13276 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

DEPARTMENT OF THE TREASURY

Office of the Comptroller of the

Currency

12 CFR Part 13

[Docket No. 97–05]

RIN 1557–AB52

FEDERAL RESERVE SYSTEM

12 CFR Parts 208 and 211

[Regulations H and K, Docket No. R–0921]

FEDERAL DEPOSIT INSURANCE

CORPORATION

12 CFR Part 368

RIN 3064–AB66

Government Securities Sales Practices

AGENCIES: Office of the Comptroller of

the Currency, Treasury; Board of

Governors of the Federal Reserve

System; Federal Deposit Insurance

Corporation.

ACTION: Joint final rule.

SUMMARY: The Office of the Comptroller

of the Currency (OCC), Board of

Governors of the Federal Reserve

System (Board), and Federal Deposit

Insurance Corporation (FDIC)

(collectively, the agencies) are issuing

rules regarding sales practices

concerning government securities by

depository institutions within their

respective jurisdictions. The agencies

are adopting the final rules in light of

recent statutory changes authorizing the

agencies to adopt rules governing

transactions in government securities in

order to provide consistent treatment for

government securities customers. The

final rules minimize regulatory burdens

to the extent feasible, consistent with

the goal of providing purchasers of

government securities with consistent

treatment regardless of whether they

engage in transactions in government

securities with banks or nonbank

government securities brokers and

dealers.

EFFECTIVE DATE: This joint rule is

effective July 1, 1997.

FOR FURTHER INFORMATION, CONTACT:

OCC: Ellen Broadman, Director, or

Elizabeth Malone, Senior Attorney,

Securities & Corporate Practices

Division (202/874–5210); Joseph W.

Malott, National Bank Examiner, Capital

Markets (202/874–5070); or Mark J.

Tenhundfeld, Assistant Director,

Legislative and Regulatory Activities

(202/874–5090), 250 E Street, SW,

Washington, DC 20219.

Board: Oliver Ireland, Associate

General Counsel (202/452–3625), or

Lawranne Stewart, Senior Attorney

(202/452–3513), Legal Division, Board

of Governors of the Federal Reserve

System, 20th and C Streets, NW,

Washington, DC 20551. For the hearing

impaired only, Telecommunication

Device for Deaf (TDD), Ernestine Hill or

Dorothea Thompson (202/452–3544).

FDIC: William A. Stark, Assistant

Director (202/898–6972), Keith Ligon,

Chief (202/898–3618), Kenton Fox,

Senior Capital Markets Specialist (202/

898–7119), Division of Supervision; or

Karen L. Main, Senior Attorney (202/

898–8838), Legal Division, Federal

Deposit Insurance Corporation, 550 17th

Street, NW, Washington, DC 20429.

SUPPLEMENTARY INFORMATION:

The Government Securities Act

Amendments of 1993

The Government Securities Act

Amendments of 1993 (Amendments)

(Pub.L. 103-202), codified at section

15C(b)(3) of the Securities Exchange Act

of 1934 (Exchange Act) (15 U.S.C. 78o5(b)(3)), authorize the agencies to adopt

rules and regulations governing

transactions in government securities as

may be necessary to prevent fraudulent

and manipulative acts and practices and

to promote just and equitable principles

of trade. Id. section 15C(b)(3)(A). Rules

adopted pursuant to the Amendments

apply to transactions in government

securities by banks that have filed, or

are required to file, notice as

government securities brokers or

dealers.

The Amendments require the banking

agencies to consider the sufficiency and

appropriateness of existing laws and

rules applicable to government

securities brokers or dealers and

associated persons before promulgating

rules governing transactions in

government securities. Id. section

15C(b)(3)(C). In determining whether

existing laws are sufficient, the agencies

may consider rules that expressly apply

to government securities activities of

financial institutions and other sales

practice rules that do not expressly

apply to these activities but that are

used by examiners and bankers as

guidance for transactions in government

securities. S. Rep. No. 109, 103d Cong.,

1st Sess. at 14. The agencies also may

consider the extent to which additional

rules are necessary to establish

consistent treatment for bank customers

engaged in transactions involving

government securities.

The Amendments also eliminated the

statutory limitations on the National

Association of Securities Dealers

(NASD) authority to apply sales practice

rules to transactions in government

securities by government securities

broker-dealers that are members of the

NASD. See section 106 of the

Amendments (15 U.S.C. 78o-3). To

implement this expanded sales practice

authority, the NASD proposed, and the

SEC approved August 20, 1996 (see SEC

Release No. 34–37588), the application

of the NASD Conduct Rules (formerly,

the Rules of Fair Practice) to

transactions in government securities.

The NASD Conduct Rules include a

Business Conduct Rule and a Suitability

Rule, as well as a Suitability

Interpretation. The rules and the

interpretation that the agencies

promulgated in both the proposed and

final rules (see text that follows) are

substantially identical to the NASD

Business Conduct and Suitability Rules

and the NASD Suitability Interpretation.

The Proposal

On April 25, 1996 (61 FR 18470), the

agencies requested comment on whether

they should require a bank that is a

government securities broker or dealer

to comply with rules that are

substantively identical to the NASD

Business Conduct and Suitability Rules

and the NASD Suitability Interpretation.

The proposal defined ‘‘bank that is a

government securities broker or dealer’’

as a bank that has filed notice, or is

required to file notice, as a government

securities broker or dealer under the

provisions of the Government Securities

Act (15 U.S.C. 78o-5(a)) and applicable

Treasury rules (17 CFR 400.1(d) and

401).

The proposal required a bank that is

a government securities broker or dealer

and its associated persons: (a) To

observe high standards of commercial

honor and just and equitable principles

of trade in the conduct of its business

as a government securities broker or

dealer; and (b) to have reasonable

grounds for believing that

recommendations are suitable for a

customer based on the facts, if any,

disclosed by a customer regarding his,

her, or its other securities holdings and

financial situation and needs. The

proposal provided that, if a bank is

doing business with a non-institutional

customer, the bank must make

reasonable efforts to obtain information

concerning the customer’s financial

situation and tax status and investment

objectives before executing a transaction

it recommended to the customer. The

suitability rule contained in the

proposal, like the Suitability Rule of the

NASD, applies only in situations where

a bank makes a ‘‘recommendation’’ to its

customer.
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13277

The proposal also set out a suitability

interpretation that identifies factors that

may be relevant when evaluating a

bank’s compliance with the suitability

rule when dealing with an institutional

customer other than a natural person.

The interpretation identified: (a) the

customer’s capability to evaluate

investment risk independently; and (b)

the extent to which the customer is

exercising independent judgement in

evaluating a bank’s recommendation as

the two most important considerations

in determining the scope of the bank’s

responsibilities to an institutional

customer. The suitability interpretation

provided that a bank will have met the

requirements of the suitability rule with

respect to a particular institutional

customer where the bank has reasonable

grounds to determine that the

institutional customer is capable of

independently evaluating investment

risk and is exercising independent

judgement in evaluating a

recommendation.

The proposed suitability

interpretation set forth certain factors

for banks to apply in evaluating an

institutional customer’s capability to

evaluate investment risk independently.

These factors include: The customer’s

use of consultants, advisors, or bank

trust departments; the experience of the

customer generally and with respect to

the specific instrument; the customer’s

ability to understand the investment

and to evaluate independently the effect

of market developments on the

investment; and the complexity of the

security involved. The interpretation

stressed that an institutional customer’s

ability to evaluate investment risk

independently may vary depending on

the particular type of instrument or its

risk. Moreover, the interpretation noted

that an institutional customer with

general ability to evaluate investment

risk may be less able to do so when

dealing with new types of instruments

or instruments with which the customer

has little or no experience.

The proposed suitability

interpretation further provided that a

determination that an institutional

customer is making an independent

investment decision depends on factors

such as the understanding between the

bank and its customer as to the nature

of their relationship, the presence or

absence of a pattern of acceptance of the

bank’s recommendations, the customer’s

use of ideas, suggestions, and

information obtained from other market

professionals, and the extent to which

the customer has provided the bank

with information concerning the

customer’s portfolio or investment

objectives.

While the proposed suitability

interpretation stated that these factors

would be considered relevant in

evaluating whether a bank that is a

government securities broker or dealer

has fulfilled the requirements of the

suitability rule with respect to any

institutional customer that is not a

natural person, it further stated that the

factors cited would be considered most

relevant for an institutional customer

with at least $10 million invested in

securities in the aggregate in its

portfolio or under management.

Final Rules and Comments Received

The final rules adopt the business

conduct and suitability rules and the

suitability interpretation as proposed,

excepting only the addition of a

definition of ‘‘government security’’ in

the final rules and minor modifications

of the suitability interpretation to

conform that interpretation to the

NASD’s Suitability Interpretation. As

discussed in greater detail below, the

agencies continue to believe that banks

and their customers will benefit

significantly from a consistent set of

rules applied to banks engaged in

transactions in government securities.

The agencies received a total of 18

comments. Of these, eight were from

trade organizations representing

interests ranging from the banks and the

securities companies to state

governments and retired persons. Seven

other comments were from insured

depository institutions or their affiliates,

two were from State governments, and

the remaining comment was from a

securities dealer. The comments were

fairly evenly split, with banks and

securities companies and their

respective trade organizations generally

opposing the proposal and the rest of

the commenters favoring it.

Commenters typically responded to

some or all of the specific questions set

out in the proposal. Below is a summary

of the comments, along with the

agencies’ responses, that follows the

order of questions presented for

comment in the proposal.

Issue 1. Adoption of rules substantially

similar to the NASD Business Conduct

and Suitability Rules

Eight commenters opposed adoption

of these rules for banks while seven

favored adoption of the rules.

(a) Comments supporting adoption of

the proposed rules. Commenters

representing purchasers of government

securities stated that certain government

securities, such as collateralized

mortgage obligations, carry considerable

risk and are unsuitable for certain

investors. The purchasers’

representatives stated further that

customers need to be protected from

potential misconduct in the sale of

government securities. They believe that

banks should be held to the same

standards as apply to other entities that

engage in government securities

transactions and that the existence of

customer protections should not depend

on the type of entity selling the security.

Several of the commenters also stated

their support for the suitability

interpretation, with one commenter

stating that a suitability determination

must be made on a case-by-case basis

and another stating that banks should be

required to ask for specific information

about an investor before making a

recommendation.

(b) Comments opposing adoption of

the proposed rules. Those opposing the

application of these rules to banks

advanced several arguments to support

their conclusion that the rule is

unnecessary. Their arguments fall into

the following eight broad categories.

(i) There have been no significant

sales practice abuses.

(ii) The Amendments and the

legislative history indicate that the

banking agencies are not required to

adopt sales practice rules.

(iii) There are sufficient market

incentives to ensure that the good

relations that exist between banks and

their customers would likely discourage

banks from making unsuitable

recommendations of government

securities.

(iv) A suitability obligation is

particularly inappropriate in the case of

institutional investors, because

institutional investors need less

protection than do retail customers and

because a bank will lack adequate

information needed to detect anomalies

between an institutional customer’s

investment objectives and the type of

trade.

(v) The rules will impose significant

additional burdens on banks, in part

because the rules are too ambiguous.

(vi) The rules could have unintended

adverse consequences by discouraging

investors from performing their own

research in order to shift responsibility

(and, therefore, liability) for making

appropriate investments to the bank that

makes a recommendation.

(vii) Case law and other issuances,

such as the Interagency Statement on

Retail Sales of Nondeposit Investment

Products (the Interagency Statement),

OCC Banking Circular 277—Risk

Management of Financial Derivatives,

the Board’s Trading Activities Manual

(March 1994) and SR 93–69 (FIS) (Dec.

20, 1993), and the Rules of the

Municipal Securities Rulemaking Board
13278 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

(MSRB), provide sufficient guidance to

banks and bank examiners on

appropriate sales practices.

(viii) The agencies should consider

alternatives to adopting the rules as

proposed, such as adopting guidelines

or amending the proposal to include a

statement that compliance with certain

requirements creates a safe harbor.

(c) Analysis of Issue 1. After carefully

considering all the arguments advanced

by the commenters, the agencies

continue to believe that the benefits of

the rules in question significantly

outweigh the burdens and, therefore, are

adopting the rules substantially as

proposed. The agencies believe that

adoption of final rules substantially in

the form proposed is appropriate to

provide consistent treatment for

government securities customers.

Although bank and nonbank

government securities dealers will

continue to be subject to different

regulatory structures, adoption of

business conduct and suitability rules

that are consistent with the NASD rules

will ensure that customers of both bank

and nonbank government securities

broker-dealers receive consistent

treatment in their government securities

transactions. The agencies agree with

those who stated that certain

government securities can carry

considerable risk and that the rules

appropriately focus the banking

industry’s attention on the issue of

suitability in recommending these

securities. An analysis of the comments

opposing adoption of the rules follows.

(i) Lack of evidence of abuses.

Opponents of the rules are correct that

sales practice abuses have not been

found to be a significant problem in

financial institutions engaged in

government securities transactions.

However, losses stemming from

unsuitable transactions in government

securities can create reputational risk

for banks. The agencies believe that

banking practices that comport with the

final rules will help minimize this risk

to banks due to losses incurred by their

customers.

(ii) Rules not required by statute.

Opponents of the rules also correctly

noted that the Amendments and the

legislative history do not require the

bank regulatory agencies to adopt sales

practice rules. However, the

Amendments authorize the agencies to

adopt rules as may be necessary to

promote, among other things, just and

equitable principles of trade. The final

rules accomplish this by providing

guidance to banks about the extent of

their obligations when recommending a

government security to a customer.

They also enable a customer to receive

consistent treatment, regardless of

whether the customer conducts business

with a bank or nonbank government

securities broker-dealer.

(iii) Sufficient market alternatives.

The agencies intend for the rules to

facilitate the good relations noted by

many commenters that exist between

banks and their customers. In addition

to codifying the business conduct and

suitability rules, the final rules provide

banks with guidance concerning those

factors that a bank may find relevant

when determining its suitability

obligations to an institutional customer.

This guidance is provided to assist

banks in identifying when an

institutional customer is capable of

evaluating investment risk

independently and is exercising

independent judgement in evaluating

the bank’s recommendation.

(iv) Suitability obligation

inappropriate for institutional

customers. The agencies agree with the

commenters who stated that any

suitability rule should reflect the

differences between institutional and

non-institutional customers. Banks

frequently will have knowledge about

an investment and its risks that are not

possessed or easily obtained by the noninstitutional customer. A more

sophisticated institutional customer, on

the other hand, may have both the

understanding of how a particular

securities issue could perform and a

desire to make investment decisions

without relying on a bank’s

recommendation.

The final rules recognize the wide

variety of customer profiles, even among

institutional customers, and provides

guidance intended to assist a bank in

determining the nature of its suitability

obligations to a customer. Under the

final rules, the nature of a suitability

determination changes, depending on

the type of customer. For a

comparatively unsophisticated

customer, the determination will need

to focus more on whether a particular

investment is appropriate for that

customer after a review of the

customer’s financial condition and

objectives. For a more sophisticated

customer, the focus of the suitability

determination shifts initially to the

question of whether the customer is

capable of evaluating risk and the bank’s

recommendation. The suitability

interpretation provides illustrative

factors that are intended to help a bank

determine how to fulfill its suitability

obligation for a given institutional

customer. As noted in the

interpretation, these factors are not

intended to be requirements or the only

factors to be considered but are offered

merely as guidance in determining the

scope of a bank’s suitability obligations.

(v) Increased burden. The agencies

believe that the sales practice rules will

not subject banks to a material increase

in regulatory burden. Almost all banks

that are government securities brokerdealers also are municipal securities

broker-dealers or sell other securities for

which they are required to comply with

business conduct and suitability rules.

As a consequence, banks frequently will

have obtained the information needed to

comply with the business conduct and

suitability rules from customers in the

course of other securities transactions,

and will have implemented policies and

procedures that can be applied to

transactions involving government

securities.

(vi) Unintended adverse

consequences. The agencies disagree

with the commenters who suggested

that the rules will discourage customers

from consulting with their own internal

or external advisors before making an

investment. These commenters are

concerned that the rules will shift

liability to banks by creating

disincentives for a customer to

undertake research that is independent

of that conducted by a bank. As noted

in the proposal, the suitability and

business conduct rules and suitability

interpretation do not provide a basis for

a private right of action against a bank

by a customer based on a violation of

these rules or interpretation. Thus, a

customer will have every incentive after

the rules are adopted that it had before

adoption to undertake whatever due

diligence it thinks is appropriate in

evaluating an investment

recommendation.

(vii) Existing guidance adequate.

While those opposed to the rules are

correct that there are banking agency

issuances that address sales practices in

other areas of securities sales, these

issuances do not provide customers who

engage in government securities

transactions with banks with treatment

that is consistent with that provided

under the NASD Business Conduct or

Suitability Rules or the NASD

Suitability Interpretation. Moreover,

existing guidance does not address

government securities sales practices for

all types of customers. The final rules

will provide a framework that will be

consistent throughout the banking

industry for analyzing the obligations of

a bank engaged in government securities

transactions.

(viii) Suggested alternatives. One

bank commenter recommended that the

agencies adopt guidelines instead of the

proposed sales practice rules. Another

suggested that the agencies adopt an
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13279

‘‘appropriateness’’ standard pursuant to

which a bank would focus on the

customer’s ability to understand the

nature of, and risks inherent in, a given

transaction. Two commenters suggested

that the final rules contain an assurance

that compliance with the interpretive

guidance will create, at a minimum, a

rebuttable presumption that a bank’s

suitability obligations with respect to

institutional customers have been

satisfied. Finally, another commenter

suggested that banks be insulated from

liability if an institutional customer has

retained a third party professional

investment advisor or if the bank

executes a transaction that is consistent

with an institutional account’s

specifically enumerated authorized

investment guidelines.

The agencies have concluded,

however, that adopting the rules in the

form of a regulation will provide

consistent treatment of customers,

regardless of whether they conduct

business with a bank or a nonbank

government securities broker-dealer.

The agencies also have decided not to

create any safe harbors whereby a bank

would be presumed to have fulfilled its

suitability obligation. The creation of

such a presumption would be

acceptable only if a definable class of

institutional customers could be

identified that would not benefit from

the suitability rule under any

conceivable circumstance. ‘‘Institutional

customers’’ include, among others,

colleges, churches, charities, and

governments. Given the wide diversity

of characteristics that such entities

present, the agencies have concluded

that it is more appropriate for a bank to

determine suitability on a case-by-case

basis. Furthermore, nonbank brokerdealers do not have safe harbors

whereby compliance with the suitability

obligation is presumed. To create a safe

harbor for banks would reduce the

benefits of consistent treatment of

customers.

Issue 2. Benefits of Consistency Among

Government Securities Brokers and

Dealers

Of the seven commenters responding

to this issue, five stated that there are

benefits of consistent treatment by

government securities broker-dealers

while two stated that consistency would

not provide significant benefits.

(a) Comments favoring consistency.

Several commenters stated that

customers are more likely to receive

equal treatment if the agencies impose

rules similar to those imposed by the

NASD. One commenter noted that the

substance of the rules applied by the

banking agencies should be as uniform

as possible with those applied by the

NASD to minimize the extent to which

there are gaps in the existing regulatory

framework. Another commenter stated

that a customer should not have to bear

the burden of determining which set of

rules apply to different dealers who are

performing exactly the same functions

concerning exactly the same types of

investments. In this commenter’s view,

the agencies’’ role in maintaining the

safety and soundness of banks includes

protecting customers. A third

commenter observed that fragmentation

of the market is likely if different rules

apply.

(b) Comments opposing consistency.

A trade association representing both

bank and nonbank interests stated that

a majority of its members believes that

adopting the final rules is not justified

because the level playing field already

exists in the form of remedial and

enforcement authority that the agencies

may exercise. Another commenter noted

that there are significant differences

between bank and nonbank government

securities broker-dealers, and concluded

that these differences justify using

different standards. This commenter

believes that the different standards

continue to result in the same level of

customer protection, thus obviating the

need to adopt the rules set out in the

proposal.

(c) Analysis of Issue 2. The agencies

believe that the final rules will provide

consistent treatment to customers

engaging in government securities

transactions, regardless of whether the

customer receives a recommendation

from a bank or nonbank government

securities broker-dealer. The existing

regulatory and common law does not

provide this consistent treatment. The

final rules avoid requiring customers to

ascertain which rules apply to which

institution. Moreover, the agencies

expect that the final rules, by focusing

banks’ attentions on suitability

concerns, will minimize the disputes

between banks and their customers

concerning the suitability of a given

recommendation.

Issue 3. Sufficiency of the Standard

Provided in the Business Conduct Rule

Five commenters responded to this

issue. Four commenters believe that the

business conduct rule is sufficiently

clear, while one commenter believes

that additional interpretation is

necessary.

(a) Comments finding business

conduct rule clear. One commenter

stated that the business conduct rule,

taken together with the suitability rule,

is sufficiently clear. In this commenter’s

opinion, a rule of this nature should

provide a general code of conduct that

protects the integrity of the profession

by setting a baseline of good conduct.

Another commenter suggested that more

specific guidelines may be too

restrictive and not benefit the customer

or bank. A third commenter restated its

request for changes in the examination

procedures to ensure compliance with

the final rule but suggested that banks

should have less latitude in the types of

information requested from a customer.

The fourth commenter stated its general

agreement that the business conduct

rule is clear.

(b) Comments finding the business

conduct rule unclear. The one comment

finding the business conduct rule

unclear stated that the rule does not

delineate proper conduct for sales

practices. This commenter stated that it

views the NASD guidance related to the

business conduct rule as providing

appropriate additional clarification.

(c) Analysis of Issue 3. The agencies

believe that the business conduct rule

set out in the proposal is sufficiently

clear. As noted by one commenter, the

rule establishes a baseline of

appropriate behavior in the industry. A

bank then has the flexibility to comply

with this standard in ways that it finds

appropriate and effective. Attempts at

additional clarification in this area are

likely to provide little additional

meaningful guidance without becoming

so detailed as to be overly burdensome

and restrictive. The agencies also are

concerned that additional clarification

in the business conduct rule would

detract from the objective of ensuring

consistent treatment for customers of

bank and nonbank government

securities broker-dealers. The agencies

note that the NASD is continuing to

consider issues concerning the

application of certain interpretations of

their Business Conduct Rule to the

government securities markets.

Issue 4. Definition of

‘‘Recommendation’’

The issue of whether to define

‘‘recommendation’’ or provide guidance

as to what is and is not a

recommendation generated responses

from seven commenters, four of whom

requested additional guidance or a

definition and three of whom stated that

no additional guidance or definition is

needed.

(a) Comments favoring defining

‘‘recommendation.’’ A point

consistently made by those requesting

additional guidance is that the rules

should clarify that a recommendation

does not include providing routine

market information, such as market

observations, forecasts about the general
13280 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

direction of interest rates, and price

quotations. One commenter also stated

that the rules should not treat subjective

analyses of market information as a

recommendation, because to do so

would discourage banks from providing

this information. This commenter

suggested that the rules exclude from

the definition of ‘‘recommendation’’ the

providing of several investment

alternatives for an investor’s

consideration. Two commenters

proposed definitions that would

include, generally speaking, an

unconditional affirmative statement by

one party urging another to enter into a

particular transaction, an explicit

identification of the statement as a

recommendation, and/or a requirement

that information be given to the bank

expressly for the purpose of enabling

the bank to make a recommendation.

One of these commenters stated that

reliance should not be considered

reasonable unless an institutional

customer has provided information

regarding its portfolio, its liabilities, and

the range of investment opportunities

available to the customer. Another

commenter concluded that the

definition is so vague that the

commenter will have to assume, despite

the fact that it makes no

recommendations, that all current sales

activities constitute making a

recommendation and then build

systems and increase staff to evaluate

and document the suitability of each

customer purchase. Another commenter

suggested that a definition should not

include trade or hedging ideas unless

there is a written agreement between the

parties or unless applicable law

expressly imposes affirmative

obligations to the contrary. This

commenter noted that this approach

would be consistent with the

‘‘impersonal advisory services’’ rule

proposed by the SEC in 1994.

(b) Comments opposing defining

‘‘recommendation.’’ Commenters

opposing defining ‘‘recommendation’’

expressed concern that a definition

would create a safe harbor protecting

banks against liability and stated that

individual facts and circumstances must

be reviewed to determine whether a

recommendation has been made. One

commenter stated further that the line of

when a bank is recommending a

product is clear, namely, when the bank

provides information to explain why a

customer should purchase a particular

product. This commenter suggested that

once a customer expresses an interest in

a particular product, the suitability

obligation should be triggered even if no

explicit recommendation is made.

(c) Analysis of Issue 4. The agencies

have decided not to define

‘‘recommendation,’’ for several reasons.

First, a determination of whether a

recommendation has been made

necessarily depends on the facts of a

given situation. The agencies believe

that a definition would not change the

need to review the entire circumstances

of a transaction, and, therefore, do not

believe that a definition would provide

a significant benefit. Second, the

agencies are concerned that a definition

might be misinterpreted as a safe harbor

whereby a government securities brokerdealer effectively recommends an

investment but argues that it had no

suitability obligation because the advice

technically was not a recommendation

according to the literal terms of a

definition. Third, the agencies believe

that there is no need to define the term,

because bankers and examiners already

are accustomed to the use of the term in

the municipal securities area where

similar rules currently exist. Finally, for

the reasons previously stated, the

agencies believe that government

securities customers will benefit from

rules that are consistent for both bank

and nonbank government securities

broker-dealers. Given that the NASD

and SEC recently decided not to define

‘‘recommendation,’’ a decision to do so

in the banking agencies’’ rule could

result in a material difference that could

undermine the benefits of consistency

and could lead to confusion concerning

what effect the definition would have

on the other rules.

While the agencies do not believe it

is appropriate to define the term

‘‘recommendation,’’ they note that they

would not view the provision of general

market information, including market

observations, forecasts about interest

rates, and price quotations, as making a

recommendation under the rule, absent

other conduct.

Issue 5. Adoption of Additional Rules

Of the four commenters addressing

the need to adopt rules similar to other

sections of the Rules of Fair Practice or

interpretations similar to other NASD

interpretations, all four supported

adopting additional rules and

interpretations.

(a) Comments supporting additional

rules. One commenter suggested that the

agencies adopt those parts of the NASD

Rules of Fair Practice that require the

establishment of a system to supervise

personnel involved in government

securities transactions. Another

commenter stated that the rules should

be extended to those practices that

adversely affect transactions, such as

markups, churning, and frontrunning. A

third commenter suggested that the

agencies adopt rules concerning the

supervision of employees, the

establishment of written procedures,

and the requirement of internal

inspections. This commenter noted that

the banking industry and its customers

would benefit from additional

uniformity with nonbank government

securities dealers. The final commenter

suggested that the agencies adopt

additional rules similar to those

applicable to bank municipal securities

dealers.

(b) Comments opposing additional

rules. While no commenter specifically

opposed adopting additional rules,

several noted their general opposition to

the agencies adopting any rules in this

area. The arguments advanced by these

commenters are summarized in the

discussion of the first issue.

(c) Analysis of Issue 5. The agencies

have decided not to adopt rules other

than the Suitability and Business

Conduct Rules and Suitability

Interpretation at this time. In some

cases, the NASD Rules overlap with

safety and soundness standards that

already apply to banks (see, e.g., Rule

3010 of the NASD’s Conduct Rules,

which requires each member to

establish and maintain a system of

supervision that is reasonably designed

to achieve compliance with applicable

securities laws and regulations). Other

NASD Rules appear to codify existing

duties and principles to which bank

employees acting in a fiduciary capacity

must adhere (see, e.g., Rule 2330 of the

NASD’s Conduct Rules, which prohibits

members and associated persons from

making improper use of a customer’s

securities or funds). While the agencies

believe that the business conduct rule is

sufficiently broad to address much of

the conduct proscribed by other NASD

Rules, the agencies will consider

whether there is a need to adopt

additional rules as the agencies examine

banks for compliance with the rules and

interpretation adopted herein. Banks

should determine the adequacy and

appropriateness of their policies,

procedures, and internal controls with

respect to the final rules.

Issue 6. Ability to contract out of the

rules

Four of the six commenters

addressing this issue favor allowing a

bank and its customers to establish

standards by contract that would govern

that relationship, while two opposed

this option.

(a) Comments favoring allowing

parties to contract out of the rules. One

commenter suggested that the agencies

look to the Principles and Practices for
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13281

Wholesale Financial Market

Transactions, prepared in 1995 under

the coordination of the Federal Reserve

Bank of New York, for guidance on the

appropriate set of governing

assumptions regarding institutional

relationships. This commenter noted

that the Amendments contain no

limitation on the agencies’’ ability to

permit this flexibility. While this

commenter opposed adoption of the

rules in general, the commenter stated

that, if the agencies adopt the rules, they

should clarify that a bank would be

insulated from liability to the extent that

the bank and customer contractually

limit liability. Another commenter

opined that a written contract should

control on the question of suitability

and that the agencies should provide

guidance on when an oral agreement

will suffice (such as, for instance,

allowing oral agreements to control if

they are entered into on a recorded

line). A third commenter stated that

banks should be encouraged to clarify

the nature of the relationship with their

customers, including providing

disclaimers about the nature of the

information given if appropriate. The

fourth commenter expressed its support

for allowing parties to contract out of

the rules but then suggested that the

presence or absence of a contract should

be one of the factors considered if a

bank’s compliance with its suitability

obligation is in dispute.

(b) Comments opposing allowing

parties to contract out of the rules.

Those commenters who opposed

allowing banks to contract out of the

rules expressed concern that an

agreement should not be used to protect

banks that make unsuitable

recommendations. One commenter

noted that a contract should be only one

factor to consider when determining

whether a suitability obligation has been

satisfied. The other commenter opposed

to contractually limiting liability stated

that, if parties are allowed to do so, the

final rules should require periodic

review of the contract. According to this

commenter, the changing nature of

financial markets may render a contract

inappropriate over time.

(c) Analysis of Issue 6. The agencies

believe that a contract establishing the

nature of the relationship can be helpful

in determining the relationship between

the bank and its customer, but that such

a contract will not be determinative of

whether the bank has fulfilled its

obligation under the rules. The agencies

also believe that the benefits to be

gained by both the banking industry and

its customers from having uniform

suitability rules and interpretations

would be significantly undermined if

banks were permitted to establish by

contract a safe harbor from their

obligations under the rules.

Accordingly, the final rules do not go

beyond the proposed interpretation,

which provides that written and oral

agreements will be considered as one of

several factors that may be relevant in

determining whether the bank has

fulfilled its obligations under the

suitability rule. Additionally, the

agencies note that because the rules do

not create a private right of action, there

is no need to provide a mechanism in

the rule for a bank to insulate itself from

liability to customers arising from a

violation of the rules.

Issue 7. Definition of ‘‘Institutional

Customer’’

Eight commenters addressed the issue

of how to define an ‘‘institutional

customer.’’ Of these, four opposed using

$50 million in total assets as the

measure by which institutional

customers are judged while one favored

using this cutoff. Five commenters

expressed support for a test based on

assets under management as the

appropriate measure, and one opposed

any test based on asset size, portfolio

size, or revenue.

(a) Comment favoring use of $50

million in total assets. The one

commenter favoring the use of $50

million in assets as the threshold for

determining who is an institutional

customer stated that the level of assets

usually is a good determinant of

whether the customer is sophisticated.

This commenter also noted that

customers above that size can afford to

hire a professional manager, and

suggested that there is no reason to shift

to the dealer the responsibility for

ensuring that investments are suitable.

The commenter suggested further that

an appropriate benchmark for

governmental entities is whether a

government’s budget is at least $50

million. Finally, this commenter opined

that a customer should be considered

‘‘institutional’’ if it is registered as an

investment adviser under either U.S. or

foreign law and that the definition

should clarify that a bank, savings

association, or insurance company may

be domestic or foreign.

(b) Comments opposing use of $50

million in total assets. All of the

commenters opposed to defining

‘‘institutional customer’’ by using total

assets stated that asset size is not a good

proxy for sophistication. One

commenter maintained that a rule that

does not apply to all registered

investment companies will result in

banks being less willing to make

recommendations to small investment

companies because the suitability

obligations to the small companies will

be more onerous. Another commenter

stated that this test will only place more

burdens and risks on banks. The

commenter opposed to any test based on

asset size, portfolio size, or revenue

stated that the tests are inaccurate and

arbitrary. Concerning an asset size test,

this commenter noted that all but the

smallest local governments have assets

of at least $50 million, although most of

these assets are in the form of buildings,

land, sewage facilities, and so on. This

commenter opposed a revenue test

because the cyclical nature of tax

receipts will temporarily swell the

amounts available for investment by a

government, thereby resulting in many

small governments being deemed

‘‘institutional customers’’ even though

they need the protections afforded by

the suitability rule. Finally, this

commenter believes that portfolio size is

problematic because it is unclear which

governmental entity’s portfolio should

be considered. To illustrate this

problem, this commenter asked whether

investments of a state government and

local governments within that state

should be considered as held in one

portfolio and whether pension funds

invested by a city are part of the city’s

portfolio. Two other commenters stated

their general opposition to an asset size

test set at $50 million.

(c) Comments favoring portfolio size

as the appropriate test. Of the four

commenters favoring a test based on

portfolio size, one agreed that $10

million was the appropriate cutoff. Two

others stated that, while portfolio size is

a better measure of sophistication than

is asset size, $10 million is too high a

threshold. Finally, one commenter

stated that portfolio size should be

considered, but that it should be only

one of several factors looked at.

(d) Analysis of Issue 7. The agencies

have decided to adopt a definition of

‘‘institutional customer’’ that is

consistent with the NASD’s definition.

As a result, all customers will receive

consistent treatment under the

suitability rule. Moreover, transactions

with all customers other than natural

persons will be covered by the

suitability interpretation, although the

factors identified in the interpretation

will be most appropriate for a customer

with at least $10 million invested in

securities in the aggregate in its

portfolio and/or under management. If

an entity has less than $50 million in

total assets, a bank making a

recommendation to that entity must

make a reasonable effort to obtain

information about the customer’s

financial and tax status, investment
13282 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

1 Data obtained since the proposal was published

show that this figure is approximately 160 banks

covered by the rule. See discussion of the

Regulatory Flexibility Act for additional analysis of

the number of institutions covered.

objectives, and other information used

or considered reasonable by the bank in

making a recommendation.

The agencies believe that if a different

measure were used, the inconsistencies

between their rule and the NASD’s

Suitability Rule would make the

agencies’ rule more difficult to apply.

Also, examiners, auditors, and

compliance officers likely would

encounter difficulties determining

compliance with suitability

requirements if the measure for an

institutional customer varies, as some

commenters suggested, depending on

the type of entity and security involved.

The agencies believe that some

commenters may have misinterpreted

the significance of the tests for

determining when an investor is an

‘‘institutional customer.’’ All customers,

whether institutional or not, are covered

by the suitability rule. In all cases, a

bank must have reasonable grounds for

believing that a recommendation is

suitable based on the facts, if any,

disclosed by a customer concerning the

customer’s other security holdings and

financial situation and needs. Moreover,

in all cases, a bank must make a

determination based on the facts of a

particular situation whether it has

fulfilled its suitability obligation. The

thresholds identified in the regulation

and interpretation are provided solely

for the purpose of assisting a bank in

identifying the type of information that

may be relevant in deciding if the

suitability obligation is met in a given

case. For all entities other than natural

persons (but particularly for entities

with at least $10 million invested in

securities in the aggregate in its

portfolio and/or under management), a

bank should consider the factors

identified in the suitability

interpretation in deciding whether a

customer is capable of evaluating

investment risk independently and

whether the customer is exercising

independent judgement in evaluating a

bank’s recommendation. For entities

(including natural persons) with less

than $50 million in total assets, a bank

is required to make reasonable efforts to

obtain the additional information listed

in the section captioned ‘‘Customer

information’’ (12 CFR 13.5, 208.25(e),

and 368.5, respectively). This

information will be in addition to

whatever other information the bank

obtains in its effort to determine

whether it has met its suitability

obligation.

Issue 8: Other Suggestions

One commenter stated that the factors

listed in the suitability interpretation

concerning a customer’s ability to

evaluate risk are reasonable but do not

require banks to provide information the

customer needs in order to make an

informed investment decision. This

commenter suggested that the

interpretation should require banks to

provide certain types of transactionspecific information, such as valuation

information, an instrument’s behavior

under a stress test, and the types of risks

incurred.

The agencies agree that this

information may be useful to a customer

in many cases. However, a

comparatively unsophisticated customer

likely will rely on the bank to evaluate

this information before making a

recommendation, while a more

sophisticated customer will, in many

cases, request this information from the

bank or obtain this information on its

own. Accordingly, the agencies have

decided not to require the information

suggested by the commenter.

This commenter also identified what

it believes are shortcomings in each of

the considerations listed in the

suitability interpretation. Many of the

shortcomings cited focus on the

inapplicability or inappropriateness of a

certain factor in a given set of

circumstances. The agencies

acknowledge that not all of the factors

identified will be helpful in every case.

However, the interpretation is not

presented as a checklist of required

information. The factors listed neither

create nor reduce a bank’s suitability

obligation. Their relevance will vary,

depending on the circumstances of a

given situation. The agencies believe

that the factors will be helpful in

assisting a bank’s determination of

whether it has met its suitability

obligation. Therefore, the agencies are

adopting the suitability interpretation as

proposed, making only the

modifications to the proposed

interpretation that are necessary to

conform the agencies’ suitability

interpretation to that of the NASD.

Two commenters requested that the

agencies clarify that the final rules do

not apply to institutions that are subject

to NASD jurisdiction. The agencies

recognize that many banks conduct a

significant portion of their securities

activities through subsidiaries or

affiliates that are registered brokerdealers. The agencies confirm that

securities activities conducted in

registered broker-dealers that are NASD

members are subject to the NASD rules

and will not be subject to the agencies’

final rules.

Another commenter requested that

the agencies add a cross-reference in the

final rules to the definition of

‘‘government securities’’ used in the

Securities Exchange Act (15 U.S.C.

78c(a)(42)) in order to assist bankers

working with the rules. The agencies

agree that a reference to this definition

would be helpful, and have amended

the final rules accordingly.

Finally, one commenter asserted that

the Regulatory Flexibility Act

certification contained in the proposal is

flawed because it fails to focus on the

300 domestic banks that are covered by

the proposal.1 The agencies note that

they did focus on these banks in

determining the impact that the rules

would have on small entities. See 61 FR

18472 (‘‘As an initial matter, the

proposed rule would apply only to

those banks that have given notice or are

required to give notice that they are

government securities brokers or dealers

under section 15C of the Securities

Exchange Act of 1934 (15 U.S.C. 78o–5)

and applicable Treasury rules under

section 15C (17 CFR 400.1(d) and 401),

including approximately 300 domestic

banks and branches of foreign banks.’’).

The Regulatory Flexibility Act

certification in these final rules also

focuses on these banks as the

appropriate pool to consider when

evaluating the rules’ impact on small

entities. See discussion of the

Regulatory Flexibility Act that follows.

Regulatory Flexibility Act

Under section 605(b) of the

Regulatory Flexibility Act (RFA) (5

U.S.C. 605(b)), the regulatory flexibility

analysis otherwise required under

section 604 of the RFA (5 U.S.C. 604) is

not required if the head of the agency

certifies that the rule will not have a

significant economic impact on a

substantial number of small entities and

the agency publishes such certification

and a statement providing the factual

basis for such certification in the

Federal Register along with the final

rule.

Pursuant to section 605(b) of the RFA,

the OCC, Board, and the FDIC each

individually certifies that these final

rules will not have a significant

economic impact on a substantial

number of small entities. As noted in

the proposal and in the preamble to the

final rules, the rules will apply only to

those banks that have given notice or are

required to give notice that they are

government securities brokers or dealers

under section 15C of the Securities

Exchange Act of 1934 (15 U.S.C. 78o–5)

and applicable Treasury rules under

section 15C (17 CFR 400.1(d) and 401).
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13283

Most small banking institutions are not

required to give notice under section

15C, as Treasury rules provide

exemptions for financial institutions

that engage in fewer than 500

government securities brokerage

transactions per year and for financial

institutions with government securities

dealing activities limited to sales and

purchases in a fiduciary capacity. See

17 CFR 401.3 and 401.4. Other

exemptions from the notice

requirements also are available. See 17

CFR Part 401. Additionally, the agencies

note that many banks conduct a

significant portion of their securities

activities through subsidiaries or

affiliates that are registered brokerdealers. Securities activities conducted

in registered broker-dealers that are

NASD members are subject to the NASD

Rules and would not be subject to the

agencies’ final rules. As a consequence,

currently there are only approximately

160 banks that are registered as a

government securities broker-dealer. Of

these, only 7 are ‘‘small entities’’ for

purposes of the Regulatory Flexibility

Act. See 13 C.F.R. 121.601.

Paperwork Reduction Act

In accordance with section 3506 of

the Paperwork Reduction Act of 1995

(44 U.S.C. 3506; see also 5 CFR 1320

Appendix a.1), the agencies have

reviewed the final rules and have

determined that no collections of

information pursuant to the Paperwork

Reduction Act are contained in the

rules.

OCC Executive Order 12866 Statement

The Office of Management and Budget

has concurred with the OCC’s

determination that these final rules are

not a significant regulatory action under

Executive Order 12866.

OCC Unfunded Mandates Act of 1995

Statement

Section 202 of the Unfunded

Mandates Reform Act of 1995, Public

Law 104–4 (Unfunded Mandates Act),

requires that the agency prepare a

budgetary impact statement before

promulgating a rule that includes a

Federal mandate that may result in the

expenditure by State, local, and tribal

governments, in the aggregate, or by the

private sector, of $100 million or more

in any one year. If a budgetary impact

statement is required, section 205 of the

Unfunded Mandates Act also requires

the agency to identify and consider a

reasonable number of regulatory

alternatives before promulgating a rule.

As discussed in the preamble, the final

rules set forth sales practice

responsibilities of banks that are

government securities brokers or

dealers. The OCC has determined that

the final rules will not result in

expenditures by State, local, or tribal

governments or by the private sector of

more than $100 million. Accordingly,

the OCC has not prepared a budgetary

impact statement or addressed

specifically the regulatory alternatives

considered.

Small Business Regulatory Enforcement

Fairness Act

The Small Business Regulatory

Enforcement Fairness Act of 1996 (Pub.

L. 104–121, 104th Cong., 2d Sess.

(1996)) provides generally for agencies

to report rules to Congress and for

Congress to review the rules. The

reporting requirement is triggered in

instances where the agency in question

issues a final rule as defined by the

Administrative Procedure Act at 5

U.S.C. 551. The agencies will file the

appropriate reports pursuant to the

statute concerning their final rules.

The Office of Management and Budget

has determined that these final rules do

not constitute ‘‘major’’ rules as defined

by the statute.

List of Subjects

12 CFR Part 13

Banks, banking, Government

securities, National banks, Securities

12 CFR Part 208

Accounting, Agriculture, Banks,

banking, Confidential business

information, Crime, Currency, Federal

Reserve System, Flood insurance,

Mortgages, Reporting and recordkeeping

requirements, Securities.

12 CFR Part 211

Exports, Federal Reserve System,

Foreign banking, Holding companies,

Investments, Reporting and

recordkeeping requirements.

12 CFR Part 368

Banks, banking, Securities.

Office of the Comptroller of the

Currency

12 CFR CHAPTER I

Authority and Issuance

For the reasons set out in the

preamble, a new part 13 is added to

chapter I of title 12 of the Code of

Federal Regulations to read as follows:

PART 13—GOVERNMENT SECURITIES

SALES PRACTICES

Sec.

13.1 Scope.

13.2 Definitions.

13.3 Business conduct.

13.4 Recommendations to customers.

13.5 Customer information.

Interpretations

13.100 Obligations concerning institutional

customers.

Authority: 12 U.S.C. 1 et seq., and 93a; 15

U.S.C. 78o–5.

§ 13.1 Scope.

This part applies to national banks

that have filed notice as, or are required

to file notice as, government securities

brokers or dealers pursuant to section

15C of the Securities Exchange Act (15

U.S.C. 78o–5) and Department of the

Treasury rules under section 15C (17

CFR 400.1(d) and part 401).

§ 13.2 Definitions.

(a) Bank that is a government

securities broker or dealer means a

national bank that has filed notice, or is

required to file notice, as a government

securities broker or dealer pursuant to

section 15C of the Securities Exchange

Act (15 U.S.C. 78o–5) and Department

of the Treasury rules under section 15C

(17 CFR 400.1(d) and part 401).

(b) Customer does not include a

broker or dealer or a government

securities broker or dealer.

(c) Government security has the same

meaning as this term has in section

3(a)(42) of the Securities Exchange Act

of 1934 (15 U.S.C. 78c(a)(42)).

(d) Non-institutional customer means

any customer other than:

(1) A bank, savings association,

insurance company, or registered

investment company;

(2) An investment adviser registered

under section 203 of the Investment

Advisers Act of 1940 (15 U.S.C. 80b–3);

or

(3) Any entity (whether a natural

person, corporation, partnership, trust,

or otherwise) with total assets of at least

$50 million.

§ 13.3 Business conduct.

A bank that is a government securities

broker or dealer shall observe high

standards of commercial honor and just

and equitable principles of trade in the

conduct of its business as a government

securities broker or dealer.

§ 13.4 Recommendations to customers.

In recommending to a customer the

purchase, sale or exchange of a

government security, a bank that is a

government securities broker or dealer

shall have reasonable grounds for

believing that the recommendation is

suitable for the customer upon the basis

of the facts, if any, disclosed by the

customer as to the customer’s other

security holdings and as to the
13284 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

1The interpretation in this section does not

address the obligation related to suitability that

requires that a bank have ‘‘* * * a ‘reasonable

basis’ to believe that the recommendation could be

suitable for at least some customers.’’ In the Matter

of the Application of F.J. Kaufman and Company

of Virginia and Frederick J. Kaufman, Jr., 50 SEC

164 (1989). 2See footnote 1 in paragraph (d) of this section.

customer’s financial situation and

needs.

§ 13.5 Customer information.

Prior to the execution of a transaction

recommended to a non-institutional

customer, a bank that is a government

securities broker or dealer shall make

reasonable efforts to obtain information

concerning:

(a) The customer’s financial status;

(b) The customer’s tax status;

(c) The customer’s investment

objectives; and

(d) Such other information used or

considered to be reasonable by the bank

in making recommendations to the

customer.

Interpretations

§ 13.100 Obligations concerning

institutional customers.

(a) As a result of broadened authority

provided by the Government Securities

Act Amendments of 1993 (15 U.S.C.

78o–3 and 78o–5), the OCC is adopting

sales practice rules for the government

securities market, a market with a

particularly broad institutional

component. Accordingly, the OCC

believes it is appropriate to provide

further guidance to banks on their

suitability obligations when making

recommendations to institutional

customers.

(b) The OCC’s suitability rule (§ 13.4)

is fundamental to fair dealing and is

intended to promote ethical sales

practices and high standards of

professional conduct. Banks’

responsibilities include having a

reasonable basis for recommending a

particular security or strategy, as well as

having reasonable grounds for believing

the recommendation is suitable for the

customer to whom it is made. Banks are

expected to meet the same high

standards of competence,

professionalism, and good faith

regardless of the financial circumstances

of the customer.

(c) In recommending to a customer

the purchase, sale, or exchange of any

government security, the bank shall

have reasonable grounds for believing

that the recommendation is suitable for

the customer upon the basis of the facts,

if any, disclosed by the customer as to

the customer’s other security holdings

and financial situation and needs.

(d) The interpretation in this section

concerns only the manner in which a

bank determines that a recommendation

is suitable for a particular institutional

customer. The manner in which a bank

fulfills this suitability obligation will

vary, depending on the nature of the

customer and the specific transaction.

Accordingly, the interpretation in this

section deals only with guidance

regarding how a bank may fulfill

customer-specific suitability obligations

under § 13.4.1

(e) While it is difficult to define in

advance the scope of a bank’s suitability

obligation with respect to a specific

institutional customer transaction

recommended by a bank, the OCC has

identified certain factors that may be

relevant when considering compliance

with § 13.4. These factors are not

intended to be requirements or the only

factors to be considered but are offered

merely as guidance in determining the

scope of a bank’s suitability obligations.

(f) The two most important

considerations in determining the scope

of a bank’s suitability obligations in

making recommendations to an

institutional customer are the

customer’s capability to evaluate

investment risk independently and the

extent to which the customer is

exercising independent judgement in

evaluating a bank’s recommendation. A

bank must determine, based on the

information available to it, the

customer’s capability to evaluate

investment risk. In some cases, the bank

may conclude that the customer is not

capable of making independent

investment decisions in general. In

other cases, the institutional customer

may have general capability, but may

not be able to understand a particular

type of instrument or its risk. This is

more likely to arise with relatively new

types of instruments, or those with

significantly different risk or volatility

characteristics than other investments

generally made by the institution. If a

customer is either generally not capable

of evaluating investment risk or lacks

sufficient capability to evaluate the

particular product, the scope of a bank’s

customer-specific obligations under

§ 13.4 would not be diminished by the

fact that the bank was dealing with an

institutional customer. On the other

hand, the fact that a customer initially

needed help understanding a potential

investment need not necessarily imply

that the customer did not ultimately

develop an understanding and make an

independent investment decision.

(g) A bank may conclude that a

customer is exercising independent

judgement if the customer’s investment

decision will be based on its own

independent assessment of the

opportunities and risks presented by a

potential investment, market factors and

other investment considerations. Where

the bank has reasonable grounds for

concluding that the institutional

customer is making independent

investment decisions and is capable of

independently evaluating investment

risk, then a bank’s obligations under

§ 13.4 for a particular customer are

fulfilled.2 Where a customer has

delegated decision-making authority to

an agent, such as an investment advisor

or a bank trust department, the

interpretation in this section shall be

applied to the agent.

(h) A determination of capability to

evaluate investment risk independently

will depend on an examination of the

customer’s capability to make its own

investment decisions, including the

resources available to the customer to

make informed decisions. Relevant

considerations could include:

(1) The use of one or more

consultants, investment advisers, or

bank trust departments;

(2) The general level of experience of

the institutional customer in financial

markets and specific experience with

the type of instruments under

consideration;

(3) The customer’s ability to

understand the economic features of the

security involved;

(4) The customer’s ability to

independently evaluate how market

developments would affect the security;

and

(5) The complexity of the security or

securities involved.

(i) A determination that a customer is

making independent investment

decisions will depend on the nature of

the relationship that exists between the

bank and the customer.

Relevant considerations could

include:

(1) Any written or oral understanding

that exists between the bank and the

customer regarding the nature of the

relationship between the bank and the

customer and the services to be

rendered by the bank;

(2) The presence or absence of a

pattern of acceptance of the bank’s

recommendations;

(3) The use by the customer of ideas,

suggestions, market views and

information obtained from other

government securities brokers or dealers

or market professionals, particularly

those relating to the same type of

securities; and

(4) The extent to which the bank has

received from the customer current

comprehensive portfolio information in
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13285

1The interpretation in this section does not

address the obligation related to suitability that

requires that a bank have ‘‘* * * a ‘reasonable

basis’ to believe that the recommendation could be

suitable for at least some customers.’’ In the Matter

of the Application of F.J. Kaufman and Company

Continued

connection with discussing

recommended transactions or has not

been provided important information

regarding its portfolio or investment

objectives.

(j) Banks are reminded that these

factors are merely guidelines that will

be utilized to determine whether a bank

has fulfilled its suitability obligation

with respect to a specific institutional

customer transaction and that the

inclusion or absence of any of these

factors is not dispositive of the

determination of suitability. Such a

determination can only be made on a

case-by-case basis taking into

consideration all the facts and

circumstances of a particular bank/

customer relationship, assessed in the

context of a particular transaction.

(k) For purposes of the interpretation

in this section, an institutional customer

shall be any entity other than a natural

person. In determining the applicability

of the interpretation in this section to an

institutional customer, the OCC will

consider the dollar value of the

securities that the institutional customer

has in its portfolio and/or under

management. While the interpretation

in this section is potentially applicable

to any institutional customer, the

guidance contained in this section is

more appropriately applied to an

institutional customer with at least $10

million invested in securities in the

aggregate in its portfolio and/or under

management.

Dated: February 18, 1997.

Eugene A. Ludwig,

Comptroller of the Currency.

Federal Reserve System

12 CFR CHAPTER II

Authority and Issuance

For the reasons set forth in the joint

preamble, parts 208 and 211 of chapter

II of title 12 of the Code of Federal

Regulations are amended as follows:

PART 208—MEMBERSHIP OF STATE

BANKING INSTITUTIONS IN THE

FEDERAL RESERVE SYSTEM

(REGULATION H)

1. The authority citation for Part 208

is revised to read as follows:

Authority: 12 U.S.C. 36, 248(a), 248(c),

321–338a, 371d, 461, 481–486, 601, 611,

1814, 1823(j), 1828(o), 1831o, 1831p-1, 3105,

3310, 3331–3351 and 3906–3909; 15 U.S.C.

78b, 781(b), 781(g), 781(i), 78o-4(c)(5), 78o-5,

78q, 78q-1, and 78w: 31 U.S.C. 5318; 42

U.S.C. 4012a, 4104a, 4104b, 4106, and 4128.

2. A new § 208.25 is added to subpart

A to read as follows:

§ 208.25 Government securities sales

practices.

(a) Scope. This subpart is applicable

to state member banks that have filed

notice as, or are required to file notice

as, government securities brokers or

dealers pursuant to section 15C of the

Securities Exchange Act (15 U.S.C. 78o5) and Department of the Treasury rules

under section 15C (17 CFR 400.1(d) and

part 401).

(b) Definitions—(1) Bank that is a

government securities broker or dealer

means a state member bank that has

filed notice, or is required to file notice,

as a government securities broker or

dealer pursuant to section 15C of the

Securities Exchange Act (15 U.S.C. 78o5) and Department of the Treasury rules

under section 15C (17 CFR 400.1(d) and

part 401).

(2) Customer does not include a

broker or dealer or a government

securities broker or dealer.

(3) Government security has the same

meaning as this term has in section

3(a)(42) of the Securities Exchange Act

of 1934 (15 U.S.C. 78c(a)(42)).

(4) Non-institutional customer means

any customer other than:

(i) A bank, savings association,

insurance company, or registered

investment company;

(ii) An investment adviser registered

under section 203 of the Investment

Advisers Act of 1940 (15 U.S.C. 80b-3);

or

(iii) Any entity (whether a natural

person, corporation, partnership, trust,

or otherwise) with total assets of at least

$50 million.

(c) Business conduct. A bank that is

a government securities broker or dealer

shall observe high standards of

commercial honor and just and

equitable principles of trade in the

conduct of its business as a government

securities broker or dealer.

(d) Recommendations to customers.

In recommending to a customer the

purchase, sale or exchange of a

government security, a bank that is a

government securities broker or dealer

shall have reasonable grounds for

believing that the recommendation is

suitable for the customer upon the basis

of the facts, if any, disclosed by the

customer as to the customer’s other

security holdings and as to the

customer’s financial situation and

needs.

(e) Customer information. Prior to the

execution of a transaction recommended

to a non-institutional customer, a bank

that is a government securities broker or

dealer shall make reasonable efforts to

obtain information concerning:

(1) The customer’s financial status;

(2) The customer’s tax status;

(3) The customer’s investment

objectives; and

(4) Such other information used or

considered to be reasonable by the bank

in making recommendations to the

customer.

3. A new § 208.129 is added to

subpart B to read as follows:

§ 208.129 Obligations concerning

institutional customers.

(a) As a result of broadened authority

provided by the Government Securities

Act Amendments of 1993 (15 U.S.C.

78o-3 and 78o-5), the Board is adopting

sales practice rules for the government

securities market, a market with a

particularly broad institutional

component. Accordingly, the Board

believes it is appropriate to provide

further guidance to banks on their

suitability obligations when making

recommendations to institutional

customers.

(b) The Board’s Suitability Rule,

§ 208.25(b), is fundamental to fair

dealing and is intended to promote

ethical sales practices and high

standards of professional conduct.

Banks’’ responsibilities include having a

reasonable basis for recommending a

particular security or strategy, as well as

having reasonable grounds for believing

the recommendation is suitable for the

customer to whom it is made. Banks are

expected to meet the same high

standards of competence,

professionalism, and good faith

regardless of the financial circumstances

of the customer.

(c) In recommending to a customer

the purchase, sale, or exchange of any

government security, the bank shall

have reasonable grounds for believing

that the recommendation is suitable for

the customer upon the basis of the facts,

if any, disclosed by the customer as to

the customer’s other security holdings

and financial situation and needs.

(d) The interpretation in this section

concerns only the manner in which a

bank determines that a recommendation

is suitable for a particular institutional

customer. The manner in which a bank

fulfills this suitability obligation will

vary, depending on the nature of the

customer and the specific transaction.

Accordingly, the interpretation in this

section deals only with guidance

regarding how a bank may fulfill

customer-specific suitability obligations

under § 208.25(d).1
13286 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

of Virginia and Frederick J. Kaufman, Jr., 50 SEC

164 (1989). 2See footnote 1 in paragraph (d) of this section.

(e) While it is difficult to define in

advance the scope of a bank’s suitability

obligation with respect to a specific

institutional customer transaction

recommended by a bank, the Board has

identified certain factors that may be

relevant when considering compliance

with § 208.25(d). These factors are not

intended to be requirements or the only

factors to be considered but are offered

merely as guidance in determining the

scope of a bank’s suitability obligations.

(f) The two most important

considerations in determining the scope

of a bank’s suitability obligations in

making recommendations to an

institutional customer are the

customer’s capability to evaluate

investment risk independently and the

extent to which the customer is

exercising independent judgement in

evaluating a bank’s recommendation. A

bank must determine, based on the

information available to it, the

customer’s capability to evaluate

investment risk. In some cases, the bank

may conclude that the customer is not

capable of making independent

investment decisions in general. In

other cases, the institutional customer

may have general capability, but may

not be able to understand a particular

type of instrument or its risk. This is

more likely to arise with relatively new

types of instruments, or those with

significantly different risk or volatility

characteristics than other investments

generally made by the institution. If a

customer is either generally not capable

of evaluating investment risk or lacks

sufficient capability to evaluate the

particular product, the scope of a bank’s

customer-specific obligations under

§ 208.25(d) would not be diminished by

the fact that the bank was dealing with

an institutional customer. On the other

hand, the fact that a customer initially

needed help understanding a potential

investment need not necessarily imply

that the customer did not ultimately

develop an understanding and make an

independent investment decision.

(g) A bank may conclude that a

customer is exercising independent

judgement if the customer’s investment

decision will be based on its own

independent assessment of the

opportunities and risks presented by a

potential investment, market factors and

other investment considerations. Where

the bank has reasonable grounds for

concluding that the institutional

customer is making independent

investment decisions and is capable of

independently evaluating investment

risk, then a bank’s obligations under

§ 208.25(d) for a particular customer are

fulfilled.2 Where a customer has

delegated decision-making authority to

an agent, such as an investment advisor

or a bank trust department, the

interpretation in this section shall be

applied to the agent.

(h) A determination of capability to

evaluate investment risk independently

will depend on an examination of the

customer’s capability to make its own

investment decisions, including the

resources available to the customer to

make informed decisions. Relevant

considerations could include:

(1) The use of one or more

consultants, investment advisers, or

bank trust departments;

(2) The general level of experience of

the institutional customer in financial

markets and specific experience with

the type of instruments under

consideration;

(3) The customer’s ability to

understand the economic features of the

security involved;

(4) The customer’s ability to

independently evaluate how market

developments would affect the security;

and

(5) The complexity of the security or

securities involved.

(i) A determination that a customer is

making independent investment

decisions will depend on the nature of

the relationship that exists between the

bank and the customer. Relevant

considerations could include:

(1) Any written or oral understanding

that exists between the bank and the

customer regarding the nature of the

relationship between the bank and the

customer and the services to be

rendered by the bank;

(2) The presence or absence of a

pattern of acceptance of the bank’s

recommendations;

(3) The use by the customer of ideas,

suggestions, market views and

information obtained from other

government securities brokers or dealers

or market professionals, particularly

those relating to the same type of

securities; and

(4) The extent to which the bank has

received from the customer current

comprehensive portfolio information in

connection with discussing

recommended transactions or has not

been provided important information

regarding its portfolio or investment

objectives.

(j) Banks are reminded that these

factors are merely guidelines that will

be utilized to determine whether a bank

has fulfilled its suitability obligation

with respect to a specific institutional

customer transaction and that the

inclusion or absence of any of these

factors is not dispositive of the

determination of suitability. Such a

determination can only be made on a

case-by-case basis taking into

consideration all the facts and

circumstances of a particular bank/

customer relationship, assessed in the

context of a particular transaction.

(k) For purposes of the interpretation

in this section, an institutional customer

shall be any entity other than a natural

person. In determining the applicability

of the interpretation in this section to an

institutional customer, the Board will

consider the dollar value of the

securities that the institutional customer

has in its portfolio and/or under

management. While the interpretation

in this section is potentially applicable

to any institutional customer, the

guidance contained in this section is

more appropriately applied to an

institutional customer with at least $10

million invested in securities in the

aggregate in its portfolio and/or under

management.

PART 211—INTERNATIONAL

BANKING OPERATIONS

(REGULATION K)

1. The authority citation for Part 211

is revised to read as follows:

Authority: 12 U.S.C. 221 et seq., 1818,

1841 et seq., 3101 et seq., 3109 et seq.; 15

U.S.C. 78o–5.

2. Section 211.24 is amended by

revising the section heading and adding

a new paragraph (h) to read as follows:

§ 211.24 Approval of offices of foreign

banks; procedures for applications;

standards for approval; representativeoffice activities and standards for approval;

preservation of existing authority; reports

of crimes and suspected crimes;

government securities sales practices.

* * * * *

(h) Government securities sales

practices. An uninsured state-licensed

branch or agency of a foreign bank that

is required to give notice to the Board

under section 15C of the Securities

Exchange Act of 1934 (15 U.S.C. 78o–5)

and the Department of the Treasury

rules under section 15C (17 CFR

400.1(d) and part 401) shall be subject

to the provisions of 12 CFR 208.25 to

the same extent as a state member bank

that is required to give such notice.
Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations 13287

1 The interpretation in this section does not

address the obligation related to suitability that

requires that a bank have ‘‘ * * * a ‘reasonable

basis’ to believe that the recommendation could be

suitable for at least some customers.’’ In the Matter

of the Application of F.J. Kaufman and Company

of Virginia and Frederick J. Kaufman, Jr., 50 SEC

164 (1989).

By order of the Board of Governors of the

Federal Reserve Board, March 11, 1997.

Jennifer J. Johnson,

Deputy Secretary of the Board.

Federal Deposit Insurance Corporation

12 CFR CHAPTER III

Authority and Issuance

For the reasons set out in the

preamble, a new part 368 is added to

chapter III of title 12 of the Code of

Federal Regulations to read as follows:

PART 368—GOVERNMENT

SECURITIES SALES PRACTICES

Sec.

368.1 Scope.

368.2 Definitions.

368.3 Business conduct.

368.4 Recommendations to customers.

368.5 Customer information.

368.100 Obligations concerning

institutional customers.

Authority: 15 U.S.C. 78o–5.

§ 368.1 Scope.

This part is applicable to state

nonmember banks and insured state

branches of foreign banks that have filed

notice as, or are required to file notice

as, government securities brokers or

dealers pursuant to section 15C of the

Securities Exchange Act (15 U.S.C. 78o–

5) and Department of the Treasury rules

under section 15C (17 CFR 400.1(d) and

part 401).

§ 368.2 Definitions.

(a) Bank that is a government

securities broker or dealer means a state

nonmember bank or an insured state

branch of a foreign bank that has filed

notice, or is required to file notice, as a

government securities broker or dealer

pursuant to section 15C of the Securities

Exchange Act (15 U.S.C. 78o–5) and

Department of the Treasury rules under

section 15C (17 CFR 400.1(d) and part

401).

(b) Customer does not include a

broker or dealer or a government

securities broker or dealer.

(c) Government security has the same

meaning as this term has in section

3(a)(42) of the Securities Exchange Act

of 1934 (15 U.S.C. 78c(a)(42)).

(d) Non-institutional customer means

any customer other than:

(1) A bank, savings association,

insurance company, or registered

investment company;

(2) An investment adviser registered

under section 203 of the Investment

Advisers Act of 1940 (15 U.S.C. 80b–3);

or

(3) Any entity (whether a natural

person, corporation, partnership, trust,

or otherwise) with total assets of at least

$50 million.

§ 368.3 Business conduct.

A bank that is a government securities

broker or dealer shall observe high

standards of commercial honor and just

and equitable principles of trade in the

conduct of its business as a government

securities broker or dealer.

§ 368.4 Recommendations to customers.

In recommending to a customer the

purchase, sale or exchange of a

government security, a bank that is a

government securities broker or dealer

shall have reasonable grounds for

believing that the recommendation is

suitable for the customer upon the basis

of the facts, if any, disclosed by the

customer as to the customer’s other

security holdings and as to the

customer’s financial situation and

needs.

§ 368.5 Customer information.

Prior to the execution of a transaction

recommended to a non-institutional

customer, a bank that is a government

securities broker or dealer shall make

reasonable efforts to obtain information

concerning:

(a) The customer’s financial status;

(b) The customer’s tax status;

(c) The customer’s investment

objectives; and

(d) Such other information used or

considered to be reasonable by such

bank in making recommendations to the

customer.

§ 368.100 Obligations concerning

institutional customers.

(a) As a result of broadened authority

provided by the Government Securities

Act Amendments of 1993 (15 U.S.C.

78o–3 and 78o–5), the FDIC is adopting

sales practice rules for the government

securities market, a market with a

particularly broad institutional

component. Accordingly, the FDIC

believes it is appropriate to provide

further guidance to banks on their

suitability obligations when making

recommendations to institutional

customers.

(b) The FDIC’s suitability rule

(§ 368.4) is fundamental to fair dealing

and is intended to promote ethical sales

practices and high standards of

professional conduct. Banks’

responsibilities include having a

reasonable basis for recommending a

particular security or strategy, as well as

having reasonable grounds for believing

the recommendation is suitable for the

customer to whom it is made. Banks are

expected to meet the same high

standards of competence,

professionalism, and good faith

regardless of the financial circumstances

of the customer.

(c) In recommending to a customer

the purchase, sale, or exchange of any

government security, the bank shall

have reasonable grounds for believing

that the recommendation is suitable for

the customer upon the basis of the facts,

if any, disclosed by the customer as to

the customer’s other security holdings

and financial situation and needs.

(d) The interpretation in this section

concerns only the manner in which a

bank determines that a recommendation

is suitable for a particular institutional

customer. The manner in which a bank

fulfills this suitability obligation will

vary, depending on the nature of the

customer and the specific transaction.

Accordingly, the interpretation in this

section deals only with guidance

regarding how a bank may fulfill

customer-specific suitability obligations

under § 368.4. 1

(e) While it is difficult to define in

advance the scope of a bank’s suitability

obligation with respect to a specific

institutional customer transaction

recommended by a bank, the FDIC has

identified certain factors that may be

relevant when considering compliance

with § 368.4. These factors are not

intended to be requirements or the only

factors to be considered but are offered

merely as guidance in determining the

scope of a bank’s suitability obligations.

(f) The two most important

considerations in determining the scope

of a bank’s suitability obligations in

making recommendations to an

institutional customer are the

customer’s capability to evaluate

investment risk independently and the

extent to which the customer is

exercising independent judgement in

evaluating a bank’s recommendation. A

bank must determine, based on the

information available to it, the

customer’s capability to evaluate

investment risk. In some cases, the bank

may conclude that the customer is not

capable of making independent

investment decisions in general. In

other cases, the institutional customer

may have general capability, but may

not be able to understand a particular

type of instrument or its risk. This is

more likely to arise with relatively new

types of instruments, or those with

significantly different risk or volatility

characteristics than other investments

generally made by the institution. If a

customer is either generally not capable
13288 Federal Register / Vol. 62, No. 53 / Wednesday, March 19, 1997 / Rules and Regulations

2 See footnote 1 in paragraph (d) of this section.

of evaluating investment risk or lacks

sufficient capability to evaluate the

particular product, the scope of a bank’s

customer-specific obligations under

§ 368.4 would not be diminished by the

fact that the bank was dealing with an

institutional customer. On the other

hand, the fact that a customer initially

needed help understanding a potential

investment need not necessarily imply

that the customer did not ultimately

develop an understanding and make an

independent investment decision.

(g) A bank may conclude that a

customer is exercising independent

judgement if the customer’s investment

decision will be based on its own

independent assessment of the

opportunities and risks presented by a

potential investment, market factors and

other investment considerations. Where

the bank has reasonable grounds for

concluding that the institutional

customer is making independent

investment decisions and is capable of

independently evaluating investment

risk, then a bank’s obligations under

§ 368.4 for a particular customer are

fulfilled. 2 Where a customer has

delegated decision-making authority to

an agent, such as an investment advisor

or a bank trust department, the

interpretation in this section shall be

applied to the agent.

(h) A determination of capability to

evaluate investment risk independently

will depend on an examination of the

customer’s capability to make its own

investment decisions, including the

resources available to the customer to

make informed decisions. Relevant

considerations could include:

(1) The use of one or more

consultants, investment advisers, or

bank trust departments;

(2) The general level of experience of

the institutional customer in financial

markets and specific experience with

the type of instruments under

consideration;

(3) The customer’s ability to

understand the economic features of the

security involved;

(4) The customer’s ability to

independently evaluate how market

developments would affect the security;

and

(5) The complexity of the security or

securities involved.

(i) A determination that a customer is

making independent investment

decisions will depend on the nature of

the relationship that exists between the

bank and the customer. Relevant

considerations could include:

(1) Any written or oral understanding

that exists between the bank and the

customer regarding the nature of the

relationship between the bank and the

customer and the services to be

rendered by the bank;

(2) The presence or absence of a

pattern of acceptance of the bank’s

recommendations;

(3) The use by the customer of ideas,

suggestions, market views and

information obtained from other

government securities brokers or dealers

or market professionals, particularly

those relating to the same type of

securities; and

(4) The extent to which the bank has

received from the customer current

comprehensive portfolio information in

connection with discussing

recommended transactions or has not

been provided important information

regarding its portfolio or investment

objectives.

(j) Banks are reminded that these

factors are merely guidelines that will

be utilized to determine whether a bank

has fulfilled its suitability obligation

with respect to a specific institutional

customer transaction and that the

inclusion or absence of any of these

factors is not dispositive of the

determination of suitability. Such a

determination can only be made on a

case-by-case basis taking into

consideration all the facts and

circumstances of a particular bank/

customer relationship, assessed in the

context of a particular transaction.

(k) For purposes of the interpretation

in this section, an institutional customer

shall be any entity other than a natural

person. In determining the applicability

of the interpretation in this section to an

institutional customer, the FDIC will

consider the dollar value of the

securities that the institutional customer

has in its portfolio and/or under

management. While the interpretation

in this section is potentially applicable

to any institutional customer, the

guidance contained in this section is

more appropriately applied to an

institutional customer with at least $10

million invested in securities in the

aggregate in its portfolio and/or under

management.

By order of the Board of Directors, dated

at Washington, D.C., this 11th day of March,

1997.

Federal Deposit Insurance Corporation

Robert E. Feldman,

Deputy Executive Secretary.

[FR Doc. 97–6803 Filed 3–18–97; 8:45 am]

BILLING CODES: 4810–33–P, 6210–01–P, 6714–01–P