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| ## Comptroller of the Currency                                        |
|                                                                       |
| > Administrator of National Banks                                     |
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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. 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 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. 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. 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.

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. 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. 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.

#### 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 . . . 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]

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. 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 Act[^10]
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 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). 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 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. 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 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.[^29]
Longstanding OCC precedent recognizes the authority of national banks to
act as financial intermediaries, for example, by engaging in swap
transactions 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. 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. 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.

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.

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**

> **(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 dealing and underwriting are
not defined in Section 24(Seventh)[^36] "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. The banks do not hold
the securities in order to engage in a regular business of buying and
selling them in the secondary market[^41] 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 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.

> **(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. 3215, introduced on January 1,
1932, permitted banks to **"purchase and hold"** 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. 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 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]

> **(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.

Courts also recognize the power of national banks to own corporate stock
in connection with satisfaction of debts previously contracted
(DPC).[^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. . . . 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**

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. 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

[^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.

[^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.

[^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.

[^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.

[^9]: *VALIC*; *Arnold Tours, Inc. v. Camp*, 472 F.2d 427 (1^st^ 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).

[^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)*.*

[^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. 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.*

[^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. 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).

[^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. 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.*

[^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.*

[^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. 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 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).

[^43]: Fabozzi and Zarb, Handbook of Financial Markets: Securities,
    Options and Futures, Second Edition (1986), at 251.

[^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.

[^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.

[^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 (6^th^ 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. 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.