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FED ER AL RESERVE BANK O F NEW YORK r Circular No. 6 2 1 6 ~1 L September 19, 1968 J INTERPRETATIONS BY BOARD OF GOVERNORS Regulation R—Relationships With Dealers in Securities Under Section 32 of the Banking Act of 1933 To All Member Banks in the Second Federal Reserve District: Printed below are excerpts from the Federal Register of September 12 and 14, containing interpretations by the Board of Governors of the Federal Reserve System of its Regulation R, entitled “ Relationships With Dealers in Securities Under Section 32 of the Banking Act of 1933.” Additional copies of this circular will be furnished upon request. A Title 12— BANKS AND BANKING Chapter II— Federal Reserve System SUB CH AP TER A — B O A R D O F G O V E R N O R S T H E F E D ER A L RESERVE S Y S TE M OF [Reg. R] PART 218— RELATIONS WITH DEAL ERS IN SECURITIES UNDER SEC TION 32, BANKING ACT OF 1933 Variable Annuity Insurance Company § 2 1 8 .1 1 2 In te rlo ck in g relationsh ips b e tween m e m b e r b a n k a nd variable an nuity in su rance co m p a n y . (a) The Board has recently been asked to consider whether Section 32 of the Banking Act of 1933 (12 U.S.C. 78) and this part prohibit interlocking service be tween member banks and (1) the board of managers of an accumulation fund, registered under the Investment Com pany Act of 1940 (15 U.S.C. 80), that sells variable annuities and (2) the board of directors of the insurance company, of which the accumulation fund is a “sep arate account,” but as to which the insurance company is the sponsor, In vestment advisor, underwriter, and dis tributor. Briefly, a variable annuity is one providing for annuity payment vary ing in accordance with the changing values of a portfolio of securities. (b) Section 32 provides in relevant part that: “No officer, director, or em ployee of any corporation or unincor porated association, no partner or. em ployee of any partnership, and no indi vidual, 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 Tat] the same time as an offi cer, director, or employee of any member bank * * *” (c) For many years, the Board’s posi tion has been that an open-end invest ment company (or mutual fund) is “pri marily engaged in the issue * * * pub lic sale, or distribution, * * * of securi ties” since the issuance and sale of its stock is essential to the maintenance of the company’s size and to the continu ance of its operations without substan tial-contraction, and that section 32 of the Banking Act of 1933 prohibits an officer, director, or employee of any such company from serving at the same time as an officer, director, or employee of any member bank. (1951 Federal Reserve Bul letin 645; 5 218.101.) (d) For reasons similar to those stated by the U B . Supreme Court in Securities and Exchange Commission v. Variable Annuity Life Insurance Company of America, 359 UJ3. 65 (1959), the Board concluded that there is no meaningful basis for distinguishing a variable annu ity interest from a mutual fund share for section 32 purposes and that, there fore, variable annuity interests should also be regarded as “ other similar secu rities” within the prohibition of the stat ute and regulation. (e) The Board concluded also that, since the accumulation fund, like a mutual fund, mustc ontinually issue and sell its investment units in order to avoid the inevitable contraction of its activities as it makes annuity payments or re deems variable annuity units, the accumutual fund, must continually issue and section 32 purposes. The Board further concluded that the insurance company was likewise “primarily engaged” for the purposes of the statute since It had no significant revenue producing operations other than as underwriter and distribu tor of the accumulation fund’s units and lfred H ayes, President. investment advisor to the fund. (f) Although it was clear, therefore, that section 32 prohibits any officers, di rectors, and employees of member banks from serving in any such capacity with the insurance company or accumulation fund, the Board also considered whether members of the board of managers of the accumulation fund are “ officers, directors, or employees” within such prohibition. The functions of the board of managers, who are elected by the var iable annuity contract owners, are, with the approval of the variable annuity contract owners, to select annually an independent public accountant, execute annually an agreement providing for investment advisory services, and rec ommend any changes in the funda mental investment policy of the ac cumulation fund. In addition, the board of managers has sole authority to ex ecute an agreement providing for sales and administrative services and to au thorize all investments of the assets of the accumulation fund in accordance with its fundamental investment policy. In the opinion of the Board of Gover nors, the board of managers of the ac cumulation fund performs functions essentially the same as those performed by classes of persons as to whom the prohibition of section 32 was specifically directed and, accordingly, are within the prohibitions of the statute. (12 U.S.C. 248 (i). Interprets or applies 12 U.S.C. 78) Dated at Washington, D.C., the 30th day of August 1968. By order of the Board of Governors. [ seal ] R obert P. F orrestal, Assistant Secretary. [F.R. Doc. 68-11004; Piled, Sept. 11, 19«8; 8:52 a.m.] ( over) allied with Fund that they should be treated as one with it in determining the applicability of section 32. An additional Chapter II— Federal Reserve System question was whether members of the Advisory Board are “officers, directors, SUB CH AP TER A — B O A R D O F G O V E R N O R S O F or employees” gf Fund with the prohibi T H E F E D ER A L R ESERVE S Y S TE M tion of the statute. [Reg. R] (f) Interlocking service with Advisory PART 2 1 8 — RELATIONS WITH DEAL Board: The function of the Advisory ERS IN SECURITIES UNDER SECTION Board was merely to make suggestions and to counsel with Fund’s Board of Di 3 2 , BANKING ACT OF 1 9 3 3 rectors in regard to investment policy. Insurance Company-Mutual Fund The Advisory Board had no authority to make binding recommendations in any Complex area, and it did not serve in any sense § 2 1 8 .1 1 3 In te rlo ck in g relation sh ips b e as a check on the authority of the Board tw een m e m b e r b a n k an d insurance of Directors. Indeed, the Fund’s bylaws co m p a n y -m u tu a l fu n d c o m p le x . provided that the Advisory Board “shall (a) The Board has been asked whether have no power or authority to make any section 32 of the Banking Act of 1933 and contract or incur any liability whatever this part prohibited interlocking serv or to take any action binding upon the ice between member banks and (1) the Corporation, the Officers, the Board of advisory board of a newly organized Directors or the Stockholders.” Members open-end investment company (mutual of the Advisory Board toere appointed by fund), (2) the fund’s incorporated in the Board of Directors ©f Fund, which vestment manager-advisor, (3) the in could remove any member of the Ad surance company sponsoring and appar visory Board at any.time. None of the ently controlling the fund. principal officers of Fund or of Under (b) X Fund, Inc. (“Fund” ), the writers were members of the Advisory mutual fund, was closely related to X Board; and the compensation of its mem Life Insurance Company (“Insurance bers was expected to be nominal. Company” ), as well as to the incor (g) The Board of Governors concluded porated manager and investment advisor that members of the Advisory Board to Fund (“Advisors” ), and the corpora need not be regarded as ‘‘officers, direc tion serving as underwriter for Fund tors, or employees” of Fund or of Under (“Underwriters” ). The same persons writers for purposes of section 32, and served as principal officers and directors that the statute, therefore, did not pro of Insurance Company, Fund, Advisors, hibit officers, directors, or employees of and Underwriters. In addition, several member banks from serving as members directors of member banks served as di of the Advisory Board. (h) Interlocking service with Advis rectors of Insurance Company and of Advisors and as members of the Advisory ors: The principal officers and several of the directors of Advisors were identical Board of Fund, and additional directors with both those of Fund and of Under of member banks had been named only writers. Entire management and invest as members of the Advisory Board. All ment responsibility for Fund had been outstanding shares of Advisors and of placed, by contract, with Advisors, sub Underwriters were app&fentiy owned by ject only to a review authority in the Insurance Company. Board of Directors of Fund. Advisors (c) Section 32 provides in relevant also supplied office space for the conduct part that: “No officer, director, or em of Fund’s affairs, and compensated mem ployee of any corporation * * * pri bers of the Advisory Board who are also marily engaged in the issue, flotation, officers or directors of Advisors. More underwriting, public sale, or distribution over, it appeared that Advisors was cre st wholesale or retail, or through syndi ated for the sole purpose of servicing cate participation, of stocks, bonds, or Fund, and its activities were to be limited other similar securities, shall serve [at] to that function. the same time as an officer, director, or (i) In the view of the Board of Gov employee of any member bank * * ernors, the structural and functional (d) The Board of Governors reaf-. identity'of Fund and Advisors was such firmed its earlier position that an openthat they were to be regarded as a single end investment company is “primarily entity for purposes of section 32, and, engaged” in activities described in sec accordingly, officers, directors, and em tion 32 “ even though the shares are sold ployees of member banks were prohibited to the public through independent or by section 32 from serving in any such ganizations with the result that the in vestment company does not derive any capacity with such entity. (j) Interlocking service with Insur direct profit from the sales.” (1951 Fed ance Company: It was clear that eral Reserve Bulletin 654, § 218.101.) Ac cordingly, the Board concluded that Fund Insurance Company was not as yet “pri must be regarded as so engaged, even marily engaged” in business of a kind though its shares were underwritten and described in section 32 with respect to the shares of the newly created.Fund distributed by Underwriters. (e) As directors of the member banks sponsored by Insurance Company, since involved in the Inquiry were not officers, the issue and sale of such shares had not directors, or employees of either Fund or yet commenced. Nor did it appear that Underwriters, the relevant questions were Insurance Company would be so engaged whether (1) Advisors, and (2) Insurance in the preliminary stages of Fund’s exist Company, should be regarded as being ence, when the disproportion between functionally and structurally so closely the insurance business of Insurance Com- Title 12— BANKS AND BANKING any and the sale of Fund shares would e very great. However, it was also clear that if Fund was successfully launched, its activities would rather quickly reach a stage where a serious question would arise as to the applicability of the section 32 prohibition. (k)- An estimate supplied to the Board indicated th a t -100,000 shares of Fund might be sold annually to produce, based on then current values, annual gross sales receipts of over $1 million. Insur ance Company’s total gross income for its last fiscal year was almost $10 million. On this basis, about one-tenth of the annual gross income of the Insurance Company-Fund complex (more than one-tenth, if income from investments of Insurance Company was eliminated) would be derived from sales of Fund shares. Although total sales of shares of Fund during the first year might not approximate expectations, it was as sumed that if the estimate or projection was correct, the annual rate of sale might well rise to that level before the end of the first year of operation. (1) It appeared that net income of Insurance Company from Fund’s opera tions would be tninimal for the foresee able future. However, it was understood that Insurance Company’s chief reason for launching Fund was to provide sales men for Insurance Company (who were to be the only sellers of shares of Fund, and most of whom, Insurance ComDany hoped, would qualify to sell those shares), with a “package” of mutual fund shares and life insurance policies that would provide increased competitive strength in a highly competitive field. (m) The Board concluded that Insur ance Company would be “primarily en gaged” in issuing or distributing shares of Fund within the meaning of section 32 by not later than the time of realiza tion of the aforementioned estimated an nual rate of sale, and possibly before. As indicated in Board of Governors v. A g new, 329 U.S. 441 at 446, the prohibition of the statute applies if the section 32 business involved is a “substantial” ac tivity of the company. (n) This, the Board observed, was not to suggest that officers, directors, or em ployees of Insurance Company who are also directors of member banks would be likely, as individuals, to use their posi tions with the banks to further sales of Fund’s shares. However, as the Supreme Court pointed out in the Agnew case, sec tion 32 is a “preventive or prophylactic measure.” The fact that the individuals involved “have been scrupulous in their relationships” to the banks in question “is immaterial.” (12 U.S.C. 248(1). Interprets or applies 12 U.S.C. 78) Dated at Washington, D.C., the 30th day of August 1966. By order of the Board of Governors. [seal] R obert P. F orrestal, Assistant Secretary. [F.R. Doc. 68-11180; Filed, Sept. 13, 1968; 8:47 ajn.]
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