4000 - Advisory Opinions
Bank Contractual Agreement with Sole Sponsor and Underwriter of Unit Investment Trusts
November 1, 1984
Pamela E. F. LeCren, Senior Attorney
The following is in response to your August 31, 1984 letter to Roger Hood requesting that the FDIC grant its approval for your client bank to enter into a particular contractual arrangement with the sole sponsor and underwriter of several unit investment trusts, i.e., registered investment companies (hereinafter referred to as "the Funds"). According to your letter and the unexecuted contract enclosed therewith, the arrangement, if entered into by the bank, would involve the placing of orders for shares in the Funds by the bank with the underwriter on behalf of bank customers. The underwriter will execute the orders and confirm directly with bank customers on a fully disclosed basis. The service would be in addition to the discount brokerage services the bank presently makes available to its customers through another broker-dealer. Your letter describes the bank's current services to include opening brokerage accounts (presumably at the bank), acceptance of buy-sell orders, and the processing of orders through customer accounts. The bank does not provide execution or clearing services in connection with its present discount brokerage services but transmits customer orders for execution and clearing to a registered broker-dealer that is a member of the National Association of Securities Dealers.
Your letter states that the Fund orders will be transmitted by the bank as agent for its customers, the transactions will be without recourse against the bank, the bank customer will obtain full beneficial ownership of the securities, the transactions would be solely initiated by the customer for the customer's account and not the account of the bank, and the bank will not provide any investment advice. The contract states that the underwriter will pay the bank a commission on each order accepted for execution in the amount set forth in the then current prospectus for the Fund. All orders are subject to acceptance or rejection by the underwriter in the underwriter's sole discretion. The bank is to pay all clearance charges in accordance with a schedule of "Dealer Clearance Service Fees" which provides for rebates of the clearing charges paid by the bank depending upon the volume of orders placed with the underwriter ("volume rebates").
While the FDIC will neither "approve" nor disapprove the above described contractual relationship, we will comment on whether or not we feel the arrangement will involve the bank in a violation of the Glass-Steagall Act. In May, 1983 the FDIC issued General Counsel Opinion #6 which examined the issue of whether or not the Glass-Steagall Act would be violated if an insured nonmember bank entered into a contractual arrangement with a third party discount broker whereby the discount broker executes securities transactions for bank customers and the bank shares in the commissions generated by the transactions. The Opinion concluded that the arrangement would not be contrary to the Glass-Steagall Act provided that: (1) the bank clearly acts solely at the direction of the customer, (2) the transactions are for the account of the customer and not the account of the bank, (3) the transactions are without recourse, (4) the bank makes no warranty as to the performance or quality of any security, and (5) the bank does not advise customers to make any particular investment decision. Although your facts present a slightly different situation in that the bank is contracting directly with the underwriter and sponsor of several funds, it would appear that the functions to be performed by the bank are identical in both situations. As the arrangement the bank intends to enter into would appear to satisfy the criteria set forth in General Counsel Opinion #6, we conclude that the bank would not be issuing, underwriting, distributing or selling securities in contravention of the Glass-Steagall Act. Moreover, FDIC's conclusion is supported by the recent Supreme Court decision in Securities Industry Association v. Board of Governors of the Federal Reserve System, 104 S. Ct. 3003 (1984) wherein the Supreme Court reaffirmed the lawfulness of brokerage services (buying and selling for the account of customers) and distinguished brokerage services from underwriting and distributing (buying and selling for one's own account as principal).
Although the contractual arrangement would not appear to violate the Glass-Steagall Act, there are several aspects of the relationship which deserve comment. We do not agree with the statement in your letter that the bank has no "salesman's stake" in the sale of the Funds as (1) the bank retains the commissions on the transactions, and (2) the clearing costs the bank must pay will decrease with the volume of sales. This could promote certain conflicts of interest. If the bank intends to engage in margin lending in connection with purchase orders forwarded to the Funds, care should be taken by the bank not only to comply with Part 221 of the Federal Reserve Board's regulations on margin lending to the extent it may be applicable, but to fully comply with sound banking practices in view of the bank's additional interest in the transactions.
Your letter also states that the bank will have no interest in promoting the Funds but will only have an interest in promoting the availability of the Funds to its customers. Although we are of the opinion that a bank may lawfully promote its brokerage services, we also feel that a bank should assure itself that its promotional literature does not mischaracterize the bank's role in the brokerage transaction. Additionally, if the bank places orders on behalf of trust accounts over which it has investment discretion, or on behalf of managed agency accounts over which it has investment discretion, the bank should be careful that it has properly discharged its fiduciary and other obligations. Although General Counsel Opinion #6 states that a bank should not split commissions with a discount broker arising from transactions executed on behalf of trust accounts, this office has sent out subsequent letters stating that such a commission split may be permissible in certain limited circumstances. Copies of these letters have been enclosed for your information.
We wish to stress that the above opinion is based solely on the representations contained in your letter and its attachment. Should additional facts or information come to our attention, the FDIC reserves its right to alter the above opinion. We also wish to stress that the FDIC is not endorsing the contractual arrangement described in your letter nor is this opinion an approval of your client bank entering into such a contract.