Part I of this article appears in the September 2004 issue of The Metropolitan Corporate Counsel.
In Part I of this article, we discussed approaches banks and broker-dealers may consider for combining their activities. In Part II, we discuss less intrusive approaches to bank and broker-dealer business relationships. In particular, we will focus on employee sharing, customer referrals and GLBA third party brokerage agreements. Again, our focus tends to view these arrangements from the broker-dealer perspective.
A typical scenario occurs when a bank wishes to have several of its employees sell securities products to the public. In this scenario, the registered broker-dealer would have to sponsor the bank employee for registration. The bank employee would have to take and pass the appropriate securities licensing examinations. Additionally, these bank employees would also have to be supervised by the broker-dealer as well as satisfy the continuing education requirements to ensure compliance with applicable securities laws, including, among other things, sales practice laws.
The real dicey area for these employee relationships arises when the focus shifts to financial allocation. Commission sharing between the two entities must be fleshed out prior to any arrangement. The SEC's position on commission-sharing is clear: persons or entities must be registered prior to receiving commissions. See Partial Denial of No-Action Request of First Global, Inc., 2001 SEC No-Act, LEXIS 557.
The SEC addressed these issues when a broker-dealer sought to pay commissions to another professional (the professional was a CPA, but the analysis is the same). The SEC staff determined that a professional, who is also a registered representative, may then receive commissions. However, professionals, who are registered representatives and then voluntarily turn the commissions over to their firm that is not registered as a broker-dealer, may be subject to enforcement action. Further, if a professional, who is a registered representative, is also part of an agreement subjecting the registered representative to an accounting by their non-registered firm, may force regulatory scrutiny if there is a turnover of commissions. Finally, if there is a professional dually registered where their firm or its partners are owned by a non-member-firm, regulatory concerns may be heightened if there is a commission sharing arrangement with partners not registered.
The parties to employee sharing must take extra precautions to avoid paying commissions to a non-registered person or entity.
Account And Customer Referrals
Similar concerns arise when a bank refers accounts or customers to a broker-dealer. Initially, the concerns of sharing of transaction fees and commissions from these customers between banks and broker-dealers is substantially similar to those discussed above. Nonetheless, other concerns are equally troubling. For example, there are significant privacy concerns associated with these referrals and transfers. Customer approval is required to refer and transfer these accounts, and some bank customers may not want to be contacted by broker-dealers or have their money placed in securities accounts.
Additionally, the parties must pay particular attention to the disclosures made to customers during the referral process. A broker-dealer must obtain various information from the customer to determine suitability before recommending any securities transaction. This process requires detailed record-keeping and supervision by the broker-dealer. However, banks currently do not require such detailed information even after the USA PATRIOT Act. Further, any transaction must ultimately be approved by the customer.
As a result, both parties have a burden of ensuring customer approval, and ensuring appropriate compensation to both parties for these services.
Third-Party Brokerage Agreements
Our final point of analysis relates to the GLBA's adoption of a third party brokerage agreement provision. Banks may enter into contractual arrangements with registered broker-dealers to sell securities to bank customers (without the bank registering under the Securities Exchange Act of 1934) under specified conditions. See 15 USCA § 78c(a)(4)(B)(i).
Twelve different exceptions exist for banks from the definitions of "broker" and "dealer" as defined under GLBA sections 201 and 202 - eight of the exceptions are only specific to "brokers," one to "dealers," and three are applicable to both brokers and dealers. The exception for third-party brokerage contracts is applicable to both brokers and dealers.
As such, a bank may enter into a contractual or other written arrangement with a registered broker-dealer so that the broker-dealer may offer brokerage services to the bank customers on or off the bank's premises. The parties must meet and their agreement must contain representations relating to nine factors.
Initially, the broker-dealer must be clearly identified as the person or entity performing the brokerage services. Further, those services must be performed in an area clearly marked, and, to the extent possible, separate from the routine deposit-taking activities of the bank. Any advertising material promoting the brokerage services, if any, must also indicate that the services are being provided by the broker-dealer and not the bank. These advertising materials must also comply with FRB and federal securities laws, and bank employees may only perform clerical or ministerial functions in connection with brokerage services. These clerical or ministerial functions may include scheduling appointments with the associated persons of a broker or dealer. However, if the bank employees are associated persons of a broker or dealer, registered pursuant to the rules of a self-regulatory organization, the bank employee may then engage in other regulated activities.
Bank employees may also not forward customer funds or securities, but may describe in general terms the types of investment vehicles available from the bank and the broker or dealer under the arrangement. Bank employees may not receive any compensation for any brokerage transaction unless such employees are associated persons of a broker or dealer and are qualified pursuant to the rules of a self-regulatory organization. Nonetheless, bank employees may receive compensation for the referral of any customer if the compensation is a nominal one-time cash fee of a fixed dollar amount and the payment of the fee is not contingent on whether the referral results in a transaction.
The broker-dealer must also provide these services on the same basis to all bank customers that receive any services on a fully disclosed basis to the broker-dealer. The bank may also not carry a securities account of the customer except as permitted. Finally, the bank or broker-dealer must inform each customer that the brokerage services are being provided by the broker-dealer, not by the bank, and that the securities are not deposits or other obligations of the bank, not guaranteed by the bank, and are not insured by the FDIC.
The parties may enter into an agreement along these parameters, and, if met, the bank will not fall within the definition of "broker" and "dealer" as defined under the GLBA. Thus, there would be no need to register as a broker-dealer, but the bank may still offer brokerage services to its customers.
There are many permutations to consider when engaging in a possible business combination between a broker-dealer and a bank. Navigating the pitfalls associated with establishing such relationships is very murky, however, the rewards associated with such an endeavor may be great. Both the broker-dealer and bank would have access to new customers and business lines, and undoubtedly new sources of revenue.
Ernest E. Badway is a Partner in the law firm of Saiber Schlesinger Satz & Goldstein, LLC, Newark, New Jersey. He previously served as an attorney with the Division of Enforcement, United States Securities and Exchange Commission. He represents broker-dealers and brokers in securities regulatory, securities defense and white collar criminal defense in matters arising from trading and underwriting activities, as well as defending enforcement actions by the SEC, NASD, NYSE, the New York Attorney General's Office, and the New Jersey Bureau of Securities.