National bank may take positions in equity securities solely to hedge bank permissible equity derivative transactions originated by customers for their independent business purposes, subject to certain bank representations.

O

Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

September 13, 2000 Interpretive Letter #892

September 2000

The Honorable James A. Leach 12 USC 24(7)

Chairman

Committee on Banking & Financial Services

2129 Rayburn House Office Building

Washington, D. C. 20515-6050

Dear Chairman Leach:

I am writing in response to your letter of today's date in which you raise concerns about an OCC

determination concerning bank holdings of securities to hedge customer-driven, bank

permissible equity derivative transactions.1 You had noted this point when we discussed this

matter at some length on Wednesday of this week, and I offered to have OCC staff fully brief

you and your staff on the issue. I regret that we were not afforded the opportunity to provide this

briefing, which would have addressed the misunderstandings that were unfortunately reflected in

your letter to me. In particular, I believe it would have been clear from such a briefing that these

carefully limited transactions have no implications at all for bank involvement in merchant

banking or for breaching the wall between banking and commerce -- matters that I know well are

of concern to you.

In brief, the OCC determined, in the case of three national banks, that the banks could take

positions in equity securities solely to hedge bank permissible equity derivative transactions

originated by customers for their valid and independent business purposes. The banks

committed that they will use equities solely for hedging and not for speculative purposes. The

banks will not take anticipatory, or maintain residual positions in equities except as necessary to

the orderly establishment or unwinding of a hedging position

to hedge bank permissible equity derivative transactions

originated by customers for their valid and independent business purposes. The banks

committed that they will use equities solely for hedging and not for speculative purposes. The

banks will not take anticipatory, or maintain residual positions in equities except as necessary to

the orderly establishment or unwinding of a hedging position. Moreover, the banks may not

acquire equities for hedging purposes that constitute more than 5% of a class of stock of any

issuer.

Based on the representations and commitments made by the banks and an extensive review by

supervisory staff of (1) the banks' derivative transactions, (2) proposed hedging of risks arising

from those transactions, including an analysis of how equity holdings reduce risks and enhance

the efficiency of the hedging, and (3) internal risk management systems, we concluded the banks

1 The term “equity derivative transactions” means transactions in which a portion of the return (including interest,

principal or payment streams) is linked to the price of a particular equity security or to an index of such securities.

Equity derivative transactions include equity and equity index swaps, equity index deposits, equity-linked loans and

debt issues, and other bank permissible equity derivative products.

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2

may hold equities to hedge customer-driven, bank permissible equity derivative transactions as

an activity that is incidental to the business of banking. National banks interested in using

equities to hedge customer-driven, bank permissible equity derivative transactions must consult

with the examiner-in-charge of the bank and obtain OCC supervisory approval prior to engaging

in the activity. Before the OCC will consider approving the activity for a national bank, the bank

must provide the OCC information about its derivative business and proposed hedging activities,

including their effectiveness and efficiency in reducing risks

ble equity derivative transactions must consult

with the examiner-in-charge of the bank and obtain OCC supervisory approval prior to engaging

in the activity. Before the OCC will consider approving the activity for a national bank, the bank

must provide the OCC information about its derivative business and proposed hedging activities,

including their effectiveness and efficiency in reducing risks. Banks will also need to establish

that they have an appropriate risk management process in place. As detailed further in the

Comptroller’s Handbook “Risk Management of Financial Derivatives” (January 1997) and OCC

Banking Circular 277,2 an effective risk management process will include Board supervision,

managerial and staff expertise, comprehensive policies and operating procedures, risk

identification, measurement and management information systems, as well as effective risk

control functions that oversee and ensure the continuing appropriateness of the risk management

process. It is unsafe and unsound for a national bank to engage in equity hedging activities

without an appropriate risk management process in place.

I. Background

Currently, the banks enter into bank permissible, customer-driven equity derivative transactions

that they book directly. The banks hedge the equity derivative transactions with equity

derivatives or through mirror transactions with nonbank affiliates. The terms of the “mirror”

transactions between the banks and nonbank affiliates exactly offset the terms of customer-

driven equity derivative transactions. The affiliates hedge the mirror transactions by taking

physical positions in equities.

To illustrate, in a “long” equity swap transaction with a customer, the bank agrees to pay the

customer the appreciation, over a set period of time, in the value of a notional principal

investment in the underlying equity. The bank may also agree to pay the customer amounts

equal to dividends on the underlying equity

filiates hedge the mirror transactions by taking

physical positions in equities.

To illustrate, in a “long” equity swap transaction with a customer, the bank agrees to pay the

customer the appreciation, over a set period of time, in the value of a notional principal

investment in the underlying equity. The bank may also agree to pay the customer amounts

equal to dividends on the underlying equity. In return, the customer agrees to pay the bank if

there is any decrease in value of the notional principal investment in the underlying equity, and

an agreed upon rate of interest applied to that investment.3

The bank hedges its long swap transaction by entering into a mirror transaction with a nonbank

affiliate. Under the mirror transaction, the nonbank affiliate agrees to pay the bank the

appreciation in, and dividends on, the same notional principal investment in the same underlying

equity under the same terms as the bank’s initial transaction with the customer. The bank, in

turn, agrees to pay the nonbank affiliate depreciation in, and the rate of interest applied to, the

value of the underlying equity.

2 OCC Banking Circular 277 (October 27, 1993) (BC-277).

3 This type of equity swap transaction is a total rate of return swap because the parties exchange the total return on

the asset for another cash-flow.

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3

The nonbank affiliate then hedges its obligations to the bank by purchasing the equity in an

amount equal to the notional principal investment in that equity under the swap transaction

between the bank and the customer.4 The banks represent that engaging in customer-driven

equity derivative transactions in this fashion effectively moves revenues from the banks to the

relevant nonbank affiliate. The banks prefer to eliminate the “mirror” portion of their equity

derivative transactions and internally book the physical hedges.

The banks demonstrated that equity holdings provide substantial financial advantages

er.4 The banks represent that engaging in customer-driven

equity derivative transactions in this fashion effectively moves revenues from the banks to the

relevant nonbank affiliate. The banks prefer to eliminate the “mirror” portion of their equity

derivative transactions and internally book the physical hedges.

The banks demonstrated that equity holdings provide substantial financial advantages. The

banks' represented that eliminating the mirror transactions enables them to downsize the staff

currently used to support the processing, reconciliation, accounting, reporting, and funding for all

the internal transactions between the banks, their holding companies, and their nonbank

affiliates, resulting in significant cost savings on an annual basis. The banks also established that

equity hedging will allow the banks to retain the revenue and profits generated by the in-house

equity derivative transactions and hedges. Finally, the banks represented that a reduction in net

interest expense results from eliminating the mirror transactions, which are funded at the

borrowing rate of their holding companies, rather than the more favorable rate enjoyed by the

banks. The banks projected that their increase in annualized savings as the business and related

funding requirements continue to grow.

The banks also established that the equity hedges provide significant operational advantages.

Upon eliminating the mirror transactions and moving the physical hedges into the banks, the

banks expect a significant potential reduction in trading, risk management, compliance, and

operation risks that currently result from the back-to-back booking of the mirror transactions.

The banks committed that they will use physical equities only to hedge risks arising from

customer-driven, bank permissible equity derivative transactions and will not engage in any

speculation

nto the banks, the

banks expect a significant potential reduction in trading, risk management, compliance, and

operation risks that currently result from the back-to-back booking of the mirror transactions.

The banks committed that they will use physical equities only to hedge risks arising from

customer-driven, bank permissible equity derivative transactions and will not engage in any

speculation. The banks further committed that they will not maintain any residual positions in

equities that are not directly for the purpose of hedging individual equity derivative transactions

or a portfolio of equity derivative transactions. Finally, the banks may not acquire equities for

hedging purposes that constitute more than 5% of a class of stock of any issuer.

Our determination that the activity in question was permissible for these particular banks was

dependent on the facts and circumstances of each situation and our supervisory knowledge and

experience with the banks involved, and did not represent a conclusion that the activity was

generally permissible for all national banks. Thus, the conclusion was conveyed as a supervisory

matter to those institutions rather than a generally applicable legal interpretation. As discussed

above, the OCC will permit equity hedging programs only after a careful review by our

examination staff of each bank’s program, only where the bank can establish equity holdings are

solely for hedging purposes and offer benefits to the bank, and only where the bank has an

appropriate risks management process in place. National banks are not generally authorized to

conduct these activities based on our response to these particular banks.

4 Alternatively, the affiliate could hedge a portfolio of swap transactions using a basket of securities having a close

correlation with the Bank’s underlying exposure.

bank has an

appropriate risks management process in place. National banks are not generally authorized to

conduct these activities based on our response to these particular banks.

4 Alternatively, the affiliate could hedge a portfolio of swap transactions using a basket of securities having a close

correlation with the Bank’s underlying exposure.

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II. Discussion

National banks may engage in customer-driven equity derivative transactions as part of the

business of banking. Hedging risks arising from these permissible banking activities is an

essential and integral part of those banking activities. The banks' use of equities to hedge

permissible equity derivative transactions provides the most accurate, least costly hedges, and

thus is convenient and useful in conducting permissible banking activities, and incidental to the

business of banking. National banks are not banned from holding equities in all circumstances

and, in fact, hold equities in a variety of contexts in connection with their banking business. The

equity hedging activity is not prohibited by Section 16 of the Banking Act of 1933.5

A. The National Bank Act (“Act”)

A national bank may engage in activities pursuant to 12 U.S.C. § 24(Seventh) if the activities are

part of, or incidental to, the business of banking. Section 24(Seventh) expressly provides that

national banks shall have the power:

To exercise . .

th their banking business. The

equity hedging activity is not prohibited by Section 16 of the Banking Act of 1933.5

A. The National Bank Act (“Act”)

A national bank may engage in activities pursuant to 12 U.S.C. § 24(Seventh) if the activities are

part of, or incidental to, the business of banking. Section 24(Seventh) expressly provides that

national banks shall have the power:

To 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 according to the provisions of title 62 of the Revised Statutes.6

The Supreme Court has rejected a narrow view of the bank powers clause that would interpret

the Act as granting to national banks only the five specified powers and such ancillary powers

needed to perform those five.

The powers clause is a broad grant of the power to engage in the business of banking, including,

but not limited to, the five specifically recited powers and such other powers that are reasonably

necessary to perform not just the enumerated powers, but the business of banking as a whole.7

Many activities that are not included in the enumerated powers, including equity derivative

transactions and risk management activities such as hedging risks arising from banking activities,

also are part of the business of banking. 8

5 48 Stat. 162 et seq. (“1933 Act”).

6 The cited language will be referred to later in this memorandum as the “powers clause.”

7 NationsBank of North Carolina v. Variable Annuity Life Insurance Co., 513 U.S. 251 (1995)(“VALIC”)

anagement activities such as hedging risks arising from banking activities,

also are part of the business of banking. 8

5 48 Stat. 162 et seq. (“1933 Act”).

6 The cited language will be referred to later in this memorandum as the “powers clause.”

7 NationsBank of North Carolina v. Variable Annuity Life Insurance Co., 513 U.S. 251 (1995)(“VALIC”).

8 Judicial cases affirming OCC interpretations establish that an activity is within the scope of the “business of

banking” if the activity: [1] is functionally equivalent to or a logical outgrowth of a traditional banking activity; [2]

would respond to customer needs or otherwise benefit the bank or its customers; and [3] involves risks similar to

those already assumed by banks. See, e.g., Merchant Bank v. State Bank , 77 U.S. 604 (1871); M & M Leasing Corp.

v. Seattle First Nat’l Bank , 563 F.2d 1377, 1382 (9th Cir. 1977), cert. denied, 436 U.S. 956 (1978); American

Insurance Assn. v. Clarke, 865 F.2d 278, 282 (2d Cir. 1988). In IAA v. Hawke, ___ F.3d (D.C. Cir. May 16,

2000), the court expressed the position that the “logical outgrowth” rational needed to be kept within bounds, but

endorsed the “functional equivalent” component of the test.

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National banks are also authorized to engage in an activity that is incidental to the performance

of the five powers enumerated in Section 24(Seventh) or incidental to the performance of an

activity that is part of the business of banking. Incidental activities are activities that are

permissible for national banks, not because they are part of the powers expressly authorized for

banks or the “business of banking,” but rather because they are “convenient” or “useful” to those

activities.9

In addition to the above authorizations, national banks are expressly authorized to enter into

contracts under 12 U.S.C. § 24(Third).

B

banking. Incidental activities are activities that are

permissible for national banks, not because they are part of the powers expressly authorized for

banks or the “business of banking,” but rather because they are “convenient” or “useful” to those

activities.9

In addition to the above authorizations, national banks are expressly authorized to enter into

contracts under 12 U.S.C. § 24(Third).

B. Equity Derivative Transactions are Authorized under Express Authorities in the

National Bank Act and as Part of the Business of Banking

Congress has recognized the authority of national banks to engage in equity derivative

transactions. Under the Gramm-Leach-Bliley Act10 banks may offer “identified banking

products” without registration under the Securities Exchange Act of 1934,11 subject only to

banking law requirements. “Identified banking products” include certain swap agreements,

defined as “any individually negotiated contract, agreement, warrant, note or option that is based,

in whole or in part, on the value of, any interest in, or any quantitative measure or the occurrence

of any event relating to, one or more commodities, securities, currencies, interest or other rates,

indices, or other assets. 12 The GLBA conference report further observes that these products are

among the "activities in which banks have traditionally engaged."13 Congress’ recognition that

banks engage in equity derivative transactions and exemption of these activities from certain

securities regulations, provides confirmation for the OCC’s longstanding position that equity

derivative transactions are permissible activities for national banks.

The OCC has found equity derivative transactions permissible under the express statutory

authority granted to national banks to accept deposits, make loans, and enter into contracts and as

part of the business of banking as a financial intermediation activity. As early as 1988, the OCC

9 VALIC; Arnold Tours, Inc. v

le activities for national banks.

The OCC has found equity derivative transactions permissible under the express statutory

authority granted to national banks to accept deposits, make loans, and enter into contracts and as

part of the business of banking as a financial intermediation activity. As early as 1988, the OCC

9 VALIC; Arnold Tours, Inc. v. Camp, 472 F.2d 427 (1st Cir. 1972) (“ Arnold Tours”); OCC Interpretive Letter No.

742 (August 19, 1996), reprinted in [1997-1998 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-106; OCC

Interpretive Letter No. 737 (August 19, 1996), reprinted in [1997-1998 Transfer Binder] Fed. Banking L. Rep.

(CCH) ¶ 81-101; OCC Interpretive Letter No. 494 (December 20, 1989), reprinted in [1989-90 Transfer Binder]

Fed. Banking L. Rep. (CCH) ¶ 83,083.

10 Pub. L. No. 106-102 (1990)(effective May 12, 2001)(GLBA).

11 15 U.S.C. § 78c.

12 Section 206 of Title II, Subtitle A of GLBA. (emphasis added). The definition of “swap agreement” is also

defined broadly in the Federal Deposit Insurance Act and U.S. Bankruptcy Code. 12 U.S.C. § 1821(e)(8)(D)(vi)(I);

11 U.S.C. § 101(53B).

13 H.R. Rep. No. 106-434 at 163 (1999)(Summary of Title II in Managers' Statement).

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determined that national banks could engage in equity derivative transactions.14 In MII Deposit,

the OCC concluded that a national bank may offer a non-transferable time deposit contract with

interest payable at a rate tied to the S&P 500 Index. 15 In reaching that conclusion, the OCC

recognized that the deposit was a permissible banking activity fully within a national bank’s

expressly authorized power to receive deposits and make loans and as part of the “business of

banking” under 12 U.S.C. § 24(Seventh)

d that a national bank may offer a non-transferable time deposit contract with

interest payable at a rate tied to the S&P 500 Index. 15 In reaching that conclusion, the OCC

recognized that the deposit was a permissible banking activity fully within a national bank’s

expressly authorized power to receive deposits and make loans and as part of the “business of

banking” under 12 U.S.C. § 24(Seventh). More recently, the OCC determined that national

banks may offer time deposit accounts or certificates of deposit that pay interest at a rate based

on the gain in designated equity indices.16 The OCC concluded that the deposits were authorized

under the express authority of national banks to receive deposits and enter into contracts under

12 U.S.C. §§ 24(Seventh) and (Third) and as part of the business of banking as a financial

intermediation activity.

In 1994, the OCC addressed the legal permissibility of national banks engaging in swap activities

tied to equities and equity indices.17 The OCC recognized that swap contracts are, in some

respects, direct descendants of traditional deposit contracts because payments under the contacts

are similar to the receipt of deposits and the payment of interest on deposits.18 Based, in part, on

that lineage, the OCC concluded that national banks may make payments to, or receive payments

from, equity and equity index swap customers in the event of a gain or loss in a designated

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

the Chase Market Index Investment Deposit Account (Comptroller concludes that a national bank may buy and sell

futures on the S&P 500 Index to hedge deposits with interest rates tied to the S&P 500 Index)(1988)(“MII

Deposit”); Investment Company Institute v. Ludwig, 884 F. Supp. 4 (D.D.C. 1995) (upholding Comptroller’s

decision that the hedged deposit in MII Deposit is a bank permissible product that does not violate the Glass-Steagall

Act)

count (Comptroller concludes that a national bank may buy and sell

futures on the S&P 500 Index to hedge deposits with interest rates tied to the S&P 500 Index)(1988)(“MII

Deposit”); Investment Company Institute v. Ludwig, 884 F. Supp. 4 (D.D.C. 1995) (upholding Comptroller’s

decision that the hedged deposit in MII Deposit is a bank permissible product that does not violate the Glass-Steagall

Act).

15 MII Deposit, supra.

16 Letter from Ellen Broadman, Director, Securities and Corporate Practices Division, OCC, to Barbara Moheit,

Regional Counsel, FDIC (October 29, 1998)(unpublished)(“Broadman Letter”).

17 OCC Interpretive Letter No. 652 (September 13, 1994), reprinted in [1994 Transfer Binder] Fed. Banking L.

Rep. (CCH) ¶ 83,600. The OCC has recognized the ability of banks to engage in swap products for a number of

years. In the 1980’s the OCC opined on the permissibility of national banks engaging in interest rate, currency, and

commodity price index swaps and caps. OCC No-Objection Letter No. 87-5 (July 20, 1987), reprinted in [1988 -

1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 84,034; OCC Interpretive Letter No. 462 (December 19,

1988), reprinted in Fed. Banking Law Rep. (CCH) ¶ 85,686; OCC Letter from J. Michael Shepherd, Senior Deputy

Comptroller, Corporate and Economic Programs (July 7, 1988)(unpublished). Then, in the 1990’s, the OCC

recognized that national banks may advise, structure, arrange, and execute transactions, as agent or principal, in

connection with interest rate, basis rate, currency, currency coupon, and cash-settled commodity swaps; swaptions,

captions, and other option-like products; forward rate agreements, rate locks and spread locks, as well as similar

products that national banks are permitted to originate and trade in and in which they may make markets. OCC

Interpretive Letter No. 725 (May 10, 1996), reprinted in [1995-1996 Transfer Binder] Fed. Banking L. Rep. (CCH)

¶ 81,040; OCC Letter from Jimmy F

d commodity swaps; swaptions,

captions, and other option-like products; forward rate agreements, rate locks and spread locks, as well as similar

products that national banks are permitted to originate and trade in and in which they may make markets. OCC

Interpretive Letter No. 725 (May 10, 1996), reprinted in [1995-1996 Transfer Binder] Fed. Banking L. Rep. (CCH)

¶ 81,040; OCC Letter from Jimmy F. Barton, Deputy Comptroller Multinational Banking, to Carl Howard,

Associate General Counsel, Citibank, N.A. (May 13, 1992)(unpublished); OCC Letter from Horace G. Sneed,

Senior Attorney, Legal Advisory Services Division (March 2, 1992)(unpublished); OCC No-Objection Letter No.

90-1 (February 16, 1990), reprinted in [1989-1990 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,095.

18 OCC Interpretive Letter No. 652, supra.

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equity or equity index. The OCC further recognized that equity and equity index swap activities

are permissible for national banks as a financial intermediation activity.19 In such arrangements,

national banks act as financial intermediaries between customers that want to manage risks

resulting from the variations in a particular equity or equity index. Customers do not deal

directly with one another, but instead make payments through the intermediary bank.

Banks, through their equity derivative transactions, are better able to meet customer needs by

offering financial instruments that serve important risk management and other financial

functions. National banks have benefited from equity derivative transactions that enable them to

diversify, expand their customer base, and increase revenues.20 Equity derivative transactions

pose risks similar to those inherent in other types of banking activities that national banks are

familiar with and manage, e.g., interest rate, liquidity, credit, and compliance risks.

C

nd other financial

functions. National banks have benefited from equity derivative transactions that enable them to

diversify, expand their customer base, and increase revenues.20 Equity derivative transactions

pose risks similar to those inherent in other types of banking activities that national banks are

familiar with and manage, e.g., interest rate, liquidity, credit, and compliance risks.

C. Hedging Risks Arising from Bank Permissible Banking Activities is Integral to

Those Permissible Activities

It is axiomatic that managing the risks arising from permissible banking activities is integral to

the business of banking; this principle is equally valid whether the activity is deposit-taking or

derivatives.21 Entering into deposit, loan, and other contracts with customers, and engaging in

other bank permissible activities involve risks that banks must manage as part of the business of

banking.22 A bank must manage the risk in those activities to operate profitably and may engage

in hedging activities to do so.23 Indeed, the OCC recognizes that national banks may sell

forwards to hedge against potential fluctuations in the price of silver as an integral part of the

explicit statutory authority of national banks to buy and sell coins.24 National banks may

19 OCC Interpretive Letter No. 652, supra. OCC Interpretive Letter No. 652 pre-dates VALIC and characterized

swaps as a financial intermediary activity incidental to a bank’s express power to engage in deposit and lending

activities under 12 U.S.C. § 24(Seventh). Upon re-examination, the OCC since has concluded that swap and funds

intermediation activities are part of the business of banking. Broadman Letter.

20 OCC Bank Derivatives Report, Second Quarter (2000).

21 Broadman Letter; OCC Interpretive Letter No. 684 (August 4, 1995), reprinted in [1993-1994 Transfer Binder]

Fed. Banking L. Rep. (CCH) ¶ 83,632; OCC Interpretive Letter No

.C. § 24(Seventh). Upon re-examination, the OCC since has concluded that swap and funds

intermediation activities are part of the business of banking. Broadman Letter.

20 OCC Bank Derivatives Report, Second Quarter (2000).

21 Broadman Letter; OCC Interpretive Letter No. 684 (August 4, 1995), reprinted in [1993-1994 Transfer Binder]

Fed. Banking L. Rep. (CCH) ¶ 83,632; OCC Interpretive Letter No. 632 (June 30, 1993), reprinted in [1993-1994

Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,516.

22 OCC “Bank Supervision Process Booklet” Comptroller’s Handbook for National Bank Examiners (April 1996).

In fact, a 1992 decision by an Indiana court and a class action filed in 1991 in the U.S. District Court of the Southern

District of Texas suggest that a duty exists for corporations to hedge their exposures to changing commodity prices

and currency values. Brane v. Roth, 590 N.E. 2d 587 (Ind. Cir. App. 1992); In re Compaq Securities Litigation, 848

F. Supp. 1307 (S.D. Tex. 1993). If corporations have a duty to manage those exposures, it reasonably follows that

corporations must also hedge the exposures arising from equity derivative transactions.

23 OCC Interpretive Letter No. 725, supra; OCC Interpretive Letter No. 652, supra; OCC Interpretive Letter No.

632, supra; OCC No-Objection Letter No. 90-1, supra; MII Deposit, supra; OCC No-Objection Letter No. 87-5

(July 20, 1987), reprinted in [1988 - 1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 84,034.

24 OCC Letter from Kenneth W. Leaf, Chief National Bank Examiner (June 12, 1974).

ns.

23 OCC Interpretive Letter No. 725, supra; OCC Interpretive Letter No. 652, supra; OCC Interpretive Letter No.

632, supra; OCC No-Objection Letter No. 90-1, supra; MII Deposit, supra; OCC No-Objection Letter No. 87-5

(July 20, 1987), reprinted in [1988 - 1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 84,034.

24 OCC Letter from Kenneth W. Leaf, Chief National Bank Examiner (June 12, 1974).

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8

purchase spot and futures contracts on exchange, coin and bullion to hedge against future price

fluctuations intrinsic to those commodities.25 National banks may also use futures to hedge

against the risk of loss due to the interest rate fluctuations inherent in bank loan operations, U.S.

Treasury Bills, and certificates of deposit.26

Hedging risks arising from permissible equity derivative activities also is an integral part of

permissible banking activities. In reviewing the legal permissibility of MII Deposit, the OCC

authorized a national bank to purchase equity index futures to hedge interest rate risk exposure

on deposit accounts having interest payable at a rate tied to the S&P 500 Index. The OCC

concluded that the activity was permissible, in part, because the hedge was a necessary

component of the bank’s deposit-taking activities. The OCC has similarly concluded that

hedging interest rate risk on deposits that pay interest at a rate based on the gain in designated

equity indices with options is an integral part of traditional bank deposit functions and the

authority of banks to enter into contracts.27 Finally, national banks may hedge swaps, including

equity and equity index swaps, to manage the risks in, and as an integral part of, those bank

permissible transactions. 28

Through hedging activities, national banks serve as financial intermediaries, a traditional and

permissible banking function

ral part of traditional bank deposit functions and the

authority of banks to enter into contracts.27 Finally, national banks may hedge swaps, including

equity and equity index swaps, to manage the risks in, and as an integral part of, those bank

permissible transactions. 28

Through hedging activities, national banks serve as financial intermediaries, a traditional and

permissible banking function. 29 Longstanding OCC precedent recognizes the authority of

national banks to act as financial intermediaries, for example, by engaging in swap transactions

25 OCC Letter to Republic National Bank from J. T. Watson, Deputy Comptroller of the Currency (March 12,

1975).

26 OCC Letter to Gregory Crane (October 26, 1976)(national banks may use GNMA futures to hedge the interest

rate fluctuation risks inherent in FHA/VA loans as an activity incidental to banking and permissible under 12 U.S.C.

§ 24(Seventh)); OCC Letter to Alan E. Rothenberg, Vice President, Bank of America, from Robert Bloom, First

Deputy Comptroller (Policy)(October 11, 1976)(national banks may hedge the risk of interest rate fluctuations in

conventional real estate loans with GNMA futures to reduce interest rate fluctuations as a legally permissible

activity under the National Bank Act.). In 1976, the OCC also permitted a national bank to purchase T-bill futures

for hedging purposes as part of the authority of national banks to deal in, underwrite, and purchase obligations

issued by the U.S. OCC Letter to Michael Sweeney, Vice President, Merchants National Bank and Trust Company

of Indianapolis (December 29, 1976); OCC Letter to Senator Huddleston, from Donald A. Melbye, Special Assistant

for Congressional Affairs (February 10, 1977) and OCC Banking Circular 79 (November 2, 1976) (BC-79). BC-79

was revised three times, with the latest revision dated April 19, 1983

issued by the U.S. OCC Letter to Michael Sweeney, Vice President, Merchants National Bank and Trust Company

of Indianapolis (December 29, 1976); OCC Letter to Senator Huddleston, from Donald A. Melbye, Special Assistant

for Congressional Affairs (February 10, 1977) and OCC Banking Circular 79 (November 2, 1976) (BC-79). BC-79

was revised three times, with the latest revision dated April 19, 1983. On October 27, 1993, the OCC issued

Banking Circular-277 which provided comprehensive guidance on all forms of financial derivatives and

simultaneously rescinded BC-79; OCC Letter to Charles N. Parrott, Associate Counsel, Deposit Guaranty National

Bank, from Peter Liebesmann, LASD (February 15, 1983) (citing BC-79 (March 19, 1980)(2d Rev)). This

determination specifically addressed the ability of national banks to buy “puts” on the GNMA certificates that would

enable the bank to sell the certificates at set prices with a given period of time. If the value of the certificates

increased, the puts would not be exercised. If the value declined, the bank would exercise the put and deliver the

certificates at the agreed upon price.

27 Broadman Letter, supra.

28 See n.17, supra.

29 Broadman Letter, supra.

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9

and assuming offsetting swap positions or hedges.30 In so doing, the bank protects itself against

risks arising from an established, permissible banking activity. As a result of hedging, a bank

becomes a financial intermediary in a swap transaction, by interposing itself between customers

initiating swap transactions and customers providing offsetting returns. Thus, hedging is an

integral part of financial intermediation services permissible for national banks.

D

bank protects itself against

risks arising from an established, permissible banking activity. As a result of hedging, a bank

becomes a financial intermediary in a swap transaction, by interposing itself between customers

initiating swap transactions and customers providing offsetting returns. Thus, hedging is an

integral part of financial intermediation services permissible for national banks.

D. Banks may Purchase Equity Securities to Hedge Equity Derivative Transactions

as an Activity that is Incidental to the Business of Banking

Section 24(Seventh) gives national banks incidental powers to engage in activities that are

necessary to carry on enumerated bank powers as well as the broader “business of banking.”31

Prior to VALIC, the standard that was 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.32 The Arnold Tours standard 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.”33 Even prior to VALIC, the Arnold Tours

formula represented the narrow interpretation of the “incidental powers” provision of the

National Bank Act.34 The VALIC decision, however, has established that the Arnold Tours

formula should be read to provide that an incidental power includes one that is “convenient” or

“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). Thus, national banks may take possession

of equities for hedging purposes as an activity that is convenient and useful to permissible equity

derivative transactions.

The equity hedges enable the banks to protect against loss in banking transactions in the most

efficient manner and therefore are convenient and useful to the banks' equity derivative business

y enumerated in 12 U.S.C. § 24(Seventh). Thus, national banks may take possession

of equities for hedging purposes as an activity that is convenient and useful to permissible equity

derivative transactions.

The equity hedges enable the banks to protect against loss in banking transactions in the most

efficient manner and therefore are convenient and useful to the banks' equity derivative business.

Here, the banks represented that physically hedging equity derivative transactions within the

banks, rather than through affiliates, will enable them to retain additional revenues from equity

derivative activities and enjoy substantial cost savings. Furthermore, when the mirror

transactions are eliminated, the revenues and profits generated by the equity derivative

transactions and the physical hedges will accrue to the benefit of the banks. Permitting the banks

to use equities to hedge risks arising from permissible equity derivative transactions thus will

enable the banks to operate more efficiently, compete more effectively with entities that engage

in similar optimal hedges, offer customers the least costly and most attractive products and

services, and operate profitably.

30 See n.17, supra.

31 VALIC, supra, at 258 n.2.

32 Arnold Tours, supra.

33 Id. at 432.

34 See n.9, supra.

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10

In addition, equity hedging is incidental to banking as a convenient and useful means of reducing

the operational risks in its equity derivative business that exist as a result of the mirror

transactions between the banks and their nonbank affiliates. In particular, by eliminating the

mirror transactions and physically hedging the equity derivative transactions in the banks, the

banks expect to see a potential reduction in trading, risk management, compliance, and operation

risks that exist from the back-to-back booking of the mirror transactions

that exist as a result of the mirror

transactions between the banks and their nonbank affiliates. In particular, by eliminating the

mirror transactions and physically hedging the equity derivative transactions in the banks, the

banks expect to see a potential reduction in trading, risk management, compliance, and operation

risks that exist from the back-to-back booking of the mirror transactions.

The equity hedges are similar to commodity hedges that are convenient and useful to bank

permissible commodity-linked derivative transactions. The OCC has determined that in some

instances national banks may take physical delivery of commodities to hedge bank permissible

commodity-linked derivative transactions as a convenient and useful means to manage the risks

arising from those permissible banking transactions.35 The OCC permitted the activity, in part,

because the commodities provided accurate and precise hedges. The banks' physical possession

of equities is similarly a means to manage the risks in bank permissible derivative transactions in

a manner that provides precise and cost-effective hedges. Accordingly, the equity hedges benefit

the banks by enabling them to more effectively manage risks arising from permissible equity

derivative transactions, and thus are convenient and useful to those bank permissible activities.

E. Use of Physical Equity Securities to Hedge Banking Risks is not Prohibited by

Section 16 of the 1933 Act

anner that provides precise and cost-effective hedges. Accordingly, the equity hedges benefit

the banks by enabling them to more effectively manage risks arising from permissible equity

derivative transactions, and thus are convenient and useful to those bank permissible activities.

E. Use of Physical Equity Securities to Hedge Banking Risks is not Prohibited by

Section 16 of the 1933 Act

(1) Using Equity Securities to Hedge Equity Derivative Transactions is not

Prohibited Underwriting or Dealing under Section 24(Seventh)

Section 24(Seventh) addresses the ability of a national bank to underwrite and deal in securities.

Specifically, Section 24(Seventh) provides that “[t]he business of dealing in securities and stock

by the association shall be 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: Provided, That

the association may purchase for its own account investment securities under such limitations

and restrictions as the Comptroller of the Currency may by regulation prescribe.”18

Here, the banks are not “dealing” in or “underwriting” securities as prohibited by Section

24(Seventh). Although Adealing@ and Aunderwriting@ are not defined in Section 24(Seventh)36

35 OCC Interpretive Letter Nos. 632 and 684, supra. The OCC also has permitted national banks to physically

hedge against the risk of loss from potential payouts on bank permissible employee compensation and benefit plans

with incidental life insurance, in order to recover the cost of providing those benefits. OCC Interpretive Letter No.

848 (November 23, 1998), reprinted in [1998-1999 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-202; OCC

Bulletin 96-51 (September 20, 1996), reprinted in Fed. Banking L. Rep. (CCH) ¶ 35-491

f loss from potential payouts on bank permissible employee compensation and benefit plans

with incidental life insurance, in order to recover the cost of providing those benefits. OCC Interpretive Letter No.

848 (November 23, 1998), reprinted in [1998-1999 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-202; OCC

Bulletin 96-51 (September 20, 1996), reprinted in Fed. Banking L. Rep. (CCH) ¶ 35-491. Most recently, the OCC

concluded that it was convenient and useful for a national bank to physically hedge an employee compensation

program with bank impermissible insurance company products and investments because the hedge virtually

eliminated all the risk arising under the program to the bank. OCC Interpretive Letter No. 878 (December 22,

1999), reprinted in [1998-1999 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 81-373.

36 Although the securities laws definitions are not dispositive in determining whether a particular type of securities

activity is permitted for banks, these definitions provide a useful starting point for characterizing a bank’s securities

activities. Under section 3 of the Securities Exchange Act of 1934, a “dealer” is defined as “any person engaged in

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11

“dealing” in securities is generally understood to encompass the purchase of securities as

principal for resale to others.37 Dealing is buying and selling as part of a regular business. A

dealer typically maintains an inventory of securities and holds itself out to the public as willing

to purchase and sell and continuously quote prices.38 “Underwriting” is generally understood as

encompassing the purchase of securities from an issuer for distribution and sale to investors.39

Case law confirms that one cannot be an underwriter in the absence of a public offering.40

Under the above definitions, the banks' purchase of equity securities for hedging customer-driven

equity derivative transactions is not “dealing” or “underwriting.” The banks committed to

holding physical equity securities solely for purposes of hedging

om an issuer for distribution and sale to investors.39

Case law confirms that one cannot be an underwriter in the absence of a public offering.40

Under the above definitions, the banks' purchase of equity securities for hedging customer-driven

equity derivative transactions is not “dealing” or “underwriting.” The banks committed to

holding physical equity securities solely for purposes of hedging. The banks do not hold the

securities in order to engage in a regular business of buying and selling them in the secondary

market41 and do not publicly offer the securities to investors.

(2) The Purchase of Equity Securities for Hedging Purposes is not Subject to

the Limitations on the Purchase of Investment Securities

The purchase of equities is not an investment in investment securities and therefore is not subject

to the limitations placed upon the purchase of those securities in 12 U.S.C. § 24(Seventh) or in

12 C.F.R. Part 1. The statutory definition of investment securities includes “marketable

obligations evidencing the indebtedness of any person, copartnership, association or corporation

in the form of bonds, notes, and/or debentures, commonly known as ‘investment securities’” and

gives the Comptroller the authority to define further that term. Accordingly, the OCC issued

implementing regulations defining “investment securities” at 12 C.F.R. Part 1. Under Part 1, an

investment security is defined as “a ‘marketable’ debt obligation that is not predominantly

speculative in nature.”42 Equity securities do not fall within the Section 16 or Part 1 definitions

the business of buying and selling securities for his own account, through a broker or otherwise, but does not include

any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary

capacity, but not part of a regular business.” 15 U.S.C. § 78c(a)(5)

t fall within the Section 16 or Part 1 definitions

the business of buying and selling securities for his own account, through a broker or otherwise, but does not include

any person insofar as he buys or sells securities for his own account, either individually or in some fiduciary

capacity, but not part of a regular business.” 15 U.S.C. § 78c(a)(5). Under the Securities Act of 1933, an

“underwriter” includes “any person who has purchased from an issuer with a view to, or offers or sells for an issuer

in connection with, the distribution of any security.” 15 U.S.C. § 77(b)(a)(11).

37 OCC Interpretive Letter No. 393 (July 5, 1987), reprinted in [1988-1989 Transfer Binder] Fed. Banking L. Rep.

(CCH) ¶ 85,617 (national bank with limited market presence not considered a dealer). See also Louis Loss,

Securities Regulation 2983-84 (3d ed. 1990).

38 Citicorp, J.P. Morgan & Co. Inc., Banker Trust New York Corporation, 73 Fed. Res. Bull. 473 n.4 (1987); OCC

Interpretive Letter No. 684, supra.

39 OCC Interpretive Letter No. 388 (June 16, 1987), reprinted in [1998-1989 Transfer Binder] Fed. Banking L. Rep.

(CCH) ¶ 85,612; OCC Interpretive Letter No. 329 (March 4, 1985), reprinted in [1985-1987 Transfer Binder] Fed.

Banking L. Rep. (CCH) ¶ 85,499.

40 SIA v. Board of Governors, 807 F.2d 1052 (D.C. Cir. 1986), cert. denied, 483 U.S. 1005 (1987).

41 While the banks may purchase and sell equity securities on a regular basis consistent with its hedging activities,

the banks will not act as market-maker in the securities by quoting prices continuously on both sides of the market.

42 12 C.F.R. § 1.2(e).

der] Fed.

Banking L. Rep. (CCH) ¶ 85,499.

40 SIA v. Board of Governors, 807 F.2d 1052 (D.C. Cir. 1986), cert. denied, 483 U.S. 1005 (1987).

41 While the banks may purchase and sell equity securities on a regular basis consistent with its hedging activities,

the banks will not act as market-maker in the securities by quoting prices continuously on both sides of the market.

42 12 C.F.R. § 1.2(e).

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12

of “investment securities.” The basic characteristic of equity securities is a fractional ownership

interest in the corporation involved.43 Equity securities do not represent debt obligations.

Accordingly, the provisions contained in Section 24(Seventh) applicable to investment securities

do not apply to equity investments held by banks for the purpose of engaging in banking

business.

(3) Using Equity Securities to Hedge is not Prohibited by the Fifth Sentence

of Section 24(Seventh)

Section 24(Seventh) does not provide a general authorization to national banks to hold equity

securities. Instead, national banks may hold equity securities only to the extent such holdings are

permissible because, in the situation presented, the holding is authorized as part of, or incidental

to, the business of banking (or other specific statutory authority). The language in the fifth

sentence of Section 24(Seventh) “nothing herein contained shall authorize the purchase by the

association for its own account of any shares of stock of any corporation” is not a blanket bar on

national bank acquisitions of stock. Rather, as discussed below, that language makes clear that

the authorization contained in the statute permitting banks to invest in investment securities does

not include stock. This proviso does not affect national banks’ authority to hold equities, if the

holding can qualify as permissible because it is part of or incidental to permissible banking

activities.

tional bank acquisitions of stock. Rather, as discussed below, that language makes clear that

the authorization contained in the statute permitting banks to invest in investment securities does

not include stock. This proviso does not affect national banks’ authority to hold equities, if the

holding can qualify as permissible because it is part of or incidental to permissible banking

activities.

(a) The Fifth Sentence Clarifies that the Authority to Invest in

Investment Securities does not apply to Stock

The language contained in the fifth sentence referenced above is not a complete bar on bank

purchases of stock. Rather, as a review of the legislative history of the language reveals, that

language references and clarifies provisions in Section 24(Seventh) authorizing the purchase of

investment securities. Congress’ intent was to make clear that the authorization in Section

24(Seventh) for national banks to invest in investment securities was not the source of authority

for national banks to purchase stock. Congress made its intent clear in several respects. First,

the authorization to purchase investment securities was the only new authorization added to

Section 24(Seventh) in 1933. Thus, the caveat in the fifth sentence that the new language does

not authorize banks to purchase stock logically refers to the authorization to purchase investment

securities. Second, the two provisions use the same language to describe the activities they

address. One provision describes activities permitted for investment securities and the other

clarifies that those same activities are not permitted for stock. The similarity in language used in

the two provisions today, and in previous statutes, as discussed below, supports reading the fifth

sentence to clarify that the authorization to invest in investment securities does not include stock.

It is important to appreciate that the 1933 Act was derived from a series of bills introduced in

1932. S

es that those same activities are not permitted for stock. The similarity in language used in

the two provisions today, and in previous statutes, as discussed below, supports reading the fifth

sentence to clarify that the authorization to invest in investment securities does not include stock.

It is important to appreciate that the 1933 Act was derived from a series of bills introduced in

1932. S. 3215, introduced on January 1, 1932, permitted banks to “purchase and hold”

43 Fabozzi and Zarb, Handbook of Financial Markets: Securities, Options and Futures, Second Edition (1986), at

251.

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13

investment securities but precluded the “purchase or holding” of stock. The bill, however, did

not define an “investment security,” and by necessity contained a clarification that the

authorization to invest in “investment securities” did not include “stock.”44

As the legislation evolved and the language authorizing investment in investment securities

changed, the language in the fifth sentence was revised to mirror the language authorizing

investment in investment securities. S. 4412, introduced on January 30, 1932, authorized an

association to “purchase for its own account investment securities” and clarified that “nothing

herein contained shall authorize the purchase” of stock. The 1933 Act similarly provided that

the association may “purchase for its own account investment securities”, and clarified that

“nothing herein contained shall authorize the purchase of stock.”45 The only difference between

these two provisions was the use of “for its own account” in the authorizing language, but not in

the proviso. That difference was eliminated in the 1935 Amendments which added the “for its

own account” to the clarifying provision so that it now reads “nothing herein contained shall

authorize the purchase by the association for its own account” of stock

e of stock.”45 The only difference between

these two provisions was the use of “for its own account” in the authorizing language, but not in

the proviso. That difference was eliminated in the 1935 Amendments which added the “for its

own account” to the clarifying provision so that it now reads “nothing herein contained shall

authorize the purchase by the association for its own account” of stock. Thus, the 1935

Amendments made the language in the fifth sentence identical to the language authorizing

investment securities, providing further confirmation that the fifth sentence clarifies that the

authorization to invest in investment securities does not include stock.

What authority that exists for national banks to own stock must be found under other provisions

of Section 24(Seventh), as part of, or incidental to, the business of banking.46 This reading is

consistent with other portions of Section 16 of the 1933 Act, enacted simultaneously with this

section, which clearly envision that national banks could own stock in connection with banking

activities

The 1933 Act recognized in several contexts the preexisting authority of national banks to own

stock as authorized under the powers clause. The 1933 Act acknowledged the continuing

authority of national banks to hold stock as part of the business of banking by placing restrictions

on the amounts of such investments. For example, the provisions limiting the amounts that

banks may invest in a safe-deposit business acknowledge a pre-existing separate, but not

expressly stated, authority of national banks to invest in such businesses, which arises from the

powers clause.47 Similarly, the provisions limiting amounts a national bank may invest in a

44 Further clarification was provided subsequently in S. 4115 which defined “investment securities” to include only

debt obligations.

45 S

g separate, but not

expressly stated, authority of national banks to invest in such businesses, which arises from the

powers clause.47 Similarly, the provisions limiting amounts a national bank may invest in a

44 Further clarification was provided subsequently in S. 4115 which defined “investment securities” to include only

debt obligations.

45 S. 4412, as reported on April, 18, l932, added “or holding” after the term “purchase” in the clarifying provision,

but this language was deleted in the 1933 Act passed by Congress so that the authorizing and qualifying language

were the same.

46 As discussed above, national banks have no general authorization to acquire stock. Other statutory sections may

also expressly authorize the acquisition of stock in specific circumstances, e.g., 12 U.S.C. § 24(Eleventh) (stock of

community development corporations), 12 U.S.C. § 371d (stock of bank premises corporations), 12 U.S.C. § 1861 et

seq. (stock of bank service corporations), and 15 U.S.C. § 682(b) (stock of small business investment corporations).

47 1933 Act §16, 48 Stat. at 185.

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14

company that holds the bank’s premises acknowledges the preexisting authority under the

powers clause for national banks to invest in those companies.48

The 1933 Act also included a definition of an “affiliate” that recognized a national bank’s

authority to own stock. Specifically, the 1933 Act definition of an affiliate included any

corporation in which a national bank owns or controls a majority of the voting shares. The

ability to own or control a majority of the voting shares of a corporation necessarily depends

upon there being the preexisting authority of a national bank to hold stock under the powers

clause.49

a national bank’s

authority to own stock. Specifically, the 1933 Act definition of an affiliate included any

corporation in which a national bank owns or controls a majority of the voting shares. The

ability to own or control a majority of the voting shares of a corporation necessarily depends

upon there being the preexisting authority of a national bank to hold stock under the powers

clause.49

(b) National Banks may Hold Equities Based on Existing Precedent

Most notably, nearly 35 years of precedent recognize the authority of national banks to hold

stock of operating subsidiaries as part of, or incidental to, the business of banking. As early as

the 1960s, the OCC developed a comprehensive scheme for the regulation and supervision of

national banks engaging in the business of banking through bank operating subsidiaries based on

authorities arising from the powers clause. In 1966, the OCC issued a new regulation and a

ruling confirming again the authority of national banks to own stock under the powers clause.

Then, in 1971, the regulation was substantially revised to reflect the more comprehensive ruling.

Subsequently, in 1983, the regulation was incorporated into 12 C.F.R. 5.34 without substantive

change. Today national banks may own equities of operating subsidiaries based on the

authorities provided under the powers clause and in accordance with 12 C.F.R § 5.34.50

Very recently, Congress affirmed in GLBA that national banks may own stock under Section

24(Seventh) by recognizing that national banks have subsidiaries engaged in activities

permissible for the national bank.51 Notably, rather than reauthorize national banks to own

operating subsidiaries in GLBA, Congress instead recognized that preexisting authority.

48 1933 Act §14, 48 Stat. at 184

A that national banks may own stock under Section

24(Seventh) by recognizing that national banks have subsidiaries engaged in activities

permissible for the national bank.51 Notably, rather than reauthorize national banks to own

operating subsidiaries in GLBA, Congress instead recognized that preexisting authority.

48 1933 Act §14, 48 Stat. at 184.

49 As an alternative, the definition may have simply referred to affiliate stock that banks could already hold pursuant

to Sections 25 and 25A of the Federal Reserve Act pertaining to Edge Act and Agreement corporations and foreign

banks under 12 U.S.C. §§ 601, 611 et seq. However, nothing in the language of this definition suggests such a

narrow reading.

50 Since the recent revisions to 12 C.F.R. § 5.34 became effective on March 11, 2000, national banks that qualify as

well capitalized and well managed have been permitted to engage through operating subsidiaries in an expanded list

of activities by giving the OCC notice after the fact. While all of the activities contained in the new 12 C.F.R. §

5.34 list are ones the OCC has found to be part of, or incidental to, the business of banking, the preamble to the rule

makes clear that the list is not all-inclusive, and that the OCC will periodically review and update the list as

necessary. See Financial and Operating Subsidiaries, 65 Fed. Reg. 12905, 12908 (2000).

51 Sections 121 and 122 of Title I, Subtitle C of GLBA.

in the new 12 C.F.R. §

5.34 list are ones the OCC has found to be part of, or incidental to, the business of banking, the preamble to the rule

makes clear that the list is not all-inclusive, and that the OCC will periodically review and update the list as

necessary. See Financial and Operating Subsidiaries, 65 Fed. Reg. 12905, 12908 (2000).

51 Sections 121 and 122 of Title I, Subtitle C of GLBA.

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15

Courts also recognize the power of national banks to own corporate stock in

connection with satisfaction of debts previously contracted (ADPC@).52 The OCC

similarly recognizes the DPC authority of national banks in its regulations and in its

Interpretive and No-Objection Letters.53 This ability to hold stock arises from the

powers of national banks under 12 U.S.C. § 24(Seventh). In First National Bank of

Charlotte, the Supreme Court made clear that as part of national bank’s powers, the

bank may hold stock in satisfaction of debt. In that case the Court stated:

[The] right of a bank to incur liabilities in the regular course of business,

as well as to become a creditor to others [must necessarily be implied]. Its

own obligations must be met and debts due to it collected or secured. The

power to adopt reasonable and appropriate measures for these purposes is

an incident to the power to incur the liability or become the creditor. . . . .

Banks may do, in this behalf, whatever natural persons could do under like

circumstances. . . . In the honest exercise of the power to compromise a

doubtful debt owing to a bank, it can hardly be doubted that stocks may be

accepted in payment and satisfaction, with a view to subsequent sale or

conversion into money so as to make good or reduce anticipated loss.

Such a transaction would not amount to a dealing in stocks. . .

whatever natural persons could do under like

circumstances. . . . In the honest exercise of the power to compromise a

doubtful debt owing to a bank, it can hardly be doubted that stocks may be

accepted in payment and satisfaction, with a view to subsequent sale or

conversion into money so as to make good or reduce anticipated loss.

Such a transaction would not amount to a dealing in stocks. . . . Of

course, all such transactions must be compromises in good faith, and not

mere cloaks or devices to cover unauthorized practices.54

Based on the above, it is apparent that Congress, the courts, and the OCC recognize that in some

instances, national banks may take physical possession of equities. Banks should similarly be

permitted to take physical possession of equities for purposes of hedging the risks associated

with permissible banking activities. The activity is permissible under 12 U.S.C. § 24(Seventh)

and is not prohibited by Section 16 of the 1933 Act.

III. Conclusion

52 First Nat’l Bank of Charlotte v. Nat’l Exchange Bank of Baltimore, 92 U.S. 122 (1875) (“First Nat’l Bank of

Charlotte”); Atherton v. Anderson, 86 F.2d 518 (6th Cir. 1936) rev’d on other grounds, 302 U.S. 643 (1937); See

also, Bouchelle v. First Nat’l Bank of Birmingham, 173 So. 83 (Ala. 1937).

53 12 C.F.R. §1.7; OCC Interpretive Letter No. 511 (June 20, 1990), reprinted in [1990-1991 Transfer

Binder] Fed. Banking L. Rep. (CCH) ¶ 83,213; OCC Interpretive Letter No. 502 (April 6, 1990), reprinted

in [1989-1990 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,097; OCC No-Objection Letter No. 89-

01 (January 25, 1989), reprinted in [1989-1990 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,009;

OCC No-Objection Letter No. 88-7 (May 20, 1988), reprinted in [1988-1989 Transfer Binder] Fed.

Banking L. Rep. (CCH) ¶ 84,047; OCC No-Objection Letter 87-10 (November 27, 1987), reprinted in

[1988-1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 84,039; OCC Interpretive Letter No

Letter No. 89-

01 (January 25, 1989), reprinted in [1989-1990 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 83,009;

OCC No-Objection Letter No. 88-7 (May 20, 1988), reprinted in [1988-1989 Transfer Binder] Fed.

Banking L. Rep. (CCH) ¶ 84,047; OCC No-Objection Letter 87-10 (November 27, 1987), reprinted in

[1988-1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 84,039; OCC Interpretive Letter No. 395

(August 24, 1987), reprinted in [1988-1989 Transfer Binder] Fed. Banking L. Rep. (CCH) ¶ 85,619.

54 First Nat’l Bank of Charlotte, supra, at 127.

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16

National banks may hold equity securities to hedge risks arising from permissible banking

activities. OCC precedents have long recognized the authority of national banks to engage in

derivative transactions, including those that are equity-linked, under express authorities and the

broader business of banking powers in Section 24(Seventh). Similarly, OCC precedents

recognize that national banks may hedge risks arising from permissible banking activities as an

integral part of those activities using a broad range of risk management tools.

The banks' equity hedges are convenient and useful to customer-driven, bank permissible equity

derivative transactions. In order to conduct authorized equity derivative transactions, the banks

must hedge the transactions to reduce risks, avoid losses, and operate profitably. The equity

hedges provide the banks with the most cost-effective, precise means to hedge risks arising from

customer-driven equity driven transactions. By physically hedging its equity derivative

transactions in-house, the banks enjoy substantial financial and operational advantages.

Accordingly, we concluded, in the particular circumstances presented, that the banks' physical

possession of equities solely for hedging purposes would be a permissible activity for those

banks

to hedge risks arising from

customer-driven equity driven transactions. By physically hedging its equity derivative

transactions in-house, the banks enjoy substantial financial and operational advantages.

Accordingly, we concluded, in the particular circumstances presented, that the banks' physical

possession of equities solely for hedging purposes would be a permissible activity for those

banks. Our conclusions were dependent on the facts and circumstances and on our supervisory

knowledge of and experience with the banks involved, and did not represent a conclusion that the

activity was generally permissible. Thus, the conclusion was communicated as a supervisory

matter rather than as a generally applicable legal interpretation.

I trust the foregoing is responsive to the issues raised in your letter, and I reiterate my offer to

provide a full briefing on this issue.

Sincerely,

-signed-

John D. Hawke, Jr.

Comptroller of the Currency