Background
A bank appealed the finding in its most recent
report of examination that it violated 12 USC 78 by having an
investment broker serve as a director of the bank. The individual is
a "retail investment executive" for a national brokerage firm. As
such, he executes orders for the purchase and sale of securities on
a daily basis. His responsibilities, however, are not solely limited
to this function. The bank argues that the individual can serve as a
bank director because the brokerage firm does not meet the 10
percent rule test and, alternatively, the individual qualifies for
the "broker exception" to 12 USC 78.
Discussion
According to 12 USC 78:
No officer, director, or employee of any
corporation or unincorporated association, no partner or employee of
any partnership, and no individual, primarily engaged in the issue,
flotation, underwriting, public sale, or distribution, at wholesale
or retail, or through syndicate participation, of stocks, bonds, or
other similar securities, shall serve the same time as an officer,
director, or an employee of any member bank except in limited
classes of cases in which the Board of Governors of the Federal
Reserve System may allow such service by general regulations when in
the judgment of the said Board it would not unduly influence the
investment policies of such member bank or the advice it gives its
customers regarding investments.
The Supreme Court interpreted the phrase
"primarily engaged" in a 1947 case. In its decision, the Court held
that an activity "may be primary.if it is substantial," even if it
is not the largest or most important activity (Board of Governors of
the Federal Reserve System v. Agnew, 329 U.S. 441, 446-47, 1947).
The Federal Reserve Board (FRB) has further
defined "primarily engaged" through orders and interpretive
opinions. In 1958, the FRB published a list of nine factors it would
consider in determining whether an entity was primarily engaged in
ineligible securities activities. These factors included the dollar
volume, gross revenue, percentage volume, and percentage revenue
form ineligible securities activities, the entity's market share in
performing these activities, and other factors such as whether the
entity had separate departments for these activities (1 Federal
Reserve Regulatory Service 3-895). A 1981 FRB staff opinion provided
a less complicated alternative test. Referred to as "the 10 percent
rule," this opinion stated the following:
The Board generally
has determined that a securities firm that receives 10 percent of
its gross income from [12 USC 78] business is "primarily engaged"
within the meaning of the statute (1 FRRS 3-939).
The term "ineligible securities activities" is
defined as follows:
.the Board is of the
opinion that when a firm is doing any significant amount of business
as a dealer or underwriter, then investments for the firm's own
account should be taken into consideration in determining whether
the firm is "primarily engaged" in the activities described in [12
U.S.C. 78]. The division into dealing for one's own account, and
dealing with customers, is a highly subjective one, and although a
particular firm or individual may be quite scrupulous in separating
the two, the opportunity necessarily exists for the kind of abuse at
which the statute is directed. The act is designed to prevent
situations from arising in which a bank director, officer, or
employee could influence the bank or its customers to invest in
securities in which his firm has an interest, regardless of whether
he, as an individual, is likely to do so (12 CFR 218.110; see also 1
FRRS 3-939).
Thus any 10 percent rule calculations should
include all of the brokerage firm's corporate securities principal
transactions ---which should cover both the brokerage firm's dealing
activities and its own investments.
The individual submitted a letter to the bank
which seems to support the bank's revenue argument by showing that
corporate underwriting generated less than 10 percent of the
brokerage firm's net income. However, the individual did not include
the principal transaction revenues generated by corporate securities
in his net revenue calculations. FRB interpretations include
underwriting, dealing, and investments for a firm's own account
---general principal transactions---in determining whether an entity
is "primarily engaged" in ineligible securities activities.
According to the five year financial summary in the brokerage firm's
1994 annual report, the combination of its corporate securities
"underwriting" fees and corporate securities 'principal transaction"
revenues accounted for more than 10 percent of its gross annual
income for each of the last five years (1994: 12.9 percent, 1993:
15.9 percent, 1992: 16.7 percent, 1991: 17.8 percent, and 1990: 12.3
percent). Consequently, the brokerage firm is "primarily engaged" in
ineligible securities activities.
The bank also presents the "brokers exception"
found in 12 CFR 218.1, n.1. This regulation states the following:
[a] broker who is engaged solely in executing orders for the
purchase and sale of securities on behalf of others in the open
market is not engaged in the business referred to in [12 USC 78].
There are two primary reasons why this exception
does not apply to the individual in this case. First, the
individual's brokerage firm duties "are not solely limited to"
broker activities. Second, even if the individual engaged solely in
executing orders for others, the broker exception would still not
allow him to serve as a bank director. The broker exception simply
states that an individual who engages solely in broker activities is
not an individual "engaged primarily" in ineligible securities
activities. This exception still leaves the prohibition against
employees of corporations and partnerships that do primarily engage
in ineligible activities---the situation here.
Conclusion
The ombudsman concluded that the individual is
prohibited from serving as a director of the bank so long as he
remains an employee of the brokerage firm. However, nothing in the
statute prohibits the individual from serving as an advisory
director to the bank pursuant to 12 CFR 7.4110 and 1 FFRS 3-936.1.
As an alternative, the bank may consider, if it desires, appointing
the individual as an advisory director of the bank.
APPEAL OF REFERRAL OF COMPLIANCE ISSUES
(First Quarter 1996)
Background
A bank appealed to the ombudsman for a review of
an OCC decision to refer examination findings to another regulatory
agency regarding certain customer transactions. In the course of
evaluating the bank's compliance systems, the examiners identified
several accounts raising compliance issues and these matters were
noted in the examination report. The OCC initially concluded a
referral was appropriate based upon these possible compliance
issues. The bank was already aware of a relevant pending
investigation by the other regulatory agency and was submitting
documents to that agency on an ongoing basis. The regulatory agency had
also previously submitted an access request to the OCC requesting
examination findings and related materials.
Bank management appealed the examination findings
for two reasons: (1) based on their view that a formal referral to
the other regulatory agency was unnecessary and inappropriate; and
(2) arguing that a referral would be inconsistent with OCC policy.
Bank management considered a referral to be unnecessary and
inappropriate because they contended the underlying transactions
were in compliance with applicable standards. The bank contended the
examiners never made a final determination that the transactions in
question were in fact noncomplying. Bank management also considered
a referral to be inconsistent with OCC's referral policy. The bank
contended that in the absence of a finding by the examiners that a
law was violated, a referral to another regulatory agency was not
appropriate.
Discussion
The OCC's examination policy in this compliance
area is first to assess whether systems are adequate. In order to
make this determination, examiners typically sample and review
transactions. If those files are incomplete, examiners customarily
request additional information from the bank. These procedures were
followed in this case. During the coursework of reviewing certain
files, the OCC examiners identified several files that raised
compliance issues. The examiners did not reach any definitive
conclusions concerning these transactions. These transactions were
noted in the examination report as raising compliance issues. Criticisms of the bank's
overall compliance systems were also noted more extensively in the
examination report.
Conclusion
The ombudsman decided that the supervisory office
should remove certain language from this examination report that
raises questions about compliance in individual transactions because
the examiners did not reach any final conclusions concerning those
accounts. The language in the examination report that criticizes the
bank's systems and controls will remain. Therefore, removal of the
language about individual transactions from the examination report
does not in any way undermine or lessen the examining team's
criticism of the bank's compliance practices. Documentation and
analysis of these criticisms will also remain in the work papers.
The ombudsman determined there is no reason to
formally refer the examination report to the other regulatory agency
because the OCC will provide it and any other relevant exam
information to that agency pursuant to its pending access request.
