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

April 26, 2006 **Interpretive Letter #1060**

**May 2006**

Subject: Portfolio-hedged Coal Derivative Transactions

Dear **\[ \]**:

**\[ \]**. ("Bank") is seeking confirmation from the Office of the
Comptroller of the Currency ("OCC") that it is permissible for the Bank
to engage in customer-driven[^1] coal derivative transactions[^2] that
settle in cash *or* by transitory title transfer and that are hedged on
a portfolio basis with derivative and spot transactions[^3] that settle
in cash *or* by transitory title transfer. Previously, the Bank received
authority to enter into customer-driven, cash-settled coal derivative
transactions and simultaneously enter into perfectly matched offsetting
derivative transactions.[^4] Under its current proposal, rather than
simultaneously entering into a perfectly matched offsetting transaction,
the Bank will hedge coal derivative transactions on a portfolio basis
with exchange-traded and over-the-counter ("OTC") cash-settled
derivative transactions, in the same manner as the Bank currently hedges
its crude oil, natural gas and electricity derivatives.[^5] The Bank
will also enter into transitory title transfers to settle and hedge coal
derivative transactions as permitted for the Bank in OCC Interpretive
Letter No. 1025, in the context of electricity derivative
transactions.[^6] For the reasons discussed below, we conclude that the
Bank may engage in the proposed transactions, provided the Bank's
examiner-in-charge ("EIC") is satisfied that the Bank has adequate risk
management and measurement systems and controls to conduct the
activities on a safe and sound basis.

#### 

#### I. Background

The Bank currently engages in a variety of financial intermediation
transactions involving a wide range of energy-related commodities. The
Bank recently received authority to engage in customer-driven,[^7]
perfectly matched, cash-settled coal derivative transactions.[^8] The
Bank now wishes to engage in customer-driven, coal derivative
transactions that settle in cash or by transitory title transfer and
hedge the transactions on a portfolio basis with derivative and spot
transactions that settle in cash or by transitory title transfer
(coal-linked transactions).

Presently, the Bank enters into a coal derivative transaction and
simultaneously enters into a perfectly matched offsetting derivative
transaction.  Under the Bank's proposal, it will enter into coal
derivative transactions and hedge the transactions, on a portfolio
basis, with cash-settled, exchange-traded and OTC coal derivative
transactions and transitory title transfers, based on the aggregate
unmatched position in the portfolio.  To the extent that the Bank
determines that a strong correlation exists between coal derivative
contracts and other commodity derivatives or the value of other
commodities, the Bank may use such interrelated contracts and take
transitory title to such commodities in its overall portfolio management
(*i.e.,* cross-hedging).  The Bank may use only derivative contracts
on commodities for cross-hedging purposes that the OCC approved for
hedging in OCC Interpretive Letter No. 1039 or other relevant OCC
precedent. Similarly, the Bank will use only those commodities for
cross-hedging that the OCC has approved for hedging by transitory title
transfer in OCC precedent.[^9] As new derivative transactions are added
to the coal derivative transaction portfolios resulting in changes to
the unmatched position, the Bank will adjust its hedging position to
manage its aggregate exposure to market risk (*i.e.,* the risk to
earnings or capital arising from changes in the value of portfolios of
coal derivative transactions).  The purpose of the proposed hedges,
similar to the transactions addressed in OCC Interpretive Letter No.
1039, is to offset market risk from its coal derivative transactions.  

The Bank believes that the expansion of the Bank's energy-related
businesses to include the proposed coal-linked transactions is a natural
extension of the Bank's existing financial intermediation activities and
will benefit customers as well as the Bank. The major difference between
the financial intermediation activities the OCC recently approved for
the Bank involving coal derivatives and the proposed activity, is that
here the Bank will manage risks arising from derivatives transactions on
a portfolio basis rather than on a perfectly matched basis. When
transactions are perfectly matched, the primary risk to the Bank is
counterparty credit risk (*i.e.,* the risk that a counterparty will not
make payments according to the terms of the transaction). In contrast,
portfolio-hedging may expose the Bank to market and basis risk (*i.e.,*
the risk that the price fluctuations of the hedging instruments will not
exactly match price fluctuations of the underlying transactions),
however, these risks will be subject to risk management limits. And, to
the extent there is any legal risk in coal-linked transactions,
indemnification provisions in the relevant documentation discussed below
will mitigate this risk.

The Bank represents that portfolio-hedging is a more cost effective
means of managing risks arising from permissible derivative activities
than perfectly matching transactions because it reduces transactional
costs and operational risks (*i.e.,* the risk of incurring financial
loss due to human or technical errors). Coal portfolios will naturally
contain offsetting transactions. Thus, the Bank need only hedge the net
residual risk position in each portfolio when it engages in
portfolio-hedging. With perfectly matched transactions, the Bank must
offset each coal transaction that it enters into and pay the costs
associated with executing each of these trades. Because the Bank must
execute a greater number of transactions to perfectly match transactions
than it would if it were portfolio-hedging, there is also greater
opportunity for back office error and reconcilement issues in perfectly
matched trades.

Periodically the Bank may hedge coal derivative portfolios by using
hedging instruments that result in basis risk. Such mismatches, and thus
the resulting basis risk, tend to become more pronounced progressively
during the life of the transactions, thus making accurate hedging
essential. In some instances, cash-settled transactions may provide less
than completely accurate hedges. The Bank believes that the ability to
engage in transitory title transfers involving coal will enable the Bank
to more accurately and precisely hedge its proposed coal derivative
transactions and substantially reduce its basis risk in portfolio-hedged
coal derivative transactions. For coal-linked transactions that involve
transitory title transfer, the Bank represents that it will execute an
offsetting transaction for settlement at the same delivery point on the
same settlement day as the original transaction.[^10] Ownership and
control of, and title to, the coal will pass instantaneously from the
Bank's upstream counterparty through the Bank to its downstream
counterparty at the delivery point. The last buyer in the chain will
provide the transport vehicles to the delivery point, and the initial
seller will load the vehicle. The Bank will not be the initial seller or
the end-buyer in the chain. The Bank represents that it will engage in
the proposed title transfer transactions solely for the accommodation of
customers or for its own risk management purposes.

The Bank plans to mitigate any potential legal risks from engaging in
transitory title transfers of coal by including indemnification
provisions in its coal documentation, a customary industry practice.
Under the indemnification provisions, the Bank will be indemnified from
legal claims when it is the buyer and will be the indemnifying party for
legal claims when it is the seller. Any legal claim the Bank may face as
a seller will be a claim that the Bank has as a buyer under the matching
indemnification provisions. Consequently, such legal claims should be
resolved by the initial seller and the ultimate buyer because the
indemnification provisions effectively pass claims up and down through
the chain of intermediary titleholders to the initial seller and
ultimate buyer.[^11]

The Bank states that its ability to engage in the proposed activities
will enable the Bank to compete more effectively with other
intermediaries, meet customer demand, operate more efficiently and
profitably, and diversify its business risks. For example, the Bank
represents that expansion of its existing energy derivatives business
will enable the Bank to compete with other market intermediaries that
can make coal products available to customers, particularly those market
intermediaries that give customers the option of engaging in coal-linked
transactions that settle by transitory title transfer. Moreover, the
Bank states that the ability to offer these products will enable the
Bank to meet the growing demand for these products by customers such as
mining companies and electricity generators. In addition, the Bank
believes that by offering customers a broader range of risk management
products that more effectively address their individual risk management
needs, the Bank will have the ability to attract a broader customer
base. Finally, the Bank represents that by participating in a broader
range of markets and expanding its customer base, it may diversify and
reduce credit and other risks arising from its energy derivatives
business. Accordingly, the Bank believes the proposed transactions will
enable it to meet customer demand and operate its energy derivatives
business more competitively, efficiently, and profitably.

In sum, the Bank contends that the proposed transactions pose risks
similar in nature to those inherent in perfectly matched, cash-settled
coal derivative transactions and in its portfolio-hedged oil, gas and
electricity derivative transactions (*e.g.,* credit, market and legal
risks), which it has demonstrated the ability to successfully manage and
control. The Bank maintains that the proposed transitory title transfers
do not pose risks different from the transitory title activities the OCC
addressed in OCC Interpretive Letter No. 1025 in the context of
electricity derivative transactions. Further, because the coal-linked
transitory title transfer transactions will not entail the physical
possession of commodities, the Bank represents that these transactions
will not involve the customary activities relating to, or risks
attendant to, commodity ownership (*e.g.,* storage costs, insurance, and
environmental protection). The Bank maintains that while coal-linked
transitory title transfer transactions will require the Bank to perform
obligations such as sending loading instructions to the previous seller
and analysis results to the next buyer[^12] as well as making payment
transfers, these functions are similar to those regularly performed by
national banks in their role as financial intermediaries.

#### The Bank states that its proposal to engage in coal-linked transactions does not envision the use of special purpose entities ("SPEs"). However, should the Bank determine that the use of SPEs may be appropriate in connection with coal-linked transactions, the Bank represents that the transactions will undergo a thorough internal due diligence and review prior to execution. The Bank further represents that such transactions would conform to the Bank's SPE Policy.

The Bank commits that the proposed coal-linked transactions will be
conducted in accordance with all the risk management processes and
procedures currently in place for the Bank's energy-related derivatives
business.[^13]

#### II. Discussion

For the reasons and subject to the conditions described below, the Bank
may engage in customer-driven coal derivative transactions that settle
in cash and hedge these transactions on a portfolio basis with
cash-settled coal derivatives, and also may engage in transitory title
transfers of coal in connection with settling and hedging coal-linked
transactions. These activities are permissible for the Bank provided the
Bank has established an appropriate risk measurement and management
process for these derivative and hedging activities that is satisfactory
to the Bank's EIC. This process is necessary for the Bank to achieve its
customer risk management objectives in a safe and sound manner and thus
must be established before the OCC can determine that the proposed
activities are permissible.

A.  **National Bank may engage in Customer-driven, Portfolio-hedged
    Coal-linked Transactions.**

The OCC has previously determined that the Bank may engage in perfectly
matched cash-settled coal derivatives as a financial intermediary under
12 U.S.C. § 24(Seventh).[^14] The Bank now proposes to portfolio-hedge
these derivatives with derivatives that settle in cash or by transitory
title transfer. The ability to engage in these transactions will
increase the Bank's hedging options and its ability to control risks in
its energy-related derivatives business. The difference between the
activities previously approved for the Bank and those for which approval
is sought here is that rather than simultaneously entering into
coal-linked transactions with perfectly matched offsetting transactions,
the Bank will enter into coal derivative transactions with customers and
manage the transactions on a portfolio basis with exchange-traded and
OTC cash-settled derivative transactions, in the same manner as the Bank
currently manages its crude oil, natural gas and electricity
derivatives. The Bank will also settle coal derivative transactions by
transitory title transfer and hedge these transactions with derivative
transactions and spot transactions that settle by transitory title
transfer, in a manner previously addressed for the Bank in OCC
Interpretive Letter No. 1025 in the context of electricity derivative
transactions.

The expansion of the Bank's derivatives business to include the proposed
transactions is a natural extension of the Bank's existing financial
intermediation activities. The OCC has previously addressed the
permissibility of portfolio-hedging and transactions that settle in cash
or by transitory title where the bank takes title to the commodity in a
"chain of title" and relinquishes title instantaneously under Section
24(Seventh).[^15] Portfolio-hedging is a more cost effective means of
managing risks arising from permissible derivative activities than
perfectly matching transactions because it reduces transactional costs
and operational risks. Portfolio-hedging and transitory title transfer
activities allow banks to compete more effectively, meet customer
demand, and operate more efficiently and profitably. Transitory title
transfers also enable banks to participate in markets using this form of
settlement and provide customers a broader range of sophisticated risk
management tools to address their financial, risk management, and
liquidity needs. In conducting transitory title transfers in connection
with a permissible derivatives business, banks act as financial
intermediaries, ultimately exchanging payments between counterparties
managing financial risks or otherwise meeting financial needs.[^16]
While a time lag may exist between the original transaction and the
offsetting transitory title transfer transaction, the Bank represents
that it will always have an offsetting transaction in place by the
settlement date to make certain that the Bank never will take physical
possession of coal.  Executing transactions and hedging in this manner
is consistent with a portfolio-hedged financial intermediation business.

The OCC finds the risks to which the Bank is exposed under this proposal
are similar in nature to other energy-related derivative transactions
where the Bank has a demonstrated ability to manage and control such
risks. Accordingly, the Bank may act as a financial intermediary in
customer-driven, portfolio-hedged coal derivative transactions that
settle in cash or by transitory title transfer, and hedge these
transactions with coal derivative and spot transactions that settle in
cash or by transitory title transfer, subject to satisfying the safety
and soundness factors discussed below.

B.  **The Portfolio-hedged Coal-linked Transactions must be Conducted in
    a Safe and Sound Manner.**

For the Bank to permissibly engage in the proposed activities, the
Bank\'s risk measurement and management capabilities must be of
appropriate sophistication to ensure that the activity can be conducted
in a safe and sound manner and in accordance with applicable law.
Consequently, in order for the OCC to conclude that this activity is
permissible for the Bank, the Bank must demonstrate to the satisfaction
of its EIC that the Bank has established an appropriate risk measurement
and management process for its proposed activity. As detailed further in
the *OCC Handbook: Risk Management of Financial Derivatives*[^17] and
Banking Circular 277,[^18] an effective risk measurement and management
process includes board supervision, managerial and staff expertise,
comprehensive policies and operating procedures, risk identification and
measurement, and management information systems, as well as an effective
risk control function that oversees and ensures the appropriateness of
the risk management process. The Bank's risk control processes should
include the Bank's compliance with accounting and reporting as
stipulated by the instructions for the Consolidated Reports of Condition
and Income and generally accepted accounting principles.

In implementing these policies, procedures, and controls, the Bank shall
commit to conducting a full evaluation of: (i) pricing, hedging
(including portfolio-hedging), processing, recordkeeping, documentation,
accounting, "back office" and risk management; (ii) the development of
adequate knowledge, staff, oversight management and technology
(including contingency planning) to accommodate the activity; (iii) the
implementation of appropriate controls; (iv) the establishment,
implementation and monitoring of appropriate risk management limits with
respect to various types of risks ---such as credit, market and basis
risk ---associated with coal derivatives and transitory title transfers
of coal; and (v) Compliance Department training of personnel and
development of a supervisory framework designed to ensure compliance
with policies and procedures, including trading practices. Risk Control,
Operations, Accounting, Legal, Compliance, Audit and Senior and Line
Management will all be involved in assuring that the risks undertaken by
the Bank are comparable to, and are addressed in ways comparable to
those applicable to, the Bank\'s existing commodity derivative products
and business.

In addition to a satisfactory risk management program, the Bank\'s
process must include an independent compliance monitoring program to
ensure ongoing compliance with the specific commitments made by the Bank
in its proposal, including the commitment to continue to conduct its
financial intermediation activities involving coal derivatives as a
customer-driven and non-proprietary trading business. The
compliance-monitoring program should also ensure that the Bank has a
supervisory framework that protects against manipulative practices of
any kind. An adequate and effective compliance-monitoring program will
include policies, training, independent surveillance and well-defined
exception approval and reporting procedures.

#### Should the Bank determine that the use of SPEs is appropriate in connection with coal-linked transactions, the Bank must satisfy its EIC of the adequacy of the Bank's SPE policies for such transactions prior to using SPEs. 

**III. Conclusion**

We conclude that the Bank may engage in the transactions it proposes,
provided the Bank's EIC is satisfied that the Bank has adequate risk
management and measurement systems and controls to conduct the
activities on a safe and sound basis. Our conclusions herein are
specifically based on the Bank's representations and written submissions
describing the facts and circumstances of the subject transactions. Any
change in the facts or circumstances could result in different
conclusions. If you have any questions please contact Tena M. Alexander,
Special Counsel, Securities and Corporate Practices Division, at (202)
874-5210.

Sincerely,

Signed

Julie L. Williams

First Senior Deputy Comptroller

and Chief Counsel

[^1]: A "customer-driven" transaction is one entered into for a
    customer's valid and independent business purpose.

    *See* OCC Interpretive Letter No. 892 (September 13, 2000).

[^2]: A coal derivative is a financial instrument used to manage the
    price exposure to the coal markets. The Bank is currently authorized
    to engage in customer-driven, perfectly matched coal derivative
    transactions such as swaps, options, forwards, caps, floors, collars
    and futures, where payments are based on coal prices and indices.
    OCC Interpretive Letter No. 1039 (September 13, 2005)*.*

[^3]: A spot transaction is a cash sale for the immediate delivery of
    the commodities. *See, e.g., OCC Handbook: Foreign Exchange* (March
    1990).

[^4]: OCC Interpretive Letter No. 1039, *supra.*

[^5]: *See, e.g.,* OCC Interpretive Letter No. 1025 (April 6, 2005).

[^6]: *Id.*

[^7]: The Bank's customers for this purpose include coal producers
    (*e.g*. mining companies), coal users (*e.g.* utilities and other
    power generators) and other financial intermediaries.

[^8]: *Id.*

[^9]: *See, e.g.,* OCC Interpretive Letter No. 1025, *supra* (transitory
    title transfer of electricity derivatives permitted for hedging
    purposes).

[^10]: A time lag may exist between the original transaction and the
    offsetting transaction. The existence and duration of that time lag
    will be a function of market conditions and customer interest.
     Notwithstanding any time lag, the Bank represents that it will
    always have an offsetting transaction in place by the settlement
    date to make certain that the Bank never will take physical
    possession of coal.  The Bank will hedge market risk created by the
    time lag through the futures or over-the-counter markets.  

[^11]: The Bank will retain the right to have a representative present
    at the delivery point during the weighing, sampling and analysis of
    the coal. The Bank represents that while most market participants
    retain this right, they do not exercise this right. If the Bank
    decides to exercise this right, the Bank will use consultants whom
    it has retained to confirm the specifications of coal at the
    relevant delivery point. If the Bank does not exercise this right,
    such representatives will not be able to confirm the specifications
    of the coal until after title has transferred and the seller
    provides the analysis report, which will ultimately be provided to
    the end-buyers. If the coal does not meet the required
    specifications, the end-buyer has the right to reject the coal, at
    which point title should revert back through the chain
    instantaneously to the initial seller. The initial seller is then
    responsible for transporting the rejected coal to another location
    and providing substitute coal at the buyer's request. In most cases,
    the end-buyer will accept non-conforming shipments with price
    adjustments rather than reject the coal.

[^12]: The Bank represents that a seller is typically required to
    provide a shipping notice to the buyer within 48 hours of loading
    the coal or prior to arrival of the vessel, barge, truck or train at
    the destination following loading of a shipment (whichever comes
    first). The shipping notice includes the vessel's name or train,
    barge or truck number, source from which supplied, tonnage shipped,
    shipping date, destination, time loading commenced and finished, and
    the results of a coal analysis showing that the coal meets the
    specifications set forth in the appropriate coal documentation. The
    Bank states that the initial seller generally sends the shipping
    notice to the first buyer in the chain. The buyer then has the
    obligation to send the results to the next buyer. The Bank
    represents that about 50% of the time, the initial seller will agree
    to send the analysis results directly to the ultimate buyer;
    however, this results only out of a courtesy agreement between
    parties. The shipping notice is tantamount to an instrument
    evidencing title.

[^13]: The Bank may execute coal hedging transactions with its unrated
    affiliate, JPMorgan Ventures Energy Corporation, if the Bank decides
    that such a hedge is the most effective one available. In such case,
    the Bank represents that it will comply with the requirements of
    section 23A and 23B of the Federal Reserve Act, the Federal Reserve
    Board\'s Regulation W and the Bank\'s section 23A and 23B and
    Regulation W policy.

[^14]: OCC Interpretive Letter No. 1039, *supra.*

[^15]: *See* OCC Interpretive Letter No. 1025, *supra*; OCC Interpretive
    Letter No. 962 (April 21, 2003); OCC Interpretive Letter No. 632
    (June 30, 1993); OCC Interpretive Letter (March 2, 1992).

[^16]: *See, e.g., OCC* Interpretive Letter No. 1025, *supra.*

[^17]: *OCC Handbook*: *Risk Management of Financial Derivatives*
    (January 1997).

[^18]: OCC Banking Circular No. 277 (October 27, 1993).