Compensation tests start in six months. Fiduciaries still have questions about what they need to show the examiner to prove that they’re pushing out commission-based securities sales.

Bank examiners have started checking on trust companies to make sure that everyone can either demonstrate that they’re obeying Regulation R, even though the specifics still perplex industry veterans.

Regulation R mandates that non-SEC-regulated institutions “push out” or refer most securities sales—and the commissions they generate—to broker-dealers. Fiduciaries can get a pass if they can prove that no more than 30% of their revenue comes from commissions.

Because this is a new requirement, not all trust companies are sure they’ll have what it takes to convince the Office of the Comptroller of the Currency’s examiners that they’re exempt when compliance testing starts on January 1.

“We’re all still waiting on record-keeping guidance,” Sally Miller, who chairs the American Bankers Association’s banking law committee, told me.

“I understand it has been drafted, but with everything else going on right now in the regulatory world, review has been slow,” she added. “It just hasn’t been a top priority.”

Caught in the middle

On the surface, the rules are clear. A fiduciary can book up to 30% of its revenue (calculated on a two-year rolling basis) from trading fees that it earns in the course of exercising its duties. All other stock and mutual fund trading needs to be pushed out.

“You don’t want to make any mistakes on this one,” warns securities lawyer Melanie Fein, who wrote the Securities & Exchange Commission’s Reg R compliance manual.

Fein acknowledges that a lot of the confusion out there stems from the fact that trust companies—especially those with state charters—occupy a somewhat nebulous position on the national regulatory map.

While trust departments affiliated with FDIC-insured banks are clearly under the OCC eye, an independent trust company operating under state jurisdiction may normally consider itself aloof from the banking world.

Fein says that’s not really an issue here. State-chartered trust companies may not be OCC-regulated banking entities, but it’s the SEC they ultimately need to convince that they’re operating on the right side of the line. And all trust companies look alike as far as the securities regulators are concerned.

“The term ‘bank’ at the SEC includes the term ‘trust company,’” Fein told me. “What a Reg R exemption means is that you are exempt from their regulation. They are not really concerned with who regulates your other activities.”

This is the real danger of failing the compensation test, Fein says. A trust company that does too much commission-based business actually loses its exemption from SEC oversight.

“If it turns out you are not exempt, you would be operating as an unregistered broker-dealer and would be liable for your customers’ losses,” she explains.

Plenty of questions remain…

In theory, a bank can get around the 30% rule by making sure all employees maintain a strict “two-hat” separation between commission-based and relationship-based business. As long as a securities-licensed bank employee takes off the “bank” hat to trade, the bank can avoid from SEC oversight.

While this may look feasible on a superficial level, every securities lawyer I talked to warned me that keeping the hats separate is an operational and supervisory nightmare for banks and broker-dealers alike.

As a result, some compliance departments on both sides of the bank/broker divide take a more restrictive position than advisors might like. That’s their perogative, but it can be frustrating.

“Our broker-dealer takes the position that independent trust companies are not exempted under Reg R,” Jim Farmer, a wealth manager at First Bankers in Quincy, Illinois, told me. “They will pay commissions to the bank, but not the trust company. I understand the two-headed issue, but sometimes I still feel stuck.”

Most banks and trust companies will simply pass the business to a favored broker and collect a fee. Sally Miller at the ABA says most of the Reg R questions she gets revolve around how the examiners will look at these referral fees.

“This is the tougher nut to crack for some of the banks out there,” she told me. “Is this commission-based or relationship-based income? And what will the OCC think is fair?”

Red-flag referrals

Miller says there are a few practices out there that trust companies should avoid if they want to keep their Reg R exemption.

Referral compensation should not be tied to either the size of the account or trade at stake or the broker-dealer’s success in getting the business. Doing this raises the odds that a payment may actually be a commission in disguise, Miller told me.

These fees should also never be tied to any kind of incentive program. The rationale here is that pushing out securities business is supposed to be a sacrifice, not a business opportunity for trust companies to chase.

“Staying exempt under Reg R means proving that you’re primarily interested in lending, cash management, trust administration or other traditional banking activities,” Miller says. “If you tell your employees they’ll get a bonus for turning over prospects to broker-dealers, it doesn’t look good.”

Although the OCC has yet to issue concrete guidance, examiners have been actively working with banks and trust companies to make sure everything is going well. If a trust company still has any questions about what it will need to pass the test, there’s plenty of time to find out, Miller says.

Melanie Fein emphatically agrees.

“Confer with your regulator and clarify your status,” she told me. “Whether you’re FDIC-insured, state-chartered, OCC-regulated, go ahead and make the call. This is very definitely serious business.”

For follow-up, we suggest reading an excellent article on compliance, published by the Federal Reserve Bank of Philadelaphia, “Regulation R: Is Your Bank in Compliance?.”

Scott Martin, contributing editor, The Trust Advisor Blog, Jerry Cooper contributed to the reporting, Steven Maimes  contributed to the research and editing

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