Letter confirms that a national bank subsidiary may hold various insurance company products and investment un funds in order to hedge, on a dollar-for-dollar basis, the subsidiary's obligations to make payments to employees under nonqualified deferred compensation plans. 12/22/99

In this letter, “[ ]” refers to [ ], Inc. and its subsidiaries.

1

Comptroller of the Currency

Administrator of National Banks

Washington, D.C. 20219

Interpretive Letter #878

December 22, 1999

January 2000

12 USC 24(7)

Re:

[ ] Bank, National Association/[ ], Inc.

Nonqualified Employee Deferred Compensation Plan

Dear [ ]:

This responds to your letter of December 20, 1999 on behalf of your client,[

] (the “Bank”) requesting that the Office of the Comptroller of the Currency (“OCC”) not object to

the Bank’s subsidiary [ ], Inc., holding various insurance company products and investment

1

funds in order to hedge, on a dollar-for-dollar basis, [ ]’s obligations to make payments to

employees under nonqualified deferred compensation plans. Based on the representations made by the

Bank, the OCC does not object to [ ] conducting the proposed activities.

I.

BACKGROUND

[ ] proposes to hold various insurance company products and investment funds in order to

hedge, on a dollar-for-dollar basis, its obligations to make payments to employees under a non-

qualified deferred compensation plan. Under the terms of the plan, a participating employee will defer a

portion of his or her income from a bonus for a period of time and select a benchmark fund from among

a list of options. At the distribution date selected by the employee, he or she will receive the sum of the

changes in values of deferred amounts indexed to the various benchmarks over the period that the

employee selected each benchmark. The performance of an employee’s deferred compensation

account is indexed to the performance of selected benchmark investments. Employees will not own an

mong

a list of options. At the distribution date selected by the employee, he or she will receive the sum of the

changes in values of deferred amounts indexed to the various benchmarks over the period that the

employee selected each benchmark. The performance of an employee’s deferred compensation

account is indexed to the performance of selected benchmark investments. Employees will not own an

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[ ]’s obligation is unsecured in order to avoid current inclusion of the deferred compensation

2

in the employee’s taxable income. See Internal Revenue Code § 83.

See 12 U.S.C. § 24(Seventh).

3

See 12 C.F.R. § 5.34(d)(1).

4

interest in the benchmark funds. Instead, employees will own an unsecured contractual obligation of [

] to pay the deferred amount at the distribution date.2

[ ] proposes to offer its employees a variety of registered investment companies and private

investment funds managed by [ ], as well as investment funds managed by third parties, as

benchmark funds under the plan. These benchmark funds will include funds that invest exclusively in

bank-eligible assets, as well as funds that invest in assets traditionally impermissible for investment by a

national bank.

[ ] proposes to hedge its obligations under this plan. [ ] will acquire the number of

units of each benchmark fund selected by each participating employee that equals the value of deferred

compensation divided by the net asset value of a unit, and hold those units for the period of time that the

employee elects to use that benchmark fund as an index. In this way, all of the increase in value and all

of the decrease in value of the units (including reinvested dividends) held by [ ] as a hedge

exactly equals [ ]’s obligations under the plan.

[ ] seeks to make its hedging investments in a way that is most neutral to [ ] from a

tax and financial accounting standpoint

nchmark fund as an index. In this way, all of the increase in value and all

of the decrease in value of the units (including reinvested dividends) held by [ ] as a hedge

exactly equals [ ]’s obligations under the plan.

[ ] seeks to make its hedging investments in a way that is most neutral to [ ] from a

tax and financial accounting standpoint. To this end, [ ] may invest in insurance company

products such as variable life or variable annuities that are funded by the insurance companies through

an investment in an insurance company separate account. This separate account will invest in an

underlying registered investment company or private investment company that is managed by [

] or a third party, or in a separate account that is managed in a way and invested in assets substantially

identical to the benchmark fund selected by the employee. In the alternative, [ ] may instead

invest directly in the benchmark funds, or invest through a “Rabbi Trust” in the benchmark funds.

II.

DISCUSSION

[ ] is an operating subsidiary of the Bank. As a general matter, a national bank may engage in

activities that are part of or incidental to the business of banking by means of an operating subsidiary.

3

An operating subsidiary is subject to the same banking laws, regulations and OCC examinations and

supervision as the national bank, unless otherwise provided by statute or regulation.4

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12 U.S.C. § 24(Seventh).

5

See NationsBank of North Carolina, N.A. v. Variable Annuity Life Insurance Co., 513 U.S. 251

6

of or incidental to the business of banking by means of an operating subsidiary.

3

An operating subsidiary is subject to the same banking laws, regulations and OCC examinations and

supervision as the national bank, unless otherwise provided by statute or regulation.4

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12 U.S.C. § 24(Seventh).

5

See NationsBank of North Carolina, N.A. v. Variable Annuity Life Insurance Co., 513 U.S. 251

6

(1995) (“VALIC”).

12 U.S.C. § 24(Fifth).

7

See 12 U.S.C. § 24(Seventh) ([a national bank shall have the power] [t]o exercise . . . all such

8

incidental powers as shall be necessary to carry on the business of banking).

There are three general principles used to determine whether an activity is within the scope of the

9

“business of banking”: (1) is the activity functionally equivalent to or a logical outgrowth of a recognized

banking function; (2) would the activity benefit bank customers and/or strengthen the bank; (3) does the

activity present risks of a type similar to those already assumed by banks. See, e.g., Interpretive Letter

No. 845 (October 20, 1998), reprinted in [1998-99 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶

81-300; Interpretive Letter No. 812 (December 29, 1997), reprinted in [1997-98 Transfer Binder]

Fed. Banking L. Rep. (CCH) ¶ 81-260; Interpretive Letter No. 742 (August 19, 1996), reprinted in

[1996-97 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-106. The power to compensate also is

“convenient or useful” in performing an expressly stated power. See Arnold Tours, Inc. v. Camp, 400

A

(CCH) ¶

81-300; Interpretive Letter No. 812 (December 29, 1997), reprinted in [1997-98 Transfer Binder]

Fed. Banking L. Rep. (CCH) ¶ 81-260; Interpretive Letter No. 742 (August 19, 1996), reprinted in

[1996-97 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-106. The power to compensate also is

“convenient or useful” in performing an expressly stated power. See Arnold Tours, Inc. v. Camp, 400

A. National Banks May Compensate Employees and Provide Employee Benefit Plans As Part of

the Business of Banking

The National Bank Act, in relevant part, provides that national banks shall have the power:

[T]o exercise … all such incidental powers as shall be necessary to carry on the

business of banking; by discounting and negotiating promissory notes, drafts, bills of

exchange, and other evidences of debt; by receiving deposits; by buying and selling

exchange, coin, and bullion; by loaning money on personal security; and by obtaining,

issuing, and circulating notes … .5

The Supreme Court has held that the powers clause of 12 U.S.C. § 24(Seventh) is a broad grant of

power to engage in the business of banking, including but not limited to the enumerated powers and the

business of banking as a whole.6

National banks and their operating subsidiaries have explicit authority to hire various officers. A

national bank is expressly permitted “[t]o elect or appoint directors, and by its board of directors to

appoint a president, vice president, cashier, and other officers, define their duties, require bonds of

them and fix the penalty thereof, dismiss such officers or any of them at pleasure, and appoint others to

fill their places.” In order to exercise this express authority, a national bank must have the power to

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compensate reasonably those employees it hires. The power to compensate is a logical and necessary

8

outgrowth of the power to employ officers and other employees, provides banks and their customers

with substantial benefits, and involves risks banks have managed since their inception.9

s to

fill their places.” In order to exercise this express authority, a national bank must have the power to

7

compensate reasonably those employees it hires. The power to compensate is a logical and necessary

8

outgrowth of the power to employ officers and other employees, provides banks and their customers

with substantial benefits, and involves risks banks have managed since their inception.9

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U.S. 45 (1970) (per curiam), 472 F.2d 427 (1st Cir. 1972); Letter from Ellen Broadman, Director,

Securities and Corporate Practices Division (January 19, 1995)(Unpublished).

See 12 U.S.C. § 1818(b); 12 C.F.R. part 30.

10

See 12 C.F.R. § 7.2011(a) (A national bank may adopt a bonus or profit-sharing plan designed to

11

ensure adequate remuneration of bank officers and employees).

See Letter from Christopher C. Manthey, Senior Attorney, Bank Activities and Structure Division

12

(June 21, 1996)(Unpublished).

See VALIC, 513 U.S. at 258 n.2.

13

472 F.2d 427 (1st Cir. 1972).

14

Id. at 432.

15

See Interpretive Letter No. 494 (December 20, 1989), reprinted in [1989-90 Transfer Binder] Fed.

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Banking L. Rep. (CCH) ¶ 83,083.

While federal banking law does not expressly limit the form of compensation that a national bank may

provide its employees, that compensation must be consistent with safety and soundness

considerations. National banks and their operating subsidiaries may establish and operate benefit

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plans for their employees. Consistent with safety and soundness standards, a national bank also may

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provide its officers and employees deferred compensation through reasonable means.12

B

t a national bank may

provide its employees, that compensation must be consistent with safety and soundness

considerations. National banks and their operating subsidiaries may establish and operate benefit

10

plans for their employees. Consistent with safety and soundness standards, a national bank also may

11

provide its officers and employees deferred compensation through reasonable means.12

B. National Banks May Hedge Risks Arising From Employee Benefit Obligations Under

Incidental Authorities

Section 24(Seventh) authorizes national banks to engage in activities that are incidental to enumerated

bank powers as well as the broader “business of banking.” Prior to VALIC, the standard that was

13

often considered in determining whether an activity was incidental to banking was the one advanced by

the First Circuit Court of Appeals in Arnold Tours, Inc. v. Camp. The Arnold Tours standard

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defined an incidental power as one that is “convenient or useful in connection with the performance of

one of the bank’s established activities pursuant to its express powers under the National Bank Act.”

15

Even prior to VALIC, the Arnold Tours formula represented the narrow interpretation of the

“incidental powers” provision of the National Bank Act. The VALIC decision, however, has

16

established that the Arnold Tours formula provides that an incidental power includes one that is

convenient and useful to the “business of banking,” as well as a power incidental to the express powers

specifically enumerated in 12 U.S.C. § 24(Seventh).

s formula represented the narrow interpretation of the

“incidental powers” provision of the National Bank Act. The VALIC decision, however, has

16

established that the Arnold Tours formula provides that an incidental power includes one that is

convenient and useful to the “business of banking,” as well as a power incidental to the express powers

specifically enumerated in 12 U.S.C. § 24(Seventh).

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See generally Arnold Tours, Inc. v. Camp, 472 F.2d 427 (1st Cir. 1972).

17

12 U.S.C. § 24(Seventh).

18

Id.

19

See Memorandum from Julie L. Williams, Chief Counsel, to Eugene A. Ludwig, Comptroller of the

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Currency (November 18, 1996) (Legal Authority for Revised Operating Subsidiary Regulation),

reprinted in [1996-97 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 90-464.

Incident to the permissible activity of compensating employees, [ ] proposes to hedge its

deferred compensation obligations, on a dollar-for-dollar basis, by holding insurance company products

and investment funds. Hedging risks arising from banking activities is “convenient and useful,” and

incidental to the business of banking. The proposed hedge is particularly effective since it virtually

17

eliminates all risks to the Bank and [ ] from the employee compensation program.

(1) Proposed Holdings Do Not Conflict with Section 24(Seventh) Restrictions

Section 24(Seventh) limits the authority of a national bank to underwrite and deal in corporate debt and

equity securities. A national bank dealing in securities and stock is “limited to purchasing and selling

such securities and stock without recourse, solely upon the order, and for the account of, customers,

and in no case for its own account, and the association shall not underwrite any issue of securities or

stock.” [ ], however, will not be acting as a “dealer” or “underwriter” with respect to the

18

shares that it owns in the investment funds

ock is “limited to purchasing and selling

such securities and stock without recourse, solely upon the order, and for the account of, customers,

and in no case for its own account, and the association shall not underwrite any issue of securities or

stock.” [ ], however, will not be acting as a “dealer” or “underwriter” with respect to the

18

shares that it owns in the investment funds. Therefore, [ ]’s proposed investments would not

implicate the prohibitions on underwriting and dealing in securities in Section 24(Seventh). Moreover, [

] will not rely on the authorization in Section 24(Seventh) to purchase “investment securities” to

make the proposed fund investments.

The 1933 Act also added the following new sentence, “Except as hereinafter provided or otherwise

permitted by law, nothing herein contained shall authorize the purchase by the association of any shares

of stock of any corporation.” In a 1996 memorandum in support of a revised operating subsidiary

19

regulation, OCC staff argued that it is important to recognize what this sentence is, and what it is not.

20

The staff argued that it is not a bar on national bank ownership of corporate stock. Rather, it is a

disclaimer which clarifies that “nothing herein contained”, i.e., nothing in the amendments to Section

24(Seventh) made by Section 16 of the 1933 Act, should be construed to increase the authority of

national banks to own stock. The staff also stated that the sentence recognizes that if a national bank’s

stock-ownership is “otherwise permitted by law”, it remains permissible. Such “law” includes the

powers sentence at the beginning of Section 24(Seventh), which dates back to 1864 and was not

altered by the Section 16 changes. Thus, the proposed fund investments to hedge employee benefit

obligations, which are authorized by the powers clause, rather than the provisions added in Section 16

of the 1933 Act, would not be restricted by the disclaimer provision.

rmissible. Such “law” includes the

powers sentence at the beginning of Section 24(Seventh), which dates back to 1864 and was not

altered by the Section 16 changes. Thus, the proposed fund investments to hedge employee benefit

obligations, which are authorized by the powers clause, rather than the provisions added in Section 16

of the 1933 Act, would not be restricted by the disclaimer provision.

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For example, a national bank may purchase an interest in an insurance company separate

21

account that in turn invests in bank-eligible securities. See Interpretive Letter No. 826 (March

17, 1998), reprinted in [1997-98 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-275. As

part of this investment strategy, the separate account, for purposes of hedging price and interest

rate exposure, may enter into exchange traded and over-the-counter futures and options

transactions; interest rate swaps, caps and floors; short sales of U.S. Treasury and Agency

securities; and covered dollar rolls, with the proceeds reinvested in short-term investments

maturing within five days of the maturity date of the corresponding dollar roll. See id.

See generally OCC Bulletin 96-51 (September 20, 1996), reprinted in Fed. Banking L. Rep.

22

(CCH) ¶ 35-491; Interpretive Letter No. 848 (November 23, 1998), reprinted in [1998-99 Transfer

Binder] Fed. Banking L. Rep. (CCH) ¶ 81-303.

See OCC Bulletin 96-51, supra; Interpretive Letter No. 848, supra.

23

See OCC Bulletin 96-51, supra.

24

See Interpretive Letter No. 848, supra.

25

See id.

26

OCC precedent has recognized that national banks may acquire equity investments and make

noncontrolling investments that are necessary to conduct a banking business, and not motivated by

speculative purposes. [ ]’s proposal lacks the speculative characteristics for the Bank and its

operating subsidiaries with which Congress was concerned in passing the prohibitions of Section

24(Seventh)

precedent has recognized that national banks may acquire equity investments and make

noncontrolling investments that are necessary to conduct a banking business, and not motivated by

speculative purposes. [ ]’s proposal lacks the speculative characteristics for the Bank and its

operating subsidiaries with which Congress was concerned in passing the prohibitions of Section

24(Seventh). The Bank and [ ] will own the assets only as a necessary incident to engaging in

the permissible banking activity of employee compensation. In addition, all gains and losses attributed

to these investments will ultimately be passed-through to the participating employees. Section

24(Seventh) thus does not restrict [ ]’s proposed investments.

(2) National Banks May Fund or Hedge Exposures From Banking Activities Through

Acquisition of Bank Eligible and Ineligible Assets

In the past, the OCC approved various plans by national banks for hedging risks, while not permitting

speculative activities as prohibited by the National Bank Act. Previous OCC opinions recognize the

21

importance of hedging liabilities under employee benefit plans as a legitimate banking activity. For

22

example, national banks may purchase and hold life insurance under 12 U.S.C. § 24(Seventh) in

connection with employee compensation and benefit plans. National banks may use permanent

23

insurance to finance or recover the cost of pre- and post-retirement employee benefit plans. A

24

national bank may purchase whole life insurance and use the death benefits eventually received under

the policies to recover the cost of payments made to officers and directors, or fund remaining payments

owed to beneficiaries. Payments to beneficiaries may be made on an installment basis.

25

26

nance or recover the cost of pre- and post-retirement employee benefit plans. A

24

national bank may purchase whole life insurance and use the death benefits eventually received under

the policies to recover the cost of payments made to officers and directors, or fund remaining payments

owed to beneficiaries. Payments to beneficiaries may be made on an installment basis.

25

26

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See Letter from Ellen Broadman, supra; see also 12 U.S.C. § 24(Fifth).

27

See generally Letter from Ellen Broadman, supra.

28

See Interpretive Letter No. 652 (September 13, 1994), reprinted in [1994 Transfer Binder] Fed.

29

Banking L. Rep. (CCH) ¶ 83,600.

See id.

30

See Decision of the Comptroller of the Currency on the Request by Chase Manhattan Bank, N.A., to

31

Offer the Chase Market Index Investment Deposit Account (August 8, 1988).

See id.

32

See No Objection Letter No. 90-1 (February 16, 1990), reprinted in [1989-90 Transfer Binder]

33

Fed. Banking L. Rep. (CCH) ¶ 83,095.

A national bank may establish a “rabbi trust” to provide reasonable, deferred compensation for its

officers and employees consistent with safety and soundness considerations. The trust may hold

27

investments beyond those allowed for national banks, without violating Section 24(Seventh) and 12

C.F.R. part 1, if the Bank does not receive any income or profit from the trust’s assets, and the trust

meets all other applicable requirements under state and federal law, the Internal Revenue Code, and

ERISA.

28

National banks and their operating subsidiaries may offer equity derivative swaps, where consistent

with safe and sound banking principles. At times, banks may hedge swaps exposure by acquiring or

29

selling non-swap financial derivative instruments, such as exchange-traded equity futures or options

her applicable requirements under state and federal law, the Internal Revenue Code, and

ERISA.

28

National banks and their operating subsidiaries may offer equity derivative swaps, where consistent

with safe and sound banking principles. At times, banks may hedge swaps exposure by acquiring or

29

selling non-swap financial derivative instruments, such as exchange-traded equity futures or options.

This hedging transaction serves the same purpose as offsetting contracts between shorts and longs, to

counteract the risk associated with the initial swap.30

A national bank also may offer a non-transferable time deposit account paying interest based in part on

movements in the S&P 500 Index, and hedge its interest obligations by purchasing or selling futures

contracts on the same index. The hedging activity is an important complement to the bank’s expressly

31

authorized deposit-taking authority, and provides a prudent means of managing the bank’s interest rate

exposure risk. This strategy also provides national banks with the flexibility to establish the amount of

the payments to be made and received under their deposit and loan contracts based on market

conditions and the needs of their customers.32

A national bank may act as principal in unmatched commodity price index swaps with their

customers. As part of such a strategy, the bank may hedge any unmatched commodity price risk

33

exposure by purchasing and selling exchange-traded commodity futures with the intention of entering

and received under their deposit and loan contracts based on market

conditions and the needs of their customers.32

A national bank may act as principal in unmatched commodity price index swaps with their

customers. As part of such a strategy, the bank may hedge any unmatched commodity price risk

33

exposure by purchasing and selling exchange-traded commodity futures with the intention of entering

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See id.

34

See Interpretive Letter No. 632 (June 30, 1993), reprinted in [1993-94 Transfer Binder] Fed.

35

Banking L. Rep. (CCH) ¶ 83,516.

Basis risk is the risk that the price fluctuations of the hedging instrument will not exactly match the

36

price fluctuations of the underlying transaction.

See Interpretive Letter No. 632, supra.

37

Moreover, we note that there are strong arguments for the assertion that variable annuities are not

38

“securities” for purposes of Section 24(Seventh).

into offsetting commodity price swaps if they become available. The bank may not use the unmatched

contracts or futures to speculate in commodity price movements.34

In addition, a national bank may, subject to limitations, hedge the financial exposure arising from

otherwise permissible banking activities in markets that involve physical delivery of commodities. In

35

some cases, exchange-traded and over-the-counter transactions do not provide the most accurate

hedges possible, thereby exposing the bank to basis risk. Access to the physical markets provides a

36

more precise hedge in these cases. Such hedging activity is limited in scope, used only to supplement a

bank’s existing hedging activities, and is customer driven and not for speculative purposes.37

In each case cited above, the hedging investment was viewed as an asset held incidental to a

permissible banking activity in order to hedge the bank’s obligations, rather than as a security held by

the bank for investment. The transactions were used to manage risks arising from otherwise permissible

banking activities and not entered into for speculative purposes

d not for speculative purposes.37

In each case cited above, the hedging investment was viewed as an asset held incidental to a

permissible banking activity in order to hedge the bank’s obligations, rather than as a security held by

the bank for investment. The transactions were used to manage risks arising from otherwise permissible

banking activities and not entered into for speculative purposes. In much the same manner, incidental to

the permissible banking activity of providing deferred compensation to employees, [ ] may hold

otherwise ineligible assets for the sole purpose of hedging on a dollar-for-dollar basis its obligations to

employees under nonqualified deferred compensation plans. This conclusion is consistent with the

foregoing OCC precedents permitting bank-impermissible investments for hedging purposes to manage

risks arising from permissible banking activities. The hedges proposed by [ ] offer a

particularly well matched and effective risk management mechanism. As the cases above illustrate,

offsetting banking risks in this manner is a prudent and desirable goal for national banks.

For these reasons, we now conclude that [ ] may hold interests in investment funds, “Rabbi

trusts,” and variable life insurance and annuities products through separate accounts for the sole

38

described purpose of hedging employee deferred compensation plans.

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III.

CONCLUSION

For the reasons discussed above, the OCC will not object to the Bank or [ ] holding interests

in insurance company products, investment funds, and “Rabbi trusts” in order to hedge, on a dollar-for-

dollar basis, their deferred compensation obligations to employees. This position is based on the facts

and representations made in your letter and any material changes in the facts or conditions may result in

a different conclusion

l not object to the Bank or [ ] holding interests

in insurance company products, investment funds, and “Rabbi trusts” in order to hedge, on a dollar-for-

dollar basis, their deferred compensation obligations to employees. This position is based on the facts

and representations made in your letter and any material changes in the facts or conditions may result in

a different conclusion. Please note that we take no position regarding [ ]’s possible future

plans that differ from the described voluntary deferral of compensation by participating employees.

Very truly yours,

/s/

Julie L. Williams

First Senior Deputy Comptroller and

Chief Counsel