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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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Washington, DC 20219

#### Interpretive Letter #1010

September 7, 2004 **October 2004**

#### 12 CFR 7.1017

Re: Authority to Issue a Financial Warranty

Dear **\[ \]**:

This letter responds to your request concerning the permissibility of
the **\[ \]**'s ("Bank's") issuance of a "financial warranty." As
described in the request, the Bank and its wholly-owned operating
subsidiary have issued certain financial warranties in connection with a
specified mutual fund ("Fund"). Basically, the financial warranties
guarantee that the investment structuring advice and monitoring services
provided by the Bank to the Fund will perform as designed. For the
reasons discussed below and based on the Bank's representations, we
conclude that the described transaction and issuance of the financial
warranties are permissible for the Bank and its operating subsidiary.

**I. [Background]{.underline}**

Financial product providers have started marketing new types of mutual
funds that offer a guaranteed return of principal plus a fixed return as
long as the investor maintains the investment without any withdrawals
for a specified period of time. This type of product offers investors
the benefit of both capital preservation and capital appreciation, and
are generally referred to as "principal protected" funds.[^1]

The circumstances you describe involve a factually complex financial
transaction in which the Bank, in effect, issues a financial warranty
that guarantees that the investment structuring advice and asset
allocation monitoring services provided by the Bank (or its subsidiary)
in the creation and operation of the Fund will result in the designed
return to the investors. The Fund offers a "Guaranteed Amount"
representing return of principal plus a minimum annual return to
investors who hold shares for seven years and who reinvest all dividends
and distributions in additional shares of the Fund.[^2] The Fund also
offers the potential of positive equity market-based returns in excess
of the minimum guaranteed amount depending on the performance of the
Fund's investment assets. The life of the Fund is divided into three
phases: an Offering Period, a Guarantee Period, and a Post-Guarantee
Period.

During the Guarantee Period, the Fund's assets are allocated between
equity and debt securities (primarily zero coupon U.S. government
securities) according to the recommendation of a pre-determined complex
model.[^3] The Bank provides structuring assistance and asset allocation
advice that includes the investment constraints and pre-defined
triggers, as set forth in the financial warranty documentation, that
would require the Fund's underlying assets to be liquidated and invested
in zero-coupon bonds that mature at a preset future date upon the
occurrence of certain events.[^4] These controls are designed to ensure
the Fund does not lose principal and provides the guaranteed return. In
the event that the Fund's investment program does not produce a
sufficient return to ensure that a shareholder can redeem its shares for
the guaranteed amount on the maturity date, the financial warranty
provides the financial result represented to investors.[^5]

Specifically, you describe two back-to-back "financial warranties" that
are in effect.[^6] **\[ \]** (" ***Op. Sub.*** "), a wholly-owned
operating subsidiary of the Bank,[^7] issued a financial warranty to the
Fund guaranteeing that it will make up any shortfall between the
"guaranteed amount" to investors on the maturity date and the Fund's
then current net asset value. Second, the Bank issued to **\[ *Op. Sub.*
\]** a corresponding warranty guaranteeing its payment to **\[ *Op.
Sub.* \]** of any amounts owed by **\[ *Op. Sub.* \]** to the Fund.[^8]
You represent that the Bank receives an on-going fee as described under
the terms of the financial warranty agreement that reflects payment for
the package of services provided by the Bank with respect to the
principal protected mutual fund product, including the financial
warranty.

**II. [Discussion]{.underline}**

***A. "Guarantees" Issued by National Banks***

The Bank asserts that the financial warranty may be viewed as a
permissible guarantee under interpretive ruling 12 C.F.R. § 7.1017. The
OCC has long recognized the authority of national banks to issue
guarantees in specific situations.[^9] The case law on national bank
guarantees is extensive. However, most of the cases occurred early in
the twentieth century and several even earlier. The general rule
oft-cited in those cases is that it is *ultra vires* for a national bank
to guarantee the obligations of others, but there have been many
exceptions. In particular and more recently, the OCC's interpretive
ruling codifies that national bank guarantees that satisfy the
"substantial interest" test are within a national bank's authority and
permissible.

***1. Statutory and Case Law Background***

The National Bank Act itself is silent on the authority of national
banks to provide guarantees.[^10] There is no express power, nor any
express prohibition, and views concerning any implied power are
varied.[^11] Significantly, the Supreme Court has not held that
guarantees are *per se* impermissible for national banks. The Court has
held a national bank has no authority to pledge assets to secure a
private deposit.[^12] On some occasions, the Court has upheld a
guarantee given the specific facts under consideration.[^13] In one
instance, for example, the Court found the bank liable on a guarantee
and explained: "the distinction between recovery on the guaranty, as
having been necessarily incidental to the business of banking, and a
recovery of the amount received by petitioner \[the iron works company\]
on account of the guaranty, becomes purely formal."[^14] Here the bank
in order to enable the company to complete its contract, and thereby
repay the advances the bank had made, gave the questioned guarantee.

Lower courts have tended to over-generalize these cases, however, in
stating that national banks may not provide guarantees. In four leading
cases from different circuits, the courts have explained a national
bank's powers with respect to various situations involving guarantees,
including a pure and simple guarantee, a guarantee incidental to another
authorized banking activity, letters of credit ("in essence only
guarantees," as stated by one court), and other agreements that may
amount to a guarantee.[^15] In sum, a reading of those cases along with
the Supreme Court cases supports the conclusion that an agreement that
is effectively a guarantee is permissible for a national bank if certain
factors are present.

> ***2. OCC Interpretive Ruling and Other Precedent***

Section 7.1017 provides in pertinent part:

> A national bank may lend its credit, bind itself as a surety to
> indemnify another, or otherwise become a guarantor . . . , if:
>
> \(a\) The bank has a substantial interest in the performance of the
> transaction involved (for example, the bank as fiduciary, has a
> sufficient interest in the faithful performance by a co-fiduciary of
> its duties to act as surety on the bond
>
> of such co-fiduciary).[^16]

Section 7.1017(a) follows the earlier court cases and codifies a
national bank's authority to guarantee an obligation of another if the
national bank has a substantial interest in the transaction, i.e., when
the guarantee is for the bank's own benefit or in furtherance of its
interests.[^17]

The OCC has explained that a bank may provide a guarantee if the
guarantee qualifies as "incidental" or "convenient" or "useful" to the
performance of the business of banking under 12 U.S.C.
§ 24(Seventh).[^18] A "substantial interest" exists if the guarantee
provided by the bank is "incidental" to another of its authorized
activities.[^19] The nexus between the bank permissible transaction and
the guarantee provides the substantial interest for the bank.[^20] For
example, the interest of a bank in assuring the financial performance of
a co-fiduciary constitutes a sufficient interest to justify the issuance
of a guarantee.[^21] That relationship is analogous to the interest of a
bank in assuring the financial performance of an affiliate, including a
subsidiary corporation. However, the OCC has indicated that issuing a
guarantee merely to maintain a customer relationship or just to receive
a fee would not satisfy the requisite substantial interest.[^22]

> ***3. Bank May Issue A Financial Warranty As a Guarantee In Connection
> with***
>
> ***Its Involvement and Interest in the Structuring and Operation of
> the Fund***

Here the Bank's involvement and interest in the structuring and
performance of the overall Fund product satisfies section 7.1017 for the
Bank to act as a guarantor. The Bank represents its role as the
financial product consultant and adviser of the principal protected
product, which includes a guarantee aspect denoted as the "financial
warranty." The Bank has provided detailed financial advice and
consultation with respect to the creation and implementation of the
Fund. This includes the development, analysis, and counseling related to
structuring the investment program, the allocation models, and the
defeasance triggers that are integral to the Fund's financial structure
and performance[^23] as well as on-going financial counseling and
monitoring related to the Fund's actual operation.[^24] The Bank also
has provided an evaluation of the financial risks and related
considerations involved in this type of product.[^25] It is well
established that national banks may provide those types of
activities.[^26]

The Bank's ability to sell the larger package of banking activities
associated with the "principal protected" model to independent mutual
funds is enhanced by the Bank's ability to provide the protection
related to the Fund's ultimate performance. One of the essential
characteristics of the principal protected mutual fund is a pledge of a
minimum guaranteed financial performance for a set time. The guarantee
of the return of principal to the shareholders (i.e., the "Guaranteed
Amount") is the same as the Bank's exposure on the financial warranty.
Functionally, the financial warranty operates to guarantee payment only
if the Fund itself fails to meet a certain expected financial
result.[^27] In this context then, if the package of banking services
provided by the Bank works as designed, the guarantee should be moot,
i.e., the guarantee is to backstop a financial result that the Bank has
designed Hence, the Bank provides the financial warranty as a guarantee
that the Bank's models, structuring advice, and asset allocations work
as represented to the Fund and its investors.

Under these circumstances, the guarantee issued by the Bank in the form
of a financial warranty satisfies the requisite substantial interest set
forth in section 7.1017(a). The Bank's interest in the financial
warranty advances the Bank's own interest in providing financial
activities related to principal protected funds and is not merely an
interest created by the guarantee itself. Accordingly, subject to
satisfying the safety and soundness considerations discussed below, the
Bank may provide the financial warranty as a guarantee under the
circumstances represented by the Bank.[^28]

***B. Safety and Soundness Considerations***

For the Bank to permissibly engage in the issuance of the financial
warranty, consideration of the Bank's risk management procedures and
internal controls must reflect that the activities are conducted safely
and soundly. The nature of this complex financial transaction requires
sophisticated risk measurement and management capacities on the part of
the bank and qualified personnel in order for the activity to actually
function as described and to operate in a safe and sound manner. In
other issuances, and as applicable here, the OCC has indicated an
effective risk measurement and management process includes appropriate
oversight and supervision, managerial and staff expertise, comprehensive
policies and operating procedures, risk identification and measurement,
and management information systems, as well as an effective and
independent risk control function that oversees and ensures the
appropriateness of the risk management process.[^29]

Our conclusion regarding legal permissibility therefore is subject to
OCC Supervisory staff concluding that the Bank has such risk measurement
and management processes in effect with respect to its financial
warranty product.[^30] Absent such a showing by the Bank, the product
might not function in the manner that is the predicate for the legal
conclusions discussed herein.

Finally, going forward, the OCC requires the Bank to seek a regulatory
capital opinion concerning treatment of the financial warranties for
capital purposes.

**III. [Conclusion]{.underline}**

Accordingly, based on the described facts and circumstances of this
transaction, for the reasons discussed, and subject to the Supervisory
staff conclusions described above, we conclude that the Bank's and its
operating subsidiary's issuance of the financial warranties in
connection with the principal protected Fund are legally permissible
under 12 C.F.R. § 7.1017. If you have any questions concerning this
matter, please contact Suzette H. Greco, Special Counsel, Securities &
Corporate Practices Division, at 202/874-5210.

Sincerely,

/s/ Julie L. Williams

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^1]: *See generally* NASD Investor Alert, *Principal-Protected
    Funds---Security Has a Price* (Mar. 27, 2003). Other names used for
    these products include "capital preservation" or "guaranteed" funds.
    Some variable annuities also offer a similar principal protection
    feature.

[^2]: Accompanying your request were various exhibits related to the
    transaction, including the financial warranties, financial warranty
    agreements, performance guarantee, calculation agent agreement, and
    Fund prospectus (confidential treatment accorded for proprietary
    information, as applicable). The "Guaranteed Amount" is equal to the
    aggregate value of an investor's shares on the business day after
    the close of the offering period (adjusted for expenses and
    distributions) plus a minimum annual compounded return on such
    amount. *See* Principal Protected Plus Fund, *Prospectus* 1
    ("Prospectus").

[^3]: *See* Prospectus at 3. The allocation will fluctuate in response
    to changes in the securities markets, and reflects various asset
    allocation methodology factors. See further discussion *infra* at 6.
    Within the parameters set forth in the financial warranty
    documentation, the investment adviser may invest the Fund's assets
    in securities that it selects using its own investment approach and
    based on its own valuation models to maximize the returns of the
    Fund. Shares of the Fund will not be offered during the Guarantee
    Period except in connection with the reimbursement of dividends and
    distributions.

[^4]: *See* Prospectus at 4, 6.

[^5]: *See id.* at 3.

[^6]: For purposes here, we refer to the "financial warranties" and the
    "financial warranty agreements" interchangeably.

[^7]: **\[ *Op. Sub.* \]** is a **\[ *State* \]** limited liability
    company that historically has held and managed certain closed-end
    residential mortgage loans and mortgage-backed securities. **\[ *Op.
    Sub.* \]** files periodic reports, including financial statements,
    with the SEC under the Securities Exchange Act of 1934.

[^8]: Separately, the Bank's holding company, **\[ \]** Corporation,
    also issued a "performance guarantee" unconditionally guaranteeing
    **\[ *Op. Sub.* \]**'s obligations under the financial warranty.
    That agreement provides added assurance to investors with respect to
    the overall Fund. The holding company's performance guarantee is not
    an obligation of the Bank. Further, the Fund's shareholders have no
    direct rights or claims against either **\[ *Op. Sub.* \]** (under
    the terms of the financial warranty) or the holding company (under
    the terms of the performance guarantee). *See* Prospectus at 3.

[^9]: *See, e.g.,* Interpretive Letter No. 929 (Feb. 11, 2002);
    Interpretive Letter No. 376 (Oct. 25, 1986); Interpretive Letter No.
    214 (July 23, 1981)

    .

[^10]: 12 U.S.C. § 24(Seventh).

[^11]: *See, e.g., Texas & Pacific Railway. v. Potorff,* 291 U.S. 245
    (1934) (court found no basis for claim that power to pledge bank's
    assets is necessary to deposit banking); *Cochran v. U.S.,* 157 U.S.
    286 (1895) (contract of guarantee held within implied powers of a
    national bank).

[^12]: *See, e.g., Texas & Pacific Railway. v. Potorff,* 291 U.S. 245
    (1934).

[^13]: *See, e.g., First Nat'l Bank of Aiken v. Mott Iron Works,* 258
    U.S. 240 (1922) (declining to void a bank's guarantee of contract
    performance, and holding bank liable since it received the benefit
    of the guarantee); *Citizens Central Nat'l Bank v. Appleton,* 216
    U.S. 196 (1910) (declining to void one national bank's guarantee to
    another bank, but deciding based on a theory of implied contract);
    *Cochran v. U.S.,* 157 U.S. 286 (1895) (contract of guarantee held
    within implied powers of a national bank); *People's Bank v. Nat'l
    Bank,* 101 U.S. 181 (1879) (guarantee of notes held within powers of
    a national bank when the transaction was in substance an
    "indorsement").

[^14]: *See First Nat'l Bank of Aiken v. Mott Iron Works,* 258 U.S. at
    241.

[^15]: *See, e.g., Dunn v. McCoy,* 113 F.2d 587 (9th Cir. 1940) (courts
    may enforce guarantees entered into by banks for furtherance of
    their own rights or as an incident to the transaction of their own
    business, but banks may not guarantee the business accounts of their
    customers); *Kimen v. Atlas Exchange Nat'l Bank*, 92 F.2d 615 (7th
    Cir. 1937) (court invalidated bank sale of bonds to a customer and
    simultaneous guarantee to repurchase the bonds noting the risks of
    contingent liabilities that lack any definitive amount or
    timeframe); *Border Nat'l Bank v. American Nat'l Bank*, 282 F. 73
    (5th Cir. 1922) (court upheld as a letter of credit, rather than an
    impermissible guarantee, an agreement covering the purchase and
    shipment of 200 tons of sugar); *Bowen v. Needles Nat'l Bank,* 94 F.
    925 (9th Cir. 1899), *cert. denied,* 176 U.S. 682 (1900) (court
    invalidated bank guarantee of payment of third party's checks as an
    *ultra vires* contract).

[^16]: 12 C.F.R. § 7.1017(a). Other provisions in the regulation are not
    applicable here. Prior to 1996, this regulation was numbered 12
    C.F.R. § 7.7010.

[^17]: *See, e.g., First Nat'l Bank of Aiken v. Mott Iron Works,* 258
    U.S. 240 (1922); *Dunn v. McCoy,* 113 F.2d 587 (9th Cir. 1940);
    *Southern Exchange Bank v. First Nat'l Bank*, 141 S.E. 323 (Ga. App.
    1928).

[^18]: *See, e.g.,* Interpretive Letter No. 929 (Feb. 11, 2002) (bank's
    provision of a default fund contribution/guarantee was incidental to
    bank's clearing and execution activities and satisfied the
    substantial interest needed for issuance of a guarantee);
    Interpretive Letter No. 542 (Feb. 6, 1991) (guaranteeing loans of
    foreign bank subsidiary fell within a guarantee issued for the
    bank's own benefit, and thus viewed as incidental to the business of
    banking).

[^19]: *See, e.g., Dunn v. McCoy,* 113 F.2d 587 (9th Cir. 1940) (bank
    guarantee enforceable in furtherance of bank's own rights);
    Interpretive Letter No. 376 (Oct. 25, 1986) (national bank's
    guarantee of third party securities borrowers' conduct was
    incidental to bank's securities lending program and constituted a
    sufficient substantial interest; guarantee was merely a minor part
    of a much larger package of banking services).

[^20]: *See, e.g.,* Interpretive Letter No. 218 (Sept. 26, 1981),
    (national bank may issue a bill of lading guarantee due to its
    substantial interest in facilitating liquidation of goods after the
    previous issuance of a letter of credit); Interpretive Letter No.
    177 (Jan. 14, 1981) (national bank may in direct deposit pension
    fund program provide for guarantee/ reimbursement of third party
    payors in the event a customer was not entitled to the payment as
    consistent with a bank's incidental powers).

[^21]: *See* 12 C.F.R. § 7.1017(a); *see also* OCC Interpretive Letter
    No. 57 (Oct. 5, 1978).

[^22]: *See, e.g.,* Interpretive Letter No. 376 (Oct. 25,1986)
    (substantial interest cannot be interest created by the guarantee
    itself).

[^23]: Numerous factors are integral to the operation of the Fund.
    "Generally, the model allocates the Fund's assets to zero coupon
    U.S. government securities with value on the maturity date, together
    with a discounted value of the Fund's other assets, sufficient to
    fund the Guaranteed Amount, with the remainder of the Fund's assets
    being allocated between equity securities and debt securities based
    upon the outlook for, and volatility of, the equity markets."
    Prospectus at 4. Factors reflected in the asset allocation
    methodology include: (1) the market value of the Fund's assets as
    compared to the aggregate "guaranteed amount;" (2) the prevailing
    level of interest rates; (3) equity market volatility; and (4) the
    length of time remaining until the maturity date. *Id.*

[^24]: The Bank represents its continuing role with respect to the
    Fund's operation includes comparisons and evaluations of financial
    performance to the designated structure, and recommended adjustments
    as necessary. The Bank performs this daily monitoring role using its
    technology and risk management infrastructure to evaluate the Fund's
    compliance with the parameters set forth within the financial
    warranty agreements. The Bank itself or the Bank's agents through an
    affiliate may perform those activities. You represent that the Bank
    has no other specific contract pertaining to those activities and
    receives no separate fee. The Bank is paid an on-going fee as
    described under the terms of the warranty agreement.

[^25]: The Bank's exposure from the principal protected Fund product is
    small. The Bank represents that because of the nature of the
    investments the credit risk is virtually zero and the market risk is
    minimized to a low level within certain defined parameters.

[^26]: National banks have long provided financial advice and counseling
    under the authority of 12 U.S.C. § 24(Seventh). *See, e.g.,*
    Conditional Approval No. 289 (Oct. 2, 1998); Interpretive Letter No.
    725 (May 10, 1996); Interpretive Letter No. 516 (Jul. 12, 1990);
    Interpretive Letter No. 367 (Aug. 19, 1986); Interpretive Letter No.
    137 (Dec. 27, 1979). Those activities include investment portfolio
    management, business advisory services, financial planning,
    investment recommendations, and analyses of economic trends, among
    other similar financial activities.

[^27]: Essentially the Bank as issuer of the financial warranty is
    secondarily liable for the payment of a certain level of performance
    by the Fund. This is consistent with a contract of guaranty where
    the guaranty creates a secondary liability on the pre-existing
    obligation of another -- to pay in the event that the other does
    not. *See e.g., American Ins. Ass'n v. Clarke,* 865 F.2d 278 (D.C.
    Cir. 1988), *vacated in part on other grounds,* 865 F.2d 287 (1989).

[^28]: Likewise, the corresponding financial warranty issued by the
    Bank's wholly-owned operating subsidiary is an integral part of the
    overall transaction and is authorized on the same basis. Other legal
    authorities, such as the independent undertaking regulation
    (12 C.F.R. § 7.1016) or a derivatives theory also may support this
    type of activity, but it is unnecessary to analyze those
    alternatives here since we find the activity permissible under the
    guarantee theory.

[^29]: *See e.g.*, OCC Bulletin 2004-20, *Risk Management of New,
    Expanded, or Modified Bank Products and Services* (May 10, 2004);
    *Interagency Statement on Sound Practices Concerning Complex
    Structured Finance Activities*, 69 Fed. Reg. 28980 (May 19, 2004)
    (proposed guidance); OCC Bulletin 1999-2, *Risk Management of
    Financial Derivatives and Bank Trading Activities* (1999);
    Comptroller's Handbook, *Risk Management of Financial Derivatives*
    (1997); BC-277, *Risk Management of Financial Derivatives* (1993).

[^30]: In the absence of particular facts and supervisory knowledge of
    an individual institution, the OCC would not be able to opine
    whether a specific financial warranty transaction would be
    permissible for a specific bank.