**Interpretive Letter #940**

May 24, 2002 **July 2002**

**12 USC 24(7)**

Re: [**\[** **\]** Investment Management Activities]{.underline}

Dear **\[ \]**:

This is in response to your letter requesting confirmation that **\[
\]** (the "Bank") may hold for limited periods of time, limited
interests in certain private investment funds for which it serves as
investment manager. The Bank contends that holding such limited
interests is convenient and useful for the Bank in order to conduct its
investment management business. For the reasons set forth below, we
conclude that the Bank may hold the interests in the funds in the manner
and as described herein.

# A. Background

The Bank, which is a subsidiary of **\[ *A* \]**, is a national bank
with powers limited to trust powers. As a national bank, the Bank is
exempt from registration as an investment advisor under the Investment
Advisers Act of 1940.[^1] The Bank serves as investment manager for a
number of private investment funds organized in the United States (the
"Funds").[^2] The Funds invest in a variety of financial instruments,
including stocks and bonds, currencies, and commodities. The Funds use
cash instruments as well as over-the-counter and exchange-traded
derivatives. The Funds also take both short and long positions in
securities. The Funds may invest in securities and other financial
assets in which a national bank ordinarily is not permitted directly to
invest.[^3]

The Funds are structured as multi-advisor funds. As investment manager,
the Bank chooses the advisors for each Fund, allocates Fund assets to
each advisor, and sets up stop-loss provisions and other limits for the
advisors. The Bank also monitors the advisors' performance and
processes, re-allocates assets among advisors, and, if necessary,
terminates advisors that no longer meet performance or other standards.
Certain of the Funds are organized as Delaware limited partnerships and
others are organized as Delaware limited liability companies. All of the
Funds are taxed as partnerships. Consistent with this tax treatment, all
the losses, gains, fees, and expenses are passed through from the Funds
to their respective investors.

The Funds' investors are primarily high net worth individuals who meet
the definitions of both accredited investors under the Securities Act of
1933[^4] and qualified purchasers under the Investment Company Act of
1940.[^5] The Funds are marketed primarily by broker-dealers that are
affiliates of the Bank. These affiliated broker-dealers are registered
with the Securities and Exchange Commission under the Securities
Exchange Act of 1934.[^6] As investment manager, the Bank receives both
a management fee and a fee for performance for each of the Funds. The
management fee is a percentage of the assets of each Fund. The fee for
performance is a percentage of the profits of each Fund above a certain
hurdle rate.

The Bank represents that it would be to the advantage of U.S. investors
in the Funds if the Bank's compensation for performance were paid as a
share of profits, rather than as a fee. To receive a share of the
profits, the Bank would need to hold an interest in the Funds. In the
case of Funds organized as limited partnerships, the Bank would become a
special limited partner. As a special limited partner, the Bank would
not participate in all of the gains and losses of the partnership, but
only in the gains equal to the performance fee to which the Bank is
entitled as investment manager. In the case of Funds organized as
limited liability companies, the Bank would be a special member of those
companies, with the same types of rights it would have in the limited
partnerships. We refer to the Bank's special limited partner and special
member interests in the Funds as "Special Interests."

Performance compensation can be a substantial percentage of the Funds'
respective returns. The Bank represents that individual investors,
trusts, and investors taxed as partnerships that in turn have individual
or trust investors, prefer that investment funds structure performance
compensation as an allocation to the investment manager's equity account
rather than as a fee. Under U.S. tax law, individual investors must
report as income their proportionate share of the gross amount of an
investment fund's income and gains *before* deducting investment-related
fees and expenses paid by the investment fund. The limit placed by the
U.S tax laws on the deductibility of these fees and expenses may
preclude high-income individuals from deducting their full proportionate
share of the fees and expenses of the investment funds. If, however, the
investment manager is paid in the form of a profit allocation, rather
than through a performance fee, the amount so paid is not treated as
income to investors who are not recipients of the allocation.

For these reasons, the Bank represents that it is an industry practice
for investment advisors and managers of certain types of investment
funds to receive performance-related compensation as a profit
allocation. The Bank has provided examples of other, similar private
investment funds that its affiliated broker-dealer markets to investors.
The similar funds marketed by the broker-dealer are structured to
provide payments for advisory services as fund allocations rather than
as fees to maximize tax efficiency for investors. Because several
nonbank investment managers follow industry practice in structuring
performance compensation as an equity interest, the Bank believes that
the limitation on deductibility on the Funds' performance fees as
currently structured (rather than the proposed performance-based equity
allocation to the Bank as investment manager) is having a significant
adverse effect on the Bank's ability to compete for this type of
advisory business. The Bank represents that if it is not able to
structure its performance-based compensation using an allocation of
income and gains to its equity account, the Funds would be significantly
disadvantaged in competing for investors' money.

The Bank's ownership interest in the Funds would be limited. The Bank
does not propose to make any out-of-pocket investments in the Funds,
although it will hold a Special Interest in each Fund to enable it to
receive its performance-based compensation in the form of a profit
allocation as described above. The Bank has represented that under the
terms of the instruments governing the Funds and creating the Special
Interests, the Bank will not participate in any losses suffered by the
Funds. The Bank will account for its Special Interest in the Funds under
the equity method of accounting. The Bank's loss exposure from an
accounting perspective will be limited to the amount of profit
allocation it expects to receive as compensation. The Special Interest
would not entitle the Bank to voting rights. The Bank represents that it
will receive a Special Interest in a Fund only while the Bank provides
investment management services to the Fund. The Bank will withdraw all
profit allocations immediately.[^7]

The Bank proposes to receive a Special Interest in a Fund for which it
serves as investment manager only to the extent it is necessary to
attract investors into the Fund. The Bank will hold Special Interests
only in investment funds that hold securities and financial instruments,
and will not invest in any fund that includes real estate or tangible
personal property. The Bank will hold a Special Interest in a Fund
containing bank-ineligible investments only while the Bank serves as an
investment manager to the Fund, and only if the terms of the instruments
governing the Fund allow the bank to sell, redeem or otherwise dispose
of its equity allocation if it no longer services the Fund.

# B. Analysis

*1. The Bank's holding an interest in funds in order to engage in the
investment advisory*

*business is incidental to the business of banking.*

The OCC has long held that a national bank may provide investment
management services as part of the business of banking authorized under
12 U.S.C. § 24(Seventh) and pursuant to their fiduciary powers under 12
U.S.C. § 92a.[^8] Section 24(Seventh) also gives national banks
incidental powers to engage in activities that are incidental to
enumerated bank powers as well as the broader "business of banking."[^9]
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*.[^10] 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."[^11] Even prior to *VALIC*, the *Arnold Tours* formula
represented the narrow interpretation of the "incidental powers"
provision of the National Bank Act. The *VALIC* decision, however, has
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,
it would be considered incidental to a permissible bank activity for a
national bank to hold interests in an investment fund to which it
provides investment management services if, under the circumstances
presented, holding the interests is convenient or useful to the clearly
bank-permissible investment management activities conducted by the
Bank.[^12]

The OCC recently confirmed that it was legally permissible for an
investment advisor that was partly owned by a national bank to hold
limited equity interests in certain investment funds to which the
investment advisor provided services.[^13] In Interpretive Letter No.
897, the OCC noted several reasons in support of limited equity
investments in funds by an investment advisor in which a national bank
proposed to hold a noncontrolling interest, to: (1) assure that the
advisor's interests were aligned with those of the other investors in
the funds; (2) provide a tax-efficient means for the advisor to receive
performance-based compensation; and (3) efficiently fund the advisor's
obligations to its staff for performance-based bonuses. These three
reasons each constituted reasons why the advisor's investments in the
funds were convenient or useful to the national bank in carrying out its
business, and not mere passive investments unrelated to the bank's
business.

In the instant proposal, the Bank's ownership for limited periods of
small interests in investment funds it manages is directly related to,
and an integral part of, the Banks activity of providing
bank-permissible investment management and administrative services to
certain investment funds. The purpose of holding the Special Interests
is to enable the Bank to act as an investment manager to the types of
investment funds in which this form of ownership by the investment
manager is convenient and useful\--indeed, necessary. The level of such
investments by the Bank in any single fund and in the aggregate will be
limited. The proposed Special Interests in the investment funds are not
passive or speculative investments on the Banks part. The investments
are made solely to enable the Bank to provide investment management
services as conducted by its competitors in the investment management
industry. As a practical matter, in order to offer the funds it manages,
the Bank must structure its compensation to hold these investments in
this limited manner. They will be held only when, and for so long as the
Bank is providing such investment management services.

Investing in the funds it manages enables the Bank to receive its
compensation in a manner that provides tax treatment to investors in a
Fund comparable to that of investors in similar funds. As described
above, because performance-based compensation frequently can be a
substantial percentage of a private investment fund's returns, the use
of a performance-based allocation can have a significant effect on
individual investors. As a result, private investment funds
traditionally have structured performance compensation as an equity
allocation in order to prevent individuals from being disadvantaged by
limits on the deductibility of performance-based compensation in the
form of fees. Permitting the Bank to receive the Special Interests in
the Funds enables it to compete more effectively with entities that can
offer this tax result to their individual investors.

Accordingly, in the instant case, because the Bank's ownership of
limited equity interests in the funds it advises is restricted to a
context where the holding is integral to facilitating a recognized
bank-permissible activity, such holdings are permissible as an incident
to the bank-permissible investment management activities.

*2. Holding an interest in funds in order to engage in the investment
advisory business is*

*not prohibited by 12 U.S.C. 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."

Here, the Bank would not be "dealing" in or "underwriting" securities
prohibited for national banks by Section 24(Seventh). Although dealing
and underwriting are not defined in Section 24(Seventh),[^14]
"dealing" in securities is generally understood to encompass the
purchase of securities as principal for resale to others.[^15] 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.[^16]
"Underwriting" is generally understood as encompassing the purchase of
securities from an issuer for distribution and sale to investors.[^17]
Case law confirms that one cannot be an underwriter in the absence of a
public offering.[^18]

Under the above definitions, the Bank receiving the Special Interests
would not constitute "dealing" or "underwriting." The Bank has
represented that it will receive the Special Interests solely for
purposes of engaging in the investment management business. The Bank
will not hold the Special Interests in order to engage in a regular
business of buying and selling them in the secondary market[^19] and
will not participate in a public offering of the securities to
investors.

The ownership by the Bank of the Special Interests would be a type of
equity investment, and therefore is not the type of security subject to
the limitations placed upon national banks' purchase of investment
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."[^20] Equity securities do not represent debt obligations.

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 was intended to make clear that the express authorization
contained in the statute permitting banks to invest in "investment
securities" does not include an authorization for investments in 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.[^21]

In the present situation, the Banks receiving the Special Interests
enables it to engage in permissible banking activities and act as
investment manager for investment funds that, in practice, require the
manager to take an equity stake. Institutional and sophisticated
individual investors in these funds require the manager to structure the
payment of performance fees in this fashion. In this connection, these
investments permit the Bank to offer funds that provide investors with a
tax treatment comparable to that of investors in other, similar funds.
The Bank would be unable to offer these funds on a competitive basis
unless it makes these investments. Based on these circumstances, the
proposed investments are an integral component of investment management
services provided by the Bank to the investment funds.

*C. Conclusion*

Based upon a review of the information you provided, including the
representations and commitments made in your letter, and for the reasons
discussed above, we conclude that the Bank may receive the Special
Interests in the Funds, subject to the following conditions:

\(1\) The Funds shall constitute "affiliates" of the Bank and Citibank,
N.A. for purposes of Sections 23A and 23B of the Federal Reserve Act.

\(2\) Prior to receiving the Special Interest in the Funds, the Bank
shall adopt and implement an appropriate risk management process,
acceptable to the OCC

Examiner-in-Charge, to monitor these interests. The Bank's risk
management process shall be comprehensive and shall include:

> \(i\) Adoption and implementation of a conflict of interest policy
> addressing all inherent conflicts associated with the Bank's holding
> of the Special Interests in the Funds; and
>
> \(ii\) Adoption and implementation of risk management policies and
> procedures for monitoring the Special Interests in the Funds and the
> risks associated with those interests, taking into account relevant
> factors noted in OCC guidance (e.g., OCC Banking Circular 277
> (BC-277 - October 1993), Supplemental Guidance 1 to BC-277 (January
> 1999) and the Handbook for National Bank Examiners, [Risk Management
> of Financial Derivatives]{.underline} (January 1997)).
>
> The Bank shall provide the OCC with copies of the policies and
> procedures described in (i) and (ii) prior to receiving a Special
> Interest in the funds it manages.
>
> \(3\) The Bank shall not receive Special Interests in the Funds other
> than Funds that invest in securities and financial instruments, and
> the Bank shall not invest in any Fund that holds real estate or
> tangible personal property.
>
> \(4\) The Bank shall make reports and other information in the Bank's
> possession readily available to OCC supervisory staff as necessary for
> the OCC to determine compliance with these conditions.
>
> \(5\) The Bank will account for its Special Interests in the Funds
> under the equity method of accounting.
>
> \(6\) The Bank will hold Special Interests in a Fund only when, and
> only for so long as, it is providing investment management services to
> the Fund.

These conditions are conditions imposed in writing by the OCC in
connection with its action on

the Bank's request for a legal opinion confirming that its interest in
the Funds is permissible under 12  U.S.C. § 24 (Seventh) and, as such,
may be enforced in proceedings under applicable law.

Sincerely,

**-signed-**

Julie L. Williams

First Senior Deputy Comptroller and Chief Counsel

[^1]: 15 U.S.C. § 80b-1 to 80b-21.

[^2]: In addition to the Funds, the Bank also serves as investment
    manager for a number of private investment funds organized outside
    the United States. This letter does not address the permissibility
    of the Bank's activities with respect to the foreign funds.

[^3]: The Bank plans to invest only in funds that invest primarily in
    securities. Any non-securities investments will be limited to
    financial investments, and will not include real estate or tangible
    personal property.

[^4]: 15 U.S.C. § 77a to 77aa.

[^5]: 15 U.S.C. § 80a-1 to 80a-64.

[^6]: 15 U.S.C. § 77b *et seq.*

[^7]: The Bank has indicated that it will have a standing request for
    redemption of all equity allocations from each Fund. The Bank will
    receive the redemption proceeds on the same business day that a Fund
    determines the final amount of each allocation. Because the Bank
    will in effect withdraw all profit allocations immediately, the
    amount of the Bank's interest in any Fund as a practical matter
    would, consistent with Interpretive Letter No. 897, *supra*, never
    exceed 24.99 percent of the total equity of any fund.

[^8]: *See*, *e.g.,* Interpretive Letter No. 897 (October 23, 2000)
    *reprinted in* \[2000-2001 Transfer Binder\] Fed. Banking Law. Rep.
    (CCH) ¶ 81-416; Interpretive Letter No. 851 (December 8, 1999)
    *reprinted in* \[1998-1999 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 81,308; Interpretive Letter No. 871 (October 14, 1999)
    *reprinted in* \[1999-2000 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 81,365; Conditional Approval Letter No. 164 (December 9,
    1994); Interpretive Letter No. 648 (May 4, 1994) *reprinted in*
    \[1994 Transfer Binder\] Fed. Banking L. Rep. (CCH)  83,557;
    Interpretive Letter No. 647 (April 15, 1994), *reprinted in* \[1994
    Transfer Binder\] Fed. Banking L. Rep. (CCH) 83,558; Interpretive
    Letter No. 622 (April 9, 1993) *reprinted in* \[1993-1994 Transfer
    Binder\] Fed. Banking L. Rep. (CCH)  83,557; Interpretive Letter
    No. 403 (December 9, 1987), *reprinted in* \[1988-1989 Transfer
    Binder\] Fed. Banking L. Rep. (CCH)  85,627*.*

[^9]: *VALIC*, *supra,* at 258 n. 2.

[^10]: *Arnold Tours v. Camp,* 472 F.2d 427 (1^st^ Cir. 1972)("*Arnold
    Tours*").

[^11]: *Id*. at 432.

[^12]: *See* Interpretive Letter No. 897 (October 23, 2000), *reprinted
    in* \[2000-2001 Transfer Binder\] Fed. Banking Law. Rep. (CCH) ¶
    81-416. *See also* Interpretive Letter No. 742 (August 19, 1996),
    *reprinted in* \[1997-1998 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 81-106; Interpretive Letter No. 737 (August 19, 1996),
    *reprinted in* \[1997-1998 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 81-101; Interpretive Letter No. 494 (December 20, 1989),
    *reprinted in* \[1989-90 Transfer Binder\] Fed. Banking L. Rep.
    (CCH) ¶ 83,083.

[^13]: Interpretive Letter No. 897 (October 23, 2000), *reprinted in*
    \[2000-2001 Transfer Binder\] Fed. Banking Law. Rep. (CCH) ¶ 81-416.

[^14]: 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 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).

[^15]: 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).

[^16]: *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.*

[^17]: Interpretive Letter No. 388 (June 16, 1987), *reprinted in*
    \[1998-1989 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 85,612;
    Interpretive Letter No. 329 (March 4, 1985), *reprinted in*
    \[1985-1987 Transfer Binder\] Fed. Banking L. Rep. (CCH) ¶ 85,499.

[^18]: *SIA v. Board of Governors,* 807 F.2d 1052 (D.C. Cir. 1986),
    *cert. denied*, 483 U.S. 1005 (1987).

[^19]: The Bank will not act as market maker in the securities by
    quoting prices continuously on both sides of the market.

[^20]: ^?^ 12 C.F.R. § 1.2(e).

[^21]: The legislative history of the language in the fifth sentence of
    Section 24(Seventh) is discussed in detail in Interpretive Letter
    892 (September 13, 2000).