank employees. The Agencies believe that doing so would allow
a direct linkage between a referral and an employee's bonus
compensation and be contrary to the purposes of the exception.
b. Safe Harbor for Plans Based on Overall Profitability or Revenue
    The safe harbor provisions of Rule 700(b)(2) are designed to allow
banks to avoid having to analyze whether a particular bonus program
meets the

requirements of the exception in paragraph (b)(1) in circumstances
where the general structure of the program clearly reduces the
potential for sales practice concerns in connection with a referral to
a broker-dealer. The Agencies have made several changes to the safe
harbor to address the issues raised by commenters and to ensure that
the safe harbor achieves its purpose. In particular, the Agencies have
modified paragraph (b)(2) of the rule to cover any bonus or similar
plan that is based on the overall profitability or revenue of:
    (i) The bank, either on a stand-alone or consolidated basis;
    (ii) Any affiliate of the bank (other than a broker-dealer), or any
operating unit of the bank or an affiliate (other than a broker-
dealer), if the affiliate or operating unit does not over time
predominately engage in the business of making referrals to a broker-
dealer; or
    (iii) A broker-dealer if:
    (A) Such measure of overall profitability or revenue is only one of
multiple factors or variables used to determine the compensation of the
officer, director or employee;
    (B) The factors or variables used to determine the compensation of
the officer, director or employee include multiple significant factors
or variables that are not related to the profitability or revenue of
the broker-dealer;
    (C) A referral made by the employee is not a factor or variable in
determining the employee's compensation under the plan; and
    (D) The employee's compensation under the plan is not determined by
reference to referrals made by any other person.
    When a bonus program is based on the overall profitability of a
bank, an affiliate of a bank (other than a broker-dealer), or an
operating unit of the bank or an affiliate (other than a broker-
dealer), any relationship between a referral made by an employee and
the amount of payments that the employee may receive under the plan are
likely to be attenuated. In these circumstances, for example, any
potential connection between the revenue received by a bank from its
partner broker-dealer as a result of a referral and the payments made
to the referring bank employee under the plan likely would be tenuous
and largely speculative given the number of other employees, business
and actions that contribute to the overall profitability of the bank,
affiliate or most operating units. The Agencies believe this
attenuation effectively addresses any potential that payments under the
plan would give an employee an undue promotional interest in any
securities transactions that may occur at the broker-dealer as a result
of a referral. A bonus plan based on the overall revenue of a bank or
qualifying affiliate or operating unit would be similarly attenuated
and, for this reason, the Agencies have modified the safe harbor to
cover plans based on either the ``overall profitability or revenue'' of
a bank or a qualifying affiliate or operating unit. This would include
plans based on an entity's earnings per share or stock price, both of
which are directly related to the entity's overall profitability or
revenue. Because other, more granular measures of the financial
performance of a bank, affiliate or operating unit could create an
unduly close connection between the employee's expected payment under
the bonus plan and referrals made to the broker-dealer or the
securities transactions that result from those referrals, the rules
provide for plans structured in more granular ways to be analyzed under
the multi-factor, discretionary criteria in Rule 700(b)(1).
    The potential connection between a referral made by a bank employee
and the payments made to the employee under a bonus plan may be
particularly strong if payments under the plan are based on the
profitability or revenue of (i) the partner broker-dealer itself or a
specific branch or operating unit of the broker-dealer (such as the
branch or operating unit responsible for handling customers referred by
the bank), or (ii) an operating unit of the bank or a non-broker-dealer
affiliate that is predominantly engaged over time in referring
customers to the broker-dealer. To address the potential for improper
incentives in these situations, the Agencies have modified Rule
700(b)(2)(iii) to allow a bonus program to be based on the overall
profitability or revenue of a broker-dealer only if the program meets
the conditions specified in (A)-(D) above. These conditions are similar
to those that would apply to a discretionary bonus or similar plan
under paragraph (b)(1) and are designed to ensure that the
profitability or revenue of the broker-dealer is only one of multiple
significant factors or variables in determining the employee's
compensation and that a referral or number of referrals made by the
employee is not a factor or variable under the program.\77\ Like the
proposal, the safe harbor in paragraph (b)(2) is not available to bonus
plans based on the profitability or revenue of a particular branch,
division or operating unit of the partner broker-dealer.
---------------------------------------------------------------------------

    \77\ As with a multi-factor bonus plan under paragraph (b)(1) of
the Rule, a non-securities factor or variable will be considered
``significant'' under paragraph (b)(2)(iii) if it plays a material
role in determining an employee's compensation under the bonus or
similar plan.
---------------------------------------------------------------------------

    In addition, the Agencies have modified paragraph (b)(2)(ii) of the
rule to exclude bonus plans based on the profitability or revenue of an
operating unit of a bank or non-broker-dealer affiliate that over time
predominantly engages in the business of making referrals to a broker-
dealer. This exclusion is intended to prevent a bank from basing a
bonus plan on the overall profitability or revenue of a bank unit that
is focused solely or predominately on making referrals to a broker-
dealer. This restriction, however, is not intended to prevent a bonus
plan from being based on the overall profitability or revenue of a bank
unit, such as a call center, that in fact markets, sells or supports a
range of bank products in addition to making referrals to a broker-
dealer and which is not, over time, predominantly engaged in the
business of making referrals to a broker-dealer.

C. Rule 701: Exemption for Referrals Involving Institutional Customers
and High Net Worth Customers

    The proposed rules included an exemption that would permit a bank,
subject to certain conditions, to pay an employee a contingent referral
fee of more than a nominal amount for referring an ``institutional
customer'' or ``high net worth customer'' to a broker-dealer with which
the bank has a contractual or other written networking arrangement.\78\
Among the conditions included in the proposed rule were conditions
that--
---------------------------------------------------------------------------

    \78\ Proposed Rule 701.
---------------------------------------------------------------------------

     Established the financial thresholds at which a customer
would be considered an ``institutional customer'' or ``high net worth
customer'';
     Limited the types of bank employees that may receive a
higher-than-nominal referral fee under the exemption and the manner in
which these fees may be structured; \79\
---------------------------------------------------------------------------

    \79\ See Proposed Rule 701(a)(1) and (d)(4).
---------------------------------------------------------------------------

     Required the bank to provide certain disclosures to the
customer regarding the referral arrangement; \80\ and
---------------------------------------------------------------------------

    \80\ See id. at 701(a)(2)(i).
---------------------------------------------------------------------------

     Required that the agreement between the bank and the
broker-dealer include certain provisions, including a provision
obligating the broker-dealer to perform a suitability analysis of
certain securities transactions that may result from the referral or a
sophistication analysis of the customer referred.\81\
---------------------------------------------------------------------------

    \81\ See id. at 701(a)(3)(ii).
---------------------------------------------------------------------------

    Many commenters supported providing an exemption for referrals

involving sophisticated individuals and entities.\82\ These commenters,
for example, asserted that the exemption was appropriate in light of
the required sophistication of the customer involved.\83\ Other
commenters, however, argued that providing an exemption to the
``nominal'' requirement would not be in the interest of investors or
the public. These commenters asserted that the exemption as proposed
would allow bank employees to have a significant salesman's stake in
securities transactions and encourage bank employees to act as finders
or salespeople for a broker-dealer.\84\
---------------------------------------------------------------------------

    \82\ See, e.g., BISA Letter, CBA Letter, Citigroup Letter, ICBA
Letter, Roundtable Letter, Securities Industry and Futures Markets
Ass'n (``SIFMA'') Letter, State Street Corp. Letter, U.S. Trust
Letter, Union Bank Letter.
    \83\ See CBA Letter.
    \84\ See, e.g., Massachusetts Securities Division Letter, NASAA
Letter.
---------------------------------------------------------------------------

    Many commenters, including a number that supported the exemption,
also asked that the Agencies modify the exemption to, among other
things, lower or alter the thresholds at which a person would be
considered an ``institutional customer'' or ``high net worth customer''
under the rule; eliminate the provisions of the rule requiring the
broker-dealer to perform a suitability or sophistication analysis in
connection with a referral; or eliminate the limitations on the manner
in which a higher-than-nominal referral fee may be structured. In
addition, many commenters requested that the Agencies modify the rule
in several respects to reduce administrative burden and complexity. For
example, several commenters asked that the Agencies provide a bank and
its partner broker-dealer greater flexibility to assign between
themselves the responsibility for fulfilling the disclosure and other
obligations included in the rule.
    After carefully considering the comments, the Agencies have decided
to retain the exemption. The Agencies continue to believe that it is
appropriate to provide an exemption from the nominal and contingency
limitations in the networking exception for referrals that both involve
institutions and individuals that meet certain financial criteria and
that occur under other conditions designed for investor protection.
When provided appropriate information, such institutions and
individuals are more likely to be able to understand and evaluate the
relationship between a bank and its employees and the bank's broker-
dealer partner and the impact of that relationship on any resulting
securities transaction with the broker-dealer. The conditions in the
final exemption are designed to help ensure that, among other things,
institutional and high net worth customers, as defined in the rule,
receive appropriate investor protections and information that enables
the customer to understand the financial interest of the bank employee
so the customer can make informed choices. Moreover, as the exemption
itself provides, a bank operating under the exemption also must comply
with the terms and conditions in the statutory networking exception
(other than the compensation restrictions in Section 3(a)(4)(B)(i)(VI)
of the Exchange Act's networking exception), including the terms and
conditions that require the disclosure of the uninsured nature of
securities and that limit the role that a bank employee may have in a
brokerage transaction.\85\ These conditions provide additional
protections to institutional and high net worth customers that may be
referred to a broker-dealer under Rule 701.
---------------------------------------------------------------------------

    \85\ See Exchange Act Section 3(a)(4)(B)(i)(V) and (IX).
---------------------------------------------------------------------------

    The Agencies have modified the final rule in several respects to,
among other things, provide banks and broker-dealers greater
flexibility in complying with the rule's disclosure requirements and to
make the exemption more workable in practice. In light of the
protections retained in the rule, the Agencies also have modified the
thresholds at which a non-natural person will be considered an
``institutional customer'' for purposes of the rule. These
modifications are discussed further below.
    Banks that pay their employees only nominal, non-contingent fees in
accordance with Rule 700 for referring customers--including
institutional or high net worth customers--to a broker-dealer do not
need to rely on, or comply with, the exemption provided in Rule 701. As
under the proposal, the final rule requires that the written agreement
between a bank operating under the exemption and its partner broker-
dealer include terms that obligate the broker-dealer to take certain
actions. Banks and broker-dealers are expected to comply with the terms
of their written networking arrangements. If a bank or broker-dealer
does not comply with the terms of the agreement, however, the bank
would not become a ``broker'' under Section 3(a)(4) of the Exchange Act
or lose its ability to operate under the proposed exemption.
1. Definitions of ``Institutional Customer'' and ``High Net Worth
Customer''
    Proposed Rule 701(d)(2) defined an ``institutional customer'' to
mean any corporation, partnership, limited liability company, trust, or
other non-natural person that has at least $10 million in investments
or $40 million in assets. Under the proposal, a non-natural person also
would qualify as an ``institutional customer'' with respect to a
referral if the customer has $25 million in assets and the bank
employee refers the customer to the broker-dealer for investment
banking services. Proposed Rule 701(d)(1) defined a ``high net worth
customer'' to mean any natural person who, either individually or
jointly with his or her spouse, has at least $5 million in net worth
excluding the primary residence and associated liabilities of the
person and, if applicable, his or her spouse. Proposed Rule 701 also
included provisions governing the allocation of assets held by a
natural person jointly with his or her spouse and provided for the
dollar thresholds in the rule to be adjusted for inflation every five
years.
    A number of commenters argued that the proposed dollar thresholds
for both types of customers were too high in light of the nature of the
transactions involved and the other requirements of the exemption.\86\
Commenters asserted that customers with lower levels of net worth,
assets or investments are sophisticated enough to understand and
evaluate the implications of a higher-than-nominal or contingent
referral fee. Commenters suggested a wide variety of alternative
thresholds, with many recommending that the Agencies use an existing
standard established under the federal securities laws for assessing a
customer's investment sophistication. For example, commenters
recommended that the Agencies use the ``accredited investor''
definition in the Commission's Regulation D, or the definition of that
term proposed for use in connection with investments in certain private
investment vehicles, for purposes of defining an institutional or high
net worth customer; \87\ treat all corporate and non-natural persons as
an institutional customer; consider all persons advised by a bank or a
registered investment adviser to be sophisticated; or lower the asset
threshold for municipalities or

charitable organizations.\88\ Several commenters also asked that the
Agencies allow banks to use a business customer's revenues for purposes
of determining if the customer is an institutional customer.
---------------------------------------------------------------------------

    \86\ See, e.g., HSBC Bank Letter, U.S. Trust Letter, SIFMA
Letter, Roundtable Letter.
    \87\ See 17 CFR 230.501(a)(3), (5) and (6); Securities Act Rel.
No. 33-8766, 72 FR 400, Jan. 4, 2007.
    \88\ See, e.g., ABA Letter, Clearing House Ass'n Letter, State
Street Corp. Letter.
---------------------------------------------------------------------------

    After carefully reviewing the comments, the Agencies have modified
the definition of an ``institutional customer'' in the final rule to
mean any corporation, partnership, limited liability company, trust, or
other non-natural person that has, or is controlled by a non-natural
person that has, at least: (i) $10 million in investments; or (ii) $20
million in revenues; or (iii) $15 million in revenues if the bank
employee refers the customer to the broker-dealer for investment
banking services.\89\ When converted to an equivalent asset number, the
$20 million and $15 million revenue thresholds in the final rule are
somewhat lower than $40 million and $25 million asset thresholds in the
proposed rule.\90\ The Agencies believe that these lower thresholds are
appropriate for corporate and other non-natural customers in light of
the other protections retained in the final rule, including the
provisions requiring a suitability or sophistication determination, and
the greater internal and external resources that business entities
typically have as compared to individuals. The Agencies have modified
the thresholds to be based on revenues (rather than assets) to
eliminate the potential for borrowings to influence the status of a
corporate customer and to promote the equivalent treatment of non-
financial companies and financial companies. In addition, the Agencies
have amended the rule to provide that a company controlled by an
institutional customer will itself be considered an institutional
customer. A company controlled by another company should generally have
access to the resources and sophistication of the controlling company.
---------------------------------------------------------------------------

    \89\ Rule 701(d)(2).
    \90\ To develop comparable asset and revenue thresholds for an
institutional customer, the Agencies used a dataset composed of all
publicly traded, U.S.-incorporated, non-financial companies with a
market capitalization of greater than $0 and for which asset and
sales data were available in the 2005 CompuStat Universe of North
American companies published by Standard & Poor's Corporation. For
more information on the CompuStat Universe, see http://www2.standardandpoors.com/spf/pdf/products/Compustat2006.pdf.
 A

company with $40 million in assets and a company with $25 million in
assets would rank at approximately the 27.5th percentile and the
21.9th percentile, respectively, of all companies within this
dataset when ranked according to assets. When the companies within
this dataset are ranked according to sales, the companies at
approximately the 27.5th percentile and the 21.9th percentile have
approximately $27.7 million and $15.7 million in sales.
---------------------------------------------------------------------------

    The lower revenue threshold for referrals involving investment
banking services is designed to facilitate access to the capital
markets by smaller companies. Like the proposal, the final rule defines
``investment banking services'' to include, without limitation, acting
as an underwriter in an offering for an issuer, acting as a financial
adviser in a merger, acquisition, tender-offer or similar transaction,
providing venture capital, equity lines of credit, private investment-
private equity transactions or similar investments, serving as
placement agent for an issuer, and engaging in similar activities.\91\
The phrase ``other similar services'' would include, for example,
acting as an underwriter in a secondary offering of securities and
acting as a financial adviser in a divestiture. These examples are not
exhaustive and are provided solely for illustrative purposes.\92\
---------------------------------------------------------------------------

    \91\ See Rule 701(d)(3).
    \92\ When used in this rule, the term ``include, without
limitation'' means a non-exhaustive list. This usage is not intended
to suggest that the term ``including'' as used in the Exchange Act
and the rules under that Act means an exhaustive list. The use of
the term ``including, but not limited to'' in Exchange Act Rules
10b-10 and 15b7-1 is also not intended to create a negative
implication regarding the use of ``including'' without the term
``but not limited to'' in other Exchange Act rules. See Exchange Act
Release No. 49879, 69 FR 39682 (June 30, 2004), at footnote 76.
---------------------------------------------------------------------------

    The final rule continues to define a ``high net worth customer'' as
a natural person who, either individually or with his or her spouse,
has at least $5 million in net worth excluding the primary residence
and associated liabilities of the person and, if applicable, his or her
spouse. In response to comments,\93\ the Agencies have modified this
definition to include any revocable, inter vivos or living trust the
settlor of which is a natural person who, either individually or
jointly with his or her spouse, meets the $5 million in net worth
test.\94\ This change is designed to reflect the fact that otherwise
sophisticated individuals may hold assets through such trusts for
estate planning or other purposes.
---------------------------------------------------------------------------

    \93\ See ABA Letter, PNC Letter, Roundtable Letter.
    \94\ Rule 701(d)(1)(i)(B).
---------------------------------------------------------------------------

    The Agencies believe that customers that meet the net worth,
investment and revenue thresholds included in the final rule should
have the ability to understand and evaluate the financial interest of
the bank employee making a referral to a broker-dealer under the
exemption. In developing these thresholds, the Agencies took into
account the limited nature of activities covered by the exemption
(i.e., a referral by a bank employee to a broker-dealer). The Agencies
have not modified the rule, as requested by some commenters, to treat
any person advised by a bank or a registered investment adviser as an
institutional or high net worth customer. The existence of such an
advisory relationship generally is not, by itself, sufficient to
establish the financial sophistication of an individual or corporate
entity for purposes of the other similar standards in or developed
under the federal securities laws.\95\
---------------------------------------------------------------------------

    \95\ See, e.g., 15 U.S.C. 80a-2(a)(51), 78c(a)(54); 17 CFR
230.501(a).
---------------------------------------------------------------------------

    For purposes of determining whether a natural person meets the $5
million net worth test, the assets of a person include: (1) Any assets
held individually; (2) if the person is acting jointly with his or her
spouse, any assets of the person's spouse (whether or not such assets
are held jointly); and (3) if the person is not acting jointly with his
or her spouse, fifty percent of any assets held jointly with such
person's spouse and any assets in which such person shares with such
person's spouse a community property or similar shared ownership
interest. These rules are designed to ensure that the full amount of
jointly owned assets are not considered in cases where one spouse acts
independently of the other in contacting a broker-dealer.\96\ The
Agencies have re-formatted these allocation provisions in the final
rule to make them easier to understand and promote compliance.
---------------------------------------------------------------------------

    \96\ One commenter asserted that the Agencies should allow a
person to include assets that the person holds jointly with someone
other than a spouse, such as a relative or domestic partner, for
purposes of calculating whether the person meets the net worth
threshold. See Roundtable Letter. The Agencies have not modified the
rule in this manner to keep the scope of individuals whose assets
may be considered in determining whether a natural person has the
appropriate level of financial sophistication consistent with the
standards used in determining whether a natural person is an
accredited investor under the Commission's Regulation D. See 17 CFR
230.501(a).
---------------------------------------------------------------------------

    As in the proposal, the dollar threshold for both institutional
customers and high net worth customers will be adjusted for inflation
on April 1, 2012, and every five years thereafter, to reflect changes
in the value of the Personal Consumption Expenditures Chain-Type Price
Index, as published by the Department of Commerce, from December 21,
2006. The Agencies selected this index because it is a widely used and
broad indicator of inflation in the U.S. economy.

2. Determining That a Customer Meets the Relevant Thresholds

    The proposal required the bank to determine that the customer being

referred met the standards to be a high net worth or institutional
customer either (i) before the referral fee was paid to the bank
employee, in the case of a non-natural person, or (ii) prior to or at
the time of the referral, in the case of a natural person.\97\ In
making these determinations for a natural person, the proposed rule
allowed the bank to rely on a signed acknowledgment from the person
that he or she met the standards to be a high net worth customer.\98\
The proposed rule also required that the written agreement between the
bank and the broker-dealer provide for the broker-dealer to (i)
determine that the customer being referred met the standards to be a
high net worth customer or institutional customer before the referral
fee was paid,\99\ and (ii) promptly inform the bank if the broker-
dealer determined that a customer referred under the exemption did not
meet the applicable standard.\100\
---------------------------------------------------------------------------

    \97\ Proposed Rule 701(a)(2)(ii).
    \98\ Proposed Rule 701(a)(2)(ii)(B)(2).
    \99\ Proposed Rule 701(a)(3)(i).
    \100\ Proposed Rule 701(a)(3)(iii)(A).
---------------------------------------------------------------------------

    Commenters argued that either the bank or the broker-dealer, but
not both, should be required to make these customer eligibility
determinations and that the bank and the broker-dealer should be
permitted to allocate responsibility for these determinations between
themselves.\101\ In addition, several commenters contended that a bank
should be allowed to make the eligibility determinations for both high
net worth customers and institutional customers before the referral fee
is paid or before a securities transaction is effected at the broker-
dealer.\102\ A few commenters also asserted that banks and broker-
dealers should be permitted to rely on a signed acknowledgement from
either an institutional or high net worth customer.\103\
---------------------------------------------------------------------------

    \101\ See, e.g., BISA Letter, Clearing House Ass'n Letter,
Citigroup Letter, and SIFMA Letter. Some commenters, for example,
suggested that requiring bank employees to make these determinations
might require the employee to go beyond the limited role a bank
employee is permitted to play in a brokerage transaction under the
statute. See, e.g., BISA Letter, ABA Letter.
    \102\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, HSBC Bank Letter, and PNC Letter.
    \103\ See, e.g., Citigroup Letter, SIFMA Letter.
---------------------------------------------------------------------------

    The status of the referred customer as a high net worth or
institutional customer is a fundamental aspect of the exemption and the
final rule continues to provide for both the bank and the broker-dealer
to determine that the customer meets the necessary qualification
criteria to provide added assurance that these criteria are met.\104\
In addition, less information typically is in the public domain
concerning the financial resources of an individual than of a
corporation or other business entity and, accordingly, there is a
greater likelihood that a bank employee--without further
investigation--will be able to preliminarily identify corporate or
other business customers that are likely to satisfy the rule's
eligibility criteria than in the case of individuals. For these
reasons, the final rule continues to provide for the bank to determine
that a natural person is a high net worth customer before a referral is
made and before the employee potentially develops an expectation of a
higher-than-nominal fee.
---------------------------------------------------------------------------

    \104\ See Rule 701(a)(2)(ii) and (3)(ii)(B). The final rule also
continues to provide for the written agreement between the bank and
the broker-dealer to require the broker-dealer to inform the bank if
the broker-dealer determines that a referred customer does not meet
the relevant eligibility thresholds. See Rule 701(a)(3)(v)(A).
---------------------------------------------------------------------------

    The Agencies, however, have modified the final rule to make it more
flexible while retaining its underlying purpose by providing that a
bank or a broker-dealer satisfies its customer eligibility requirements
if the bank or broker-dealer ``has a reasonable basis to believe that
the customer'' is an institutional customer or high net worth customer
before the time specified in the rule.\105\ A bank or broker-dealer
would have a ``reasonable basis to believe'' that a customer is a high
net worth customer or institutional customer if, for example, the bank
or broker-dealer obtains a signed acknowledgment from the customer (or,
in the case of an institutional customer, from an appropriate
representative of the customer) that the customer meets the applicable
standards to be considered a high net worth customer or an
institutional customer, respectively, and the bank employee making the
referral or the broker-dealer employee dealing with the referred
customer does not have information that would cause the employee to
believe that the information provided by the customer (or
representative) is false.
---------------------------------------------------------------------------

    \105\ Rule 701(a)(2)(ii).
---------------------------------------------------------------------------

3. Conditions Relating to Disclosures
    The proposed exemption required that the bank provide a high net
worth customer or institutional customer being referred to the bank's
broker-dealer partner certain written disclosures about the bank
employee's potential interest in the referral prior to or at the time
of the referral.\106\ Commenters generally believed that providing
these types of disclosures to a high net worth or institutional
customer would help ensure that the customer received appropriate
information concerning the relationship between the bank and the
broker-dealer,\107\ although a few questioned whether sophisticated
customers required any disclosures at all or suggested that more
simplified disclosures be permitted.\108\ A number of commenters also
asserted that the requirement that the bank provide these disclosures
``prior to or at the time of the referral'' was impractical or
burdensome.\109\ Commenters instead asserted that the rule should allow
the disclosures to be provided before the referral fee is paid or
before a securities transaction is effected at the broker-dealer, or
allow the bank and the broker-dealer to determine which entity would
make the disclosures.\110\
---------------------------------------------------------------------------

    \106\ Proposed Rule 701(a)(2)(i).
    \107\ See, e.g., ABA Letter, JP Morgan Letter, Roundtable
Letter, BISA Letter.
    \108\ See, e.g., Bank of America Corp. (``BofA'') Letter and WBA
Letter.
    \109\ For example, some commenters noted that some referrals may
occur only by telephone or asserted that it may be unclear to an
employee when a referral actually occurs.
    \110\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, HSBC Bank Letter, and WBA Letter. In addition, some
commenters contended that banks should be required to provide
similar conflict-of-interest disclosures to customers referred to a
broker-dealer under the statutory networking exception. See, e.g.,
Boyd Financial Letter, Pace Project Letter, University of Cincinnati
Corp. Law Center Letter. The statutory networking exception itself
sets certain disclosures that the bank or broker-dealer must provide
a customer in situations where the bank employee making the referral
may receive only a ``nominal'' referral fee. 15 U.S.C.
78c(a)(4)(i)(IX).
---------------------------------------------------------------------------

    The final rule continues to require that a high net worth or
institutional customer referred to a broker-dealer under the exception
receive disclosures that clearly and conspicuously disclose (i) the
name of the broker-dealer; and (ii) that the bank employee participates
in an incentive compensation program under which the bank employee may
receive a fee of more than a nominal amount for referring the customer
to the broker-dealer and that payment of this fee may be contingent on
whether the referral results in a transaction with the broker-
dealer.\111\ This requirement ensures that high net worth or
institutional customers receive notice of the financial interest the
referring employee may have in the transaction so they can make
informed choices.
---------------------------------------------------------------------------

    \111\ Rule 701(b).
---------------------------------------------------------------------------

    In light of the comments, the Agencies have modified the provisions
of the rule governing how and when these disclosures must be provided
to make the rule more workable and less burdensome while also requiring
that customers receive the information in time to make informed
choices. Specifically, the final rule provides two options for
providing the required

disclosures. Under the first option, as under the proposal, the bank
must provide the high net worth or institutional customer the
disclosures in writing prior to or at the time of the referral.\112\
The second option allows the bank to provide the disclosure to the
customer orally prior to or at the time of the referral. However, if
the bank provides the customer the required disclosures only orally,
then either (i) the bank must provide the disclosure to the customer in
writing within 3 business days of the date of the referral; or (ii) the
broker-dealer must be obligated, under the terms of its written
agreement with the bank, to provide the disclosures in writing to the
customer.\113\ If the broker-dealer is responsible for providing the
written disclosures, then it must provide the disclosures to the
customer prior to or at the time the customer begins the process of
opening an account at the broker-dealer (if the customer does not
already have an account with the broker-dealer) or prior to the time
the customer places an order for a securities transaction with the
broker-dealer as a result of the referral (if the customer already has
an account at the broker-dealer).\114\ In this way, the rule provides a
mechanism for customers to receive the disclosures in writing when they
initially are provided only orally. Whether provided orally or in
writing, the required disclosures will be considered to have been made
in a clear and conspicuous manner if they are provided in a manner
designed to call attention to the nature and significance of the
information.
---------------------------------------------------------------------------

    \112\ Rule 700(a)(2)(i).
    \113\ Rule 701(a)(2)(i) and (a)(3)(i).
    \114\ Rule 701(a)(3)(i). As a general matter, a customer begins
the account-opening process when the customer fills out the
appropriate forms provided by the broker-dealer to establish an
account.
---------------------------------------------------------------------------

4. Suitability or Sophistication Analysis by Broker-Dealer
    The proposed exemption required that the written agreement between
the bank and the broker-dealer provide for the broker-dealer to perform
a suitability or sophistication analysis of a securities transaction or
the customer being referred, respectively. The type and timing of the
analysis needed to be conducted by the broker-dealer depended on
whether the referral fee was contingent on the completion of a
securities transaction at the broker-dealer.\115\ The proposed rule
also required that the written agreement between the bank and its
partner broker-dealer obligate the broker-dealer to inform the bank if
it determined that a customer referred under the exemption, or a
transaction to be conducted by the customer, did not meet the relevant
suitability or sophistication standard.\116\
---------------------------------------------------------------------------

    \115\ Proposed Rule 701(a)(3)(ii).
    \116\ Proposed Rule 701(a)(3)(iii)(C).
---------------------------------------------------------------------------

    Several commenters objected to this suitability/sophistication
requirement arguing that the broker-dealer should be required to
conduct a suitability/sophistication analysis only when such an
analysis would otherwise be required under the rules of the broker-
dealer's self-regulatory organization (``SRO'') (i.e., in those cases
where the broker-dealer makes a recommendation to the customer
concerning securities).\117\ Commenters also argued that the
suitability/sophistication requirement was unworkable or unnecessary
given that the transaction may involve only a referral (without a
securities transaction occurring) of a sophisticated customer.\118\ In
addition, some commenters expressed concern that the proposed standards
would increase the potential liability of broker-dealers or delay the
ability of a broker-dealer to respond to a customer's instructions.
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    \117\ See, e.g., ABA Letter, Clearing House Ass'n Letter,
Citigroup Letter, and PNC Letter. See also FINRA Rule 2310 and FINRA
IM-2310-3 (discussing suitability obligations of member broker-
dealers). One commenter also asserted that any expansion of a
broker-dealer's suitability obligations should be processed and
approved through the normal market regulation and SRO process. See
SIFMA Letter.
    \118\ See, e.g., Clearing House Ass'n Letter, SIFMA Letter.
Commenters also asserted that a broker-dealer may not be able to
perform the proposed ``sophistication'' analysis if the customer
does not open an account or refuses to provide the broker-dealer the
information necessary to perform the analysis.
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    After carefully considering the comments, the Agencies have
retained the requirement that the parties' written agreement provide
for the broker-dealer to perform a suitability analysis when a referral
fee is contingent on a transaction and a suitability or sophistication
analysis for other referrals. These requirements provide additional
investor protections in those circumstances where the bank employee
making the referral may receive a higher-than-nominal referral fee. The
suitability and sophistication standards included in the final rule are
based on the standards that broker-dealers currently must apply and use
under applicable SRO rules and, thus, should be familiar to those
broker-dealers that partner with banks operating under the
exemption.\119\ In addition, the exemption gives a broker-dealer the
flexibility to perform a suitability analysis, if one is otherwise
required by the rule, in connection with all referrals made under the
exemption if the broker-dealer determines that such an approach is
appropriate for business, compliance or other reasons.
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    \119\ One commenter expressed concern that the suitability/
sophistication requirements of the rule may discourage low-cost,
execution-only brokers from establishing relationships with banks
under the exemption. See Business Law Section Letter. The Agencies
are mindful of the need to keep appropriate investment options,
including low-cost options, available to investors. However, given
the cost structure of low-cost brokers, the Agencies expect that few
such brokers would participate in referral arrangements under the
exemption that provides for higher-than-nominal referral fees.
Broker-dealers that do not wish to become obligated to perform the
suitability/sophistication analyses required by the rule also may
continue to establish and maintain networking arrangements pursuant
to the statutory networking exception.
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    Specifically, for contingent referral fees payable under the
exemption, the written agreement between the bank and the broker-dealer
must provide for the broker-dealer to conduct a suitability analysis of
each securities transaction that triggers any portion of the
contingency fee in accordance with the rules of the broker-dealer's
applicable SRO as if the broker-dealer had recommended the securities
transaction.\120\ This analysis must be performed by the broker-dealer
before each securities transaction on which the referral fee is
contingent is conducted.
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    \120\ Rule 701(a)(3)(ii)(A). Because the exemption provides for
a broker-dealer to conduct its suitability analysis in accordance
with the rules of its applicable SRO, the broker-dealer may follow
and take advantage of any applicable SRO rules or interpretations
that allow the broker-dealer to make an alternative suitability
evaluation. See, e.g., FINRA IM-2310-3 (discussing a member's
suitability obligations with respect to certain institutional
investors).
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    For non-contingent referral fees payable under the exemption, the
written agreement must provide for the broker-dealer to conduct, before
the referral fee is paid, either (1) a sophistication analysis of the
customer being referred; or (2) a suitability analysis with respect to
all securities transactions requested by the customer contemporaneously
with the referral in accordance with the rules of the broker-dealer's
applicable SRO as if the broker-dealer had recommended the securities
transaction.\121\ Under the sophistication analysis option, the broker-
dealer must determine that the customer has the capability to evaluate
investment risk and make independent decisions, and determine that the
customer is exercising independent judgment based on the customer's own
independent assessment of the opportunities and risks presented by a
potential investment, market factors, and other investment
considerations.\122\ This sophistication analysis is based on

elements of FINRA IM-2310-3 (Suitability Obligations to Institutional
Customers).
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    \121\ Rule 701(a)(3)(iii)(B).
    \122\ Rule 701(a)(3)(ii)(B)(1).
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    The Agencies have modified the final rule to provide for the
broker-dealer to notify the customer, rather than the bank, if the
broker-dealer determines that a high net worth or institutional
customer, or a securities transaction to be conducted by such a
customer, does not meet the applicable sophistication or suitability
standard.\123\ Providing such notification to the customer should
assist the customer in deciding whether or not to conduct the
transaction.
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    \123\ Rule 701(a)(3)(iv).
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5. Conditions Relating to Bank Employees
    Paragraph (b)(1) of the Proposed Rule included certain limitations
on the types of bank employees that may receive a higher-than-nominal
referral fee under the rule. In particular, the Proposed Rule provided
that the bank employee: be predominantly engaged in banking activities,
other than making referrals to a broker-dealer; encounter the high net
worth or institutional customer in the ordinary course of the
employee's assigned business for the bank; not be qualified or required
to be qualified under the rules of a SRO; and not be subject to
statutory disqualification under Section 3(a)(39) of the Exchange Act
(other than subparagraph (E) of that Section) (``statutory
disqualification'').\124\
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    \124\ See Proposed Rule 701(a)(1).
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    The proposed exemption also included other provisions related to
the SRO and statutory disqualification conditions. First, it required
that the written agreement between the bank and the broker-dealer must
provide for the bank and the broker-dealer to affirmatively determine,
before a referral fee is paid to a bank employee under the exemption,
that the employee is not subject to statutory disqualification.\125\
Second, it required that the bank provide the broker-dealer the name of
the employee and such other identifying information that may be
necessary for the broker-dealer to determine whether the bank employee
is subject to statutory disqualification or associated with a broker-
dealer.\126\ And third, it required that the parties' written agreement
obligate the broker-dealer to promptly inform the bank if it determined
the bank employee was subject to statutory disqualification.\127\
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    \125\ Proposed Rule 701(a)(3)(i)(A).
    \126\ Proposed Rule 701(a)(2)(iii).
    \127\ Proposed Rule 701(a)(3)(iii)(B).
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    The final rule retains these provisions with the following
modifications.\128\ In response to comments,\129\ the Agencies have
modified the SRO condition in paragraph (a)(1)(A) of the Rule to
provide that the employee receiving the referral fee must not be
``registered or approved, or otherwise required to be registered or
approved, in accordance with the qualification standards established by
the rules of any self-regulatory organization.'' The Agencies have
modified the related language in paragraph (a)(2)(iii) of the rule in a
similar manner.
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    \128\ See Rule 701(a)(1), (a)(2)(iii), (a)(3)(ii)(A), and
(a)(3)(v)(B).
    \129\ See Business Law Section Letter.
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    Several commenters argued that the requirement that a bank employee
encounter the high net worth or institutional customer ``in the
ordinary course of the bank employee's assigned duties'' was
unnecessary and ambiguous.\130\ The Agencies have retained the
requirement to help ensure that a bank employee making a referral under
the rule does so as part of the employee's duties as a bank employee
and not as a sales representative of the broker-dealer. However, the
Agencies recognize that in the ordinary course of his or her assigned
duties for the bank, a bank employee may encounter customers or
potential customers outside the employee's regular business hours or at
locations outside of the bank, such as at social or civic functions or
gatherings.
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    \130\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, Comerica Bank Letter, and U.S. Trust Letter. For example,
some asserted that bank employees may be expected to identify and
develop client relationships at social or other events and expressed
concern that the language might prevent a bank employee from
receiving a referral fee for institutional or high net worth
customers encountered in these ways.
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    A number of commenters contended that the bank and the broker-
dealer should not both be required to verify that the bank employee is
not subject to statutory disqualification and suggested that the bank
and broker-dealer be permitted to allocate this responsibility between
themselves.\131\ The Agencies have modified the rule to provide for
these determinations to be made by the broker-dealer under the terms of
the parties' written agreement.\132\ The Agencies believe that broker-
dealers are better suited to make this determination given their
familiarity with the Exchange Act's statutory disqualification
standards, provided that they receive the necessary information
concerning the employee from the bank. A broker-dealer fulfills its
responsibilities under paragraph (a)(3)(ii)(A) of Rule 701 if the
broker-dealer determines that a bank employee is not subject to
statutory disqualification before the employee first receives a
referral fee under Rule 701 and at least once each year thereafter as
long as the employee remains eligible to receive referral fees under
the rule.
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    \131\ See, e.g., ABA Letter, BISA Letter, Clearing House Ass'n
Letter, Citigroup Letter, PNC Letter, and SIFMA Letter.
    \132\ Rule 701(a)(3)(ii)(A).
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    As a means designed to ensure that the broker-dealer has the
appropriate information to make these determinations, the rule
continues to require that, before a higher-than-nominal referral fee is
paid to a bank employee under the exemption, the bank provide the
broker-dealer the name of the employee and such other identifying
information that the broker-dealer may need to determine whether the
employee is subject to statutory disqualification.\133\ Once the
information for a particular employee is conveyed to the broker-dealer,
the bank should provide at least annually its broker-dealer partner any
changes to the identifying information initially provided under
paragraph (a)(2)(iii) of Rule 701 for an employee who continues to make
referrals and receive referral fees under the exemption so that the
broker-dealer may perform its periodic review of the employee's
qualifications under paragraph (a)(3)(ii)(A).
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    \133\ Rule 700(a)(2)(iii).
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6. Good Faith Compliance and Corrections by Banks
    As in the proposal, the final exemption provides that a bank that
acts in good faith and that has reasonable policies and procedures in
place to comply with the requirements of the exemption will not be
considered a ``broker'' under Section 3(a)(4) of the Exchange Act
solely because the bank fails, in a particular instance, to determine
that a customer is an institutional or high net worth customer, provide
the customer the required disclosures, or provide the broker-dealer the
required information concerning the bank employee receiving the
referral fee within the time periods prescribed. If the bank is seeking
to comply and takes reasonable and prompt steps to remedy the error,
such as by promptly making the required determination or promptly
providing the broker-dealer the required information, the bank will not
lose the exemption from registration in these circumstances. Similarly,
to promote compliance with the terms of the

exemption, the bank must make reasonable efforts to reclaim the portion
of the referral fee paid to the bank employee for a referral that does
not, following any required remedial actions, meet the requirements of
the exemption and that exceeds the amount the bank otherwise would be
permitted to pay under the statutory networking exception and Rule
700.\134\
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    \134\ Rule 701(a)(2)(iv).
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    A few commenters suggested that the Agencies strike the requirement
that the bank seek to reclaim the higher-than-nominal portion of a
referral fee. The Agencies have retained this requirement as it helps
provide employees an incentive to comply with the rule.\135\
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    \135\ One commenter requested that the rule provide a similar
safe harbor for broker-dealers. See SIFMA Letter. Any obligations of
a broker-dealer that arise by reason of Rule 701 run only to its
bank partner under the terms of their agreement and the Agencies
believe the issue of contractual liability between the parties is
best addressed by the parties themselves. As stated in the proposal,
the Commission anticipates that it may be necessary for either FINRA
or the Commission to propose a rule that would require broker-
dealers to comply with the written agreements entered into pursuant
to Rule 701.
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7. Referral Fees Permitted Under the Exemption
    Proposed Rule 701 placed certain limits on how a higher-than-
nominal referral fee paid under the exemption may be structured.\136\
Some commenters argued that these restrictions are unnecessary in light
of the other protections included in the exemption, or that the rule
should allow a higher-than-nominal referral fee to be based on a
percentage of any type of securities transaction conducted at a broker-
dealer (rather than just investment banking transactions).\137\ On the
other hand, one commenter asserted that, by allowing a referral fee to
be based on the total amount of assets maintained in an account with
the broker-dealer, the rule would provide an incentive for bank
employees to provide ongoing investment advice to customers.\138\
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    \136\ Proposed Rule 701(d)(4).
    \137\ See, e.g., Clearing House Ass'n Letter and JPMorgan
Letter.
    \138\ See NASAA Letter.
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    The final rule continues to place limits on the types of referral
fees a bank employee may receive under the exemption. These limitations
are designed to reduce the potential ``salesman's stake'' of the bank
employee in securities transactions conducted at the broker-dealer.
Specifically, the exemption provides that a referral fee paid under the
exemption may be a dollar amount based on a fixed percentage of the
revenues received by the broker-dealer for investment banking services
provided to the customer.\139\ Alternatively, the referral fee may be a
predetermined dollar amount, or a dollar amount determined in
accordance with a predetermined formula, so long as the amount does not
vary based on (1) the revenue generated by, or the profitability of,
securities transactions conducted by the customer with the broker-
dealer; (2) the quantity, price, or identity of securities purchased or
sold over time by the customer with the broker-dealer; or (3) the
number of customer referrals made.\140\ For these purposes,
``predetermined'' means established or fixed before the referral is
made. The requirement that the amount of the referral fee not vary
based on the number of customer referrals made does not prohibit an
employee from receiving a referral fee for each referral made by the
employee under the exemption.
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    \139\ Rule 701(d)(4)(ii).
    \140\ Rule 701(d)(4)(i). A referral fee paid under the exemption
may be contingent on whether the customer opens an account with the
broker-dealer or executes one or more transactions in the account
during the initial phases of the account.
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    As the exemption provides, these restrictions do not prevent a
referral fee from being paid in multiple installments or from being
based on a fixed percentage of the total dollar amount of assets placed
in an account with the broker-dealer. Additionally, these restrictions
do not prevent a referral fee from being based on a fixed percentage of
the total dollar amount of assets (including securities and non-
securities assets) maintained by the customer with the broker-dealer.