1. Exceptions to the Regulation 2. Record Keeping 3. Confirmations 4. Settlement of Securities Transactions 5. Written Policies and Procedures 6. Officer/Employee Reporting of Personal Investment Transactions K. Compliance with SEC Requirements 1. Marketable Securities a. Acquisition Statements for Registered Equity Securities - SEC 13(d) and SEC 13(g) b. Reports of Equity Holdings - SEC 13F c. Section 16 Statements for 10 percent or More Holders of Registered Stocks 2. Restricted Equity Securities - SEC Rule 144 3. Electronic Submission of Forms and Notices A. Brokerage Placement The Board of Director or trust committee should approve policies regarding the selection and retention of securities dealers. The FDIC Supervisory Statement Policy Statement on Investment Securities and End-User Derivative Activities considers the selection of dealers, investment bankers, and brokers particularly important in effectively managing risks. Trust management should have sufficient knowledge about the securities firm and the personnel with whom they are conducting business. At a minimum, trust management should consider the following before selecting a securities firm:
B. Securities Trading Trust department investment policies and procedures should prohibit research analysts, traders and/or portfolio managers from trading for their own account through brokerage accounts maintained by the trust department. Examiners should verify that the trust department's accounts with brokerage firms are used only to effect transactions for trust accounts or approved outside clients. If the bank has not established policies or control procedures, the examiner should discuss the potential hazards with management, and recommend adoption of policies and procedures. The audit program should include procedures to detect misuse of brokerage accounts. In general, borrowing for the purpose of investment is an improper activity for a trustee, except when purchasing improved real estate. The bank as fiduciary should not maintain a margin account with a broker unless specifically authorized by the terms of the governing instrument and directed by a party having appropriate authority. Examiners should be alert for any involvement in speculative securities trading activities. Any speculative transaction ordinarily evidences contravention of "prudent man" doctrines. Churning is a term for excessive trading in an account for the purpose of generating and maximizing broker commissions and can occur in both discretionary and nondiscretionary accounts. The practice is illegal and is among the most common claims made against stockbrokers, investment advisers, and financial planners. In determining whether churning has occurred, consideration should be given to the following:
To be considered churning, the broker:
The broker's lack of or poor judgment does not demonstrate intent to defraud or reckless behavior. Furthermore, accounts with investment objectives of growth or speculation are likely to have more frequent transactions than accounts with investment objectives of long-term growth or income. Therefore, what may appear to be churning in accounts should be reviewed in light of the investment objectives of each account. For a more detailed discussion on broker selection, internet trading, and due diligence policies and practices, refer to A. Brokerage Placement. C. Brokerage Selection on Basis of Soft Dollars - SEC § 28(e)(1) Section 28(e) was added to the Securities Exchange Act of 1934 by the Securities Acts Amendments of 1975. This section provides "safe harbor" protection to the fiduciary exercising investment discretion, provided certain conditions are met. Under Section 28(e)(1), "No person . . . shall be deemed to have acted unlawfully or to have breached a fiduciary duty . . . solely by reason of his having caused the account to pay . . . an amount of commission . . . in excess of the amount of commission another . . . dealer would have charged . . . if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided . . . in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion." Section 28(e)(3) defines research and brokerage services. in order to qualify as research or brokerage services, the services provided must:
Note that transactions in futures or for transactions done on a principal basis are not covered by the safe harbor. Four requirements must generally be satisfied to obtain "safe harbor" protection under Section 28(e):
Section 28(e) is a "safe harbor" which affords "protection." It is not a regulation, and, therefore, cannot in itself be violated. Any "violations" connected with transactions not afforded the protections under Section 28(e), would be of the antifraud provisions of federal securities laws. Also, while not specifically addressed within Section 28(e), there exists a general fiduciary duty to seek "best execution." Best execution implies the best net price to the customer, together with accuracy and speed of execution. It is not intrinsically linked with, nor does it imply, the lowest brokerage commission. Trust institutions which engage in soft- dollar trading are required to disclose the research products and services it obtains to the trust accounts paying soft-dollar commissions. In an inspection report on soft-dollar practices released September 22, 1998, the SEC stated that Section 28(e) "does not shield a person who exercises investment discretion from, violations of antifraud provisions of federal securities laws arising from churning an account, failing to obtain the best price or best execution, or failing to make required disclosure." Regarding full disclosure, the report provided, "Disclosure is required whether the product or service acquired by the adviser using soft dollars is inside or outside the safe harbor. Advisers are required to disclose, among other things, the products and services through soft dollar arrangements, regardless of whether the safe harbor applies." The SEC has directed advisers that they ".need not list individually each product, item of research, or service received, but rather .state the types of products, research, or services obtained with enough specificity so that clients can understand what is being obtained." The SEC has also long taken the position that "mixed use items," or products and services that provide both research and non-research benefits (such as in-house computer networks used for other purposes in addition to research), should be allocated between soft dollars and hard-dollars. This requires institutions to allocate the costs associated with these products and to pay for the non-research portion with their own funds. Refer to subsection E.2.a., located in Section 8 for additional discussion of this topic. Refer to Securities and Exchange Act of 1934 Release No. 34-23170, "Section 28(e) and Soft Dollars", for a discussion of the scope of Section 28(e). D. Broker Selection on Basis of Deposits - SEC § 28(e)(2) The Justice Department has long viewed the allocation of brokerage business by banks based upon the volume of demand deposits maintained by a security dealer as reciprocity in violation of antitrust laws. Reciprocity means the use by a company of its power as the buyer of products or services to influence the sale of its own products or services. Section 28(e)(2) of the Securities Exchange Act of 1934 states "A person exercising investment discretion . . . shall make such disclosure of his policies and practices with respect to commissions that will be paid . . . at such times and in such manner, as the appropriate regulatory agency, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors." Although the Corporation does not require the disclosure of brokerage policies and practices, examiners should review this area to determine whether the bank is complying with its fiduciary duties in the placement of brokerage business. Consequently, the type and amount of deposit relationships maintained by brokerage firms used by trust departments should be ascertained. Examiners should evaluate whether reciprocity (as opposed to the quality of execution, research, cost, or other ancillary services), may have played a role in the selection of brokers. E. Best Execution The SEC and the courts have stressed the duty to obtain best execution. The term is usually defined as seeking the most favorable terms for a customer transaction reasonably available under the circumstances. Best execution does not require that the lowest possible commission be obtained and the SEC has not adopted regulations that require a trade to be executed within a set period of time. Trust management should consider various qualitative and quantitative factors when determining the quality of execution and should establish policy and procedures to evaluate and demonstrate that trades are made using the following criteria: The selection of broker/dealers should comply with the FDIC Supervisory Policy Statement on Investment Securities and End-User Derivative Activities. The points to consider in determining best execution should consist of research provided if any, best price, speed of execution, certainty of execution, access to initial public offerings, recordkeeping, and the commission rate or spread. These general criteria do not endorse or prohibit on-line transactions. The SEC has brought enforcement proceedings against investment advisors and those actions have been centered in transactions involving soft dollars, cross trade, affiliated trades, and advisors' failure to disclose execution practices. Failure to use best execution procedures, may violate the antifraud provisions under securities law. Trust investment officers can verify that a particular investment is registered with the SEC via the SEC's EDGAR system. The NASD can provide information on brokers and dealers, such as disciplinary information. States have securities regulators that can provide information and accept complaints for various causes, including but not limited to poor or inappropriate execution, and broker/dealer licensing status, and fraud. F. Securities Settlement Practices Settlement occurs when the transaction is completed by the exchange of securities and money between the buyer and seller. On settlement date, the buyer receives the securities in either book-entry or definitive (physical) form, and a change in ownership is recorded. The settlement period is the time between trade date and settlement date. Since 1995, most trades of U.S. government and federal agency securities settle the day after the trade date, which is known as next-day settlement. The standard for corporate debt and equities, American Depository Receipts (ADRs), and municipal securities has been three days. However, an initiative is underway to ultimately allow for straight-through processing (STP), in real-time with multiple currencies. In order for STP to occur, various actions must be implemented, and includes, but is not limited to the following: International /Foreign Exchange -Implications to foreign investors trading U.S. issued securities Legal and Regulatory - Rule changes to accommodate STP improvements Payment Processing - Automated payment process Physical Securities - Eliminate the movement of physical securities Securities Lending - Implement the Automated Recall Management Systems (ARMS) to improve level of STP in the stock loan recall process Real-time trade matching - For fixed income securities The following is a more detailed explanation of current settlement practices based on the type of investment: Transactions involving U. S. Treasury and Agency obligations are typically in book-entry form, rather than in physical certificate form. Book-entry is an electronic registration, transfer, and settlement system that enables the rapid and accurate registration and transfer of securities with concurrent cash settlement. Book-entry reduces handling costs and quickens transaction completion. U. S. Treasury and Agency book-entry securities are delivered and cleared over the Federal Reserve Wire System (Fedwire) on a delivery versus payment basis. Acceptance of the security automatically debits the payment amount from the buyer's account and credits it to the seller's account. The payment and securities involved are transferred over the Fedwire system. The Federal Reserve Bank of New York maintains the book-entry custody system. All depository banks are eligible to maintain book-entry accounts at their Federal Reserve District Bank, provided that they also maintain a funds account with that Federal Bank. Mortgage securities settlement procedures are more complex than those for government, corporate, and municipal bonds. The Bond Market Association developed the Uniform Practices for the Clearance and Settlement of Mortgage-Backed Securities and Other Related Securities (hereinafter, "Uniform Practices") to establish industry standards for mortgage securities settlements. Since the Uniform Practices are updated frequently, trust management engaged in mortgage and asset-backed securities transactions should keep abreast of current settlement standards. Corporate and municipal debt securities are available in book-entry and registered, definitive form. Book-entry corporate and municipal bonds settle through the Depository Trust Company (DTC). Electronic trade processing and recordkeeping systems have improved the trade and settlement time and have reduced failed trades. However, failed trades may occur due to the following reasons
If the receiving party accepts delivery (upon payment) and discovers that it was not a good delivery, then the buyer can correct the error by reclamation. In the reclamation process, the buyer returns the securities with an explanation to the seller (who has already received payment). The seller is obligated to return the payment, if the claim is valid. Either party may make a reclamation, if information is discovered after delivery, which, if known at the time of delivery, would have caused the delivery not to constitute good delivery. However, reclamation must be made within the stated time limitations established by the Bond Market Association. If a trade has a settlement date between a record date and a payable date, delivery of the securities must be accompanied by a due bill. A due bill is a document delivered by a seller of a security to a buyer evidencing that any principal and interest or dividends received by the seller past the record date will be paid to the buyer by the seller upon submission of the due bill for redemption. The record date is the date for determining who will be paid principal, dividends or interest on an issue. Book-entry messages are considered acceptable due bill substitutes for securities transferred over Fedwire (Treasury), DTC (Corporates and Municipals), or PTC (GNMA). Due bills and book-entry messages cease to be valid after 60 days from their issue date. A trust department may experience considerable delays in attempting to recover payments without the use of a due bill, which result in the accumulation of significant principal and interest receivable accounts. If delivery and payment on a trade occur after a record date and on or after a payable date, delivery of the securities must be accompanied by a check for the principal, dividend or interest due. G. Securities Transfer Agent's Medallion Program (STAMP Program) The Securities and Exchange Commission created a universal signature guarantee program that consists of a stamp that serves as a signature by an eligible institution, such as a bank, brokerage, or trust company, that participates in the program. The purpose is to ensure that the person signing the certificate or irrevocable stock or bond power form is the owner or authorized agent. The program also standardizes the signature guarantee by assigning a standard format and numbering system. The latter identifies the financial institution. The stamp is an ink impression applied to a certificate that allows good delivery form. It is not the same as a notary, which attests to the authenticity of documents and contracts and signatures of testator and witnesses. H. Shareholder Communications Act of 1985 This Act gives the SEC jurisdiction to regulate the proxy processing of all entities exercising fiduciary powers, including trust departments. The Act is implemented primarily by SEC Rule 14b-2, which can be found in Appendix D. The purpose of this regulation is to ensure that beneficial owners of securities are provided proxy materials and other corporate communications within specified time periods. Refer to Operations and Internal Controls - Shareholder Communication Act for additional information and guidance. I. Proxy Voting As a function of equity ownership, a fiduciary has the duty to cast proxy votes for shares of stock held in a discretionary capacity. A policy should be developed which establishes the department's position with regard to voting on routine, as well as controversial, issues. The policy should also establish voting and recordkeeping procedures. For ESOP investing in the employer securities that are registered with the SEC, participants must be given full voting rights for stock allocated to their accounts. In addition, the DOL has opined in a letter ruling dated September 28, 1995, that fiduciaries of ESOP in which participating employees are covered by a collective bargaining agreement must pass through decisions concerning tender offers or proxy voting to the plan's participants and vote as directed. ESOPS maintained by employers whose securities are not registered with the SEC are required to pass through voting rights to participants with stock allocated to their accounts only for the following purposes: Corporate mergers or consolidations; recapitalizations, reclassifications, liquidations, dissolutions, or, the sale of substantially all assets. Furthermore, the plan may authorize the trustees to vote allocated stock based on a one vote per participant basis, rather than number of shares basis. IRC 409(e) Employer stock held in a suspense account, i.e., not yet allocated to participants, may be voted by the trustee, in accordance with their duty to plan participants and beneficiaries. J. FDIC Regulations
K . Compliance with SEC Requirements Securities and transactions in securities are largely governed by Federal law. The following discussion addresses some important aspects of securities regulation which are relevant to trust departments. Special reports or notices may need to be filed in those accounts holding equity securities which are registered under Federal securities laws. These requirements may apply to the trust department as a whole, to individual trust accounts, and to individual transactions. Others apply to the selection of brokers, the placement of brokerage transactions, and mutual fund 12b-1 fees.
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