Dear Board of Directors:
The purpose of this letter is to provide guidance to federal credit unions on the establishment and operation of third party brokerage arrangements for sales of nondeposit investment products.1 This letter supersedes and replaces NCUA’s Letter to Credit Unions No. 150 (December 1993) (Letter No. 150), which contains NCUA’s previous guidance to credit unions on the sales of nondeposit investments.
NCUA needs to update its guidance because of several changes that have taken place since Letter No. 150 was issued in 1993. First, NCUA replaced the group purchasing activities rule with the incidental powers rule, eliminating some restrictions on the compensation a federal credit union may receive for its finder activities. See 12 C.F.R. Part 721. Second, the NCUA Office of General Counsel has issued several legal opinion letters since 1993 regarding the sale of nondeposit investments that add to or refine the previous guidance.2
Nondeposit investments, including stocks, bonds, mutual funds, and variable annuities, are subject to a complex set of federal and state securities laws. In particular, federal securities laws require that any entity “engaged in the business of effecting transactions in securities for the account of others,” must register as a securities broker with the SEC and comply with SEC broker-dealer regulations. See 15 U.S.C. 78c.
Historically, banks had enjoyed a “blanket exemption” from SEC’s broker-dealer registration requirements until Congress repealed this broad exemption in the Gramm-Leach-Bliley Act of 1999 (GLBA). GLBA sets out specific exemptions for certain bank activities.
The Financial Services Regulatory Relief Act of 2006 (FSRRA) required the SEC and the Federal Reserve to jointly issue a regulation governing the broker exemptions. FSRRA also amended the definition of the term “bank” to include thrifts or other savings associations insured by the Federal Deposit Insurance Corporation (FDIC). In 2007, the SEC and the Federal Reserve issued Regulation R to implement the GLBA broker exemptions relating to third party networking arrangements, trust and fiduciary activities, sweep activities, and safekeeping and custody activities. See 12 C.F.R. Part 218; 17 C.F.R. Parts 240 and 247; see also 72 Fed. Reg. 56,514 (Oct. 3, 2007). Regulation R does not apply to federal credit unions.3
Federal credit unions have limited powers and are not authorized under the Federal Credit Union Act (the Act) to sell nondeposit investments directly to their members. Further, federal credit unions cannot register as broker-dealers because the SEC requirements, including capital and reserve requirements, are inconsistent with those NCUA and state supervisory authorities place on federal credit unions. Federal credit unions, therefore, must structure their securities activities carefully to strictly meet the terms of SEC guidance applicable to federal credit unions contained in a “no action” letter. See, eg., Chubb Securities Corp., 1993 SEC No-Act. LEXIS 1204 (Nov. 24, 1993) (Chubb Letter).
The most common way for federal credit unions to offer nondeposit investment products to their members is by employing third party brokerage arrangements.4 Federal credit unions involved in third party brokerage arrangements must have a written agreement clearly outlining the duties and responsibilities of each party in the arrangement. Generally, there are three permissible ways to structure a third party brokerage arrangement. First, a credit union may wholly or partly own a credit union service organization (CUSO) that sells nondeposit investment products, primarily to credit union members.5 Based on the SEC’s review of the extent of the CUSO’s involvement in the purchase and sale of nondeposit investment products, the CUSO may have to register with the SEC as a broker-dealer.
Second, a federal credit union may use a shared employee arrangement with a third party brokerage firm. In a shared employee arrangement, a “dual employee” operates as both a federal credit union employee and an employee of a third party broker. A shared employee may sell nondeposit investment products to the credit union’s members on its premises or from another location; however, it must be clear that when a shared employee is selling nondeposit investment products, the employee is acting exclusively in his or her capacity as an employee of the third party broker, not the credit union. See OGC Op. 01-0742 (Aug. 31, 2001).
Third, a federal credit union may act as a finder. The incidental powers rule allows a federal credit union to bring, through a networking agreement or other means, a registered third party broker to its members for the sale of nondeposit investment products. 12 U.S.C. §1757; 12 C.F.R. §721.3(f). A federal credit union may earn income from finder activities. 12 C.F.R. §721.6; OGC Op. 02-0523a (May 24, 2002). The SEC permits credit unions to receive transaction-related compensation from the third party broker without triggering the broker-dealer registration requirements, as long as the brokerage arrangement adheres strictly to the terms of the Chubb Letter.
Guidelines for the Sales of Nondeposit Investments
The guidelines in this letter provide assistance and direction to federal credit unions offering the sale of nondeposit investment products to their members through third party brokerage arrangements, including:
- Sales by a CUSO wholly or partly owned by a federal credit union.
- Sales by a “dual employee” operating as both a credit union employee and an employee of a third party broker.
- Sales resulting from a federal credit union bringing a registered third party broker to its members through a networking agreement or other means.
II. General Guidelines
Federal credit unions must comply with all the applicable laws, regulations, and sound business practices in the sale of nondeposit investment products through third party brokerage arrangements. The credit union’s directors should, as with any business activity, fully evaluate the risks involved with nondeposit investment activities, including legal risks, reputation risks, and economic risks.
A. Due Diligence
Federal credit unions should take care to select an appropriate broker before entering into a third party brokerage arrangement for the sale of nondeposit investment products. In selecting a third party broker, credit unions should:
- Ensure the broker can provide the services credit union members need.
- Review the broker’s financial statements and capital adequacy.
- Determine if the broker can adequately supervise its sales representatives at the credit union’s location.
- Seek references for the broker and the sales representatives that will be working at the credit union (preferably other depository institutions) and speak with those references.
- Conduct background and Financial Industry Regulatory Authority (FINRA) 6 checks on the broker’s principals and the sales representatives that will be working at the federal credit union. For example, FINRA BrokerCheck® is a free resource federal credit unions can utilize to help research the professional backgrounds of current and former FINRA-registered brokerage firms and brokers.7
- Retain key documentation reflecting its due diligence process in selecting a broker for a third party brokerage arrangement. Documentation should be made available to NCUA examiners, if necessary.
B. Credit Union Policies, Procedures and Agreements
The federal credit union’s board of directors should adopt written policies and procedures concerning third party brokerage arrangements to ensure compliance with applicable law and regulation and to ensure consistency with these guidelines. Credit unions should consider engaging legal counsel to evaluate their policies, procedures, and contractual agreements.
Federal credit unions must have a written agreement outlining the duties and responsibilities of each party in a third party brokerage arrangement. Contracts with third party brokers should reflect the federal credit union’s policies and procedures regarding brokerage arrangements. At a minimum, the credit union’s policies, procedures, and contracts should address the following:
- The features of the sales program. Credit union policies and agreements should describe the types of products that a broker may offer through the third party brokerage arrangement. For all products, the credit union should identify specific laws, regulations, and any other limitations or requirements, including qualitative considerations, that will expressly govern the selection and marketing of products a third party broker may offer. Qualitative considerations include an analysis of the level of complexity and volatility in the investments that the credit union will permit the broker to offer members. For example, comprehensive qualitative investment data (e.g., key ratios, dollar amounts, risk parameters, etc.) should be prepared and presented to the federal credit union’s management and board of directors for review.
- A description of the responsibilities of the credit union and the third party broker. Credit union policies and contracts should make clear that the third party broker is primarily responsible for ensuring that the nondeposit sales function is conducted in compliance with all applicable laws, regulations, and policies. The credit union should maintain the right to check for compliance and access member accounts for verification and oversight.
- Indemnification by the third party broker. Credit unions should require contracts with third party brokers to include provisions to indemnify the federal credit union for any monetary damages arising from nondeposit sales activities.
- The roles of credit union, third party broker, and dual employees. Policies should describe the roles of credit union employees in nondeposit investment activities, including the limits on their activities. Policies and contracts should also identify and describe the duties of the broker’s sales representatives and indicate who will supervise the sales representatives. If the third party brokerage arrangement involves the use of a dual employee, credit union policies should include job descriptions for the duties performed for the credit union and the nondeposit investment sales duties performed for the third party broker. Credit unions should seek an indemnification agreement from the broker, as described above, to limit credit union liability arising from employee misconduct related to nondeposit investment activities conducted by a dual employee.
- The location of nondeposit sales. Credit union policies should describe where nondeposit sales may take place and how those sales will be separated from deposit-taking activities.
- The use of credit union member information. Policies should describe the information that may be transferred between the credit union and the third party broker or the broker’s sales representative. The policies and contracts should describe how such information will be used, how the information will be safeguarded, and the associated privacy notices to be provided to members. The policies and contract terms should comply with NCUA's Privacy of Consumer Financial Information Rule and NCUA's Security Program Rule. 12 C.F.R. Parts 716 and 748. The third party broker should agree in writing to comply with the credit union's policies on information practices.
- Termination of the contract. Contracts should contain a provision that permits the credit union to terminate the contract for both cause and for the convenience of the credit union. Failure by the third party broker to supervise its sales representative adequately should be included as a specific for-cause reason for contract termination.
- Compliance with the requirements of all applicable law and regulation. Credit unions should maintain programs to monitor compliance by the third party broker, its salespeople, and other entities involved in the sales of nondeposit investments. The compliance function should be performed independently of any nondeposit investment product sales and management. At a minimum, the compliance function should include a system that monitors member complaints and periodically reviews and randomly samples member account activity to look for evidence of abuse. Credit unions should also provide regular, periodic compliance reports to their board of directors to ensure appropriate oversight.
C. Conduct in Third Party Brokerage Arrangements
Federal credit unions offering the sale of nondeposit investment products through a third party brokerage arrangement should do so in a manner that does not mislead or confuse members as to the nature or risks of these uninsured products. To avoid member confusion, third party brokers should not offer investment products with a product name that is intentionally similar to the federal credit union’s name.
If the third party brokerage arrangement involves the use of shared employees, the dual employee should not use any materials that could potentially confuse a member as to the capacity in which the dual employee is functioning. For example, dual employees should use separate business cards for their credit union and investment sales functions. Likewise, dual employees should use separate stationery for credit union correspondence and investment activity correspondence.
When selling, advertising, or otherwise marketing uninsured investment products to members, members must be informed that the products offered:
- are not federally insured;
- are not obligations of the credit union;
- are not guaranteed by the credit union;
- involve investment risk; and
- if applicable, are being offered by a dual employee who accepts deposits on behalf of the credit union and also sells nondeposit investment products on behalf of a third party broker.
These disclosures should be made in writing and in a location and type size that are clear and conspicuous to the member. Oral disclosures should also be made as part of any oral sales presentation.
Credit union policies should specifically address the locations at which sales will take place. The credit union’s routine deposit-taking activities should be physically separated from nondeposit investment sales functions to emphasize that important differences exist between these activities, such as the degree of risk and insurability. If limited office space makes physical separation of these functions impractical, nondeposit investment sales and deposit-taking may be conducted in close proximity to each other if appropriate disclosures, as described above, are made to members.
D. Investment Advice
No employee of a federal credit union may provide investment advice that would subject the employee or credit union to federal or state securities laws. A federal credit union, however, may offer investment advice services to its members by establishing a shared employee arrangement with a third party registered investment adviser. The dual employee may provide investment advice on behalf of the third party, but not the credit union.8 A federal credit union may also act as a finder9 to introduce or otherwise bring together an outside vendor of investment adviser services to its members or wholly or partly own a CUSO that provides investment adviser services. OGC Op. 09-0511 (June 3, 2009). A CUSO may have to register with the SEC as a Registered Investment Adviser (RIA). 15 U.S.C. §80-3(a).
Compliance with this letter is essential for credit unions to establish third party brokerage arrangements properly and prevent triggering SEC’s broker-dealer registration requirements. By adhering to these guidelines, credit unions will also help to avoid member confusion about the risk and uninsured nature of nondeposit investment products. Prudent management of securities activities will ensure credit unions are offering their members nondeposit investment options in a safe and sound manner.
If you have any questions related to this letter, you should contact your regional office or district examiner.