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

**Interpretive Letter #1019**

**March 2005**

**12 USC 24(7)**

February 10, 2005

Re: **\[ \]** ("Bank") Proposed Agricultural Loan Program

Dear **\[ \]**:

The Bank has proposed to offer agricultural loans with payments that
vary based on changes in commodity prices. For the reasons discussed
below and subject to the limitations described herein, we believe that
the proposed transactions are permissible for the Bank. The Bank may
engage in these proposed transactions as an activity that is incidental
to its existing agricultural lending business, provided the Bank has
established, to the satisfaction of its Supervisory Office, an
appropriate risk measurement and management process for its proposed
transactions. In addition, before engaging in the program, the Bank
should satisfy itself concerning application of commodity laws to the
program and its responsibilities thereunder. [^1]

#### The Program

The Bank proposes to engage in a loan program designed to assist
borrowers to reduce volatility in farm income. The Bank proposes to lend
money to its agricultural customers at a rate that is at or below
generally prevailing market rates to finance the growing of certain
commodity crops (*e.g*., grain). The Bank also would forgive a portion
of the borrower's debt at maturity to reflect declines in the value of
crops resulting from decreases in commodity prices. In return for this
below-market rate of interest and possible debt forgiveness, the
borrower would agree to give up to the Bank a percentage of increases in
the value of his crops resulting from rising commodity market prices.
The Bank would make its loans in amounts as low as \$5,000 to
agricultural customers.

If the price of a commodity decreases over the term of the loan, the
Bank would reduce the principal amount of the loan due at maturity.
Depending on the amount of price reduction in the commodity, the
principal amount of the loan outstanding could be reduced by as much as
50% or more. Conversely, if the market price of the commodity increases
over the loan term, then the principal amount of the loan due at
maturity would be increased, *e.g*., by an amount equal to 50%, or more,
of the increase in value of the farmer's crop resulting from an increase
in commodity prices.

The Bank would hedge the risks it assumes under the program by entering
into a series of individual swap transactions with **\[ \]** (" ") that
separately mirror the risks in the transactions between the Bank and
each of its borrowers. At the maturity of the swap, **\[ \]** would
reimburse the Bank an amount equal to the reduction of principal that
the borrowers would receive due to a reduction in commodity prices.
Should commodity prices increase over the term of the loans, the Bank
would simultaneously pay **\[ \]** the increased amount it receives from
its borrowers. Further, **\[ \]** will pay at the time of loan
disbursement any reduction in interest that the Bank would charge its
borrowers. The amount of the interest reduction would be a function of a
variety of variables, such as volatility in the price of agricultural
commodities collateralizing the loan and the amount of risk exposure the
borrower is willing to assume. **\[ \]** would pay the interest subsidy
from a portion of the profit **\[ \]** anticipates from its transactions
under the program. Depending on the success of the program, **\[ \]**
will maintain or reduce the amount of the interest subsidy it is willing
to pay. Also, **\[ \]** will pay the Bank a one percent origination fee
at the time of the loan disbursement. The net result of these
arrangements is that the Bank would continue to receive a market rate of
interest on its agricultural loans plus a one percent origination fee.
The Bank benefits under the program by obtaining additional fee income
from **\[ \]** and reducing the credit risk of its customers resulting
from volatility in underlying commodity prices.

#### Law and Discussion

##### Financial Intermediation

The Bank's proposal would involve it in lending and certain derivatives
transactions, both of which are clearly permissible for national banks.

Lending money is clearly part of the business of banking.[^2] The Bank's
loans to its customers under the program would be consistent with loans
it already makes, except that **\[ \]** would subsidize a portion of the
interest rate and the principal would be adjusted to reflect changes in
the price of commodities collateralizing the loans. The proposed loans
are substantively identical to the combination of a traditional loan and
a derivative that protects against price fluctuations of the commodity
collateralizing the loan. In effect, the borrower has entered into a
loan and a collar (*i.e*., sold a call option and bought a put option)
with the Bank. The borrower has sold a call option, by giving the Bank a
portion of the increase in value of its crops, and purchased a put
option, by obtaining forgiveness of a portion of loan principal to
reflect reductions in the value of its crop. Those new features are
consistent with existing law and recognized banking activities.

A variety of OCC precedents collectively permit the Bank to accept
repayment of its loans in the manner the Bank now proposes, by accepting
additional payments or reductions in principal depending upon changes in
the price of a commodity that collateralizes the borrower's payment
obligations. National banks already may make loans with variable
interest rates.[^3] Banks may take deposits with interest payable at a
rate tied to gains in the S&P 500 index.[^4] Banks also may take as
consideration for making loans a share in the profit, income, or
earnings from a business enterprise of a borrower, in addition to or in
lieu of interest,[^5] and may accept stock warrants as consideration for
making a loan.[^6] All of these arrangements share features that provide
loan and deposit customers payment mechanisms calibrated to their
financial needs or that reduce risk to acceptable levels.

The Bank's program similarly can help manage credit risk and reduce
volatility by providing relief to borrowers from reductions in
collateral value. This is precisely the effect of other strategies that
banks and borrowers already engage in to protect borrowers from price
fluctuations in agricultural commodities.

The Bank has represented that the transactions with its borrowers are
hybrid instruments that are not subject to the commodity laws. The Bank
would hedge its exposures to borrowers by entering into a series of
swaps transactions with **\[ \]** that generally are exempt from
regulation under the commodity laws as over-the-counter derivatives.
National banks already have authority to engage in a broad range of
derivative contracts, including swaps on agricultural products.

The OCC long has permitted national banks to fashion new ways to help
agricultural borrowers manage and reduce the risks to collateral values
from changing commodity prices. In Interpretive Letter No. 356, a
national bank operating subsidiary sought to act as a futures commission
merchant with respect to agricultural and metals futures.[^7] The OCC
found it incidental to the business of banking for a national bank, and
therefore its subsidiary, to perform futures commission merchant
activities on behalf of bank loan customers who are engaging in futures
transactions to hedge risks underlying their loans from the bank. The
OCC noted that futures are often used as a risk management tool to hedge
against price and other risks incurred in the cash markets for
commodities. A bank borrower's cash market risks are often reflected as
credit risks to the bank where the cash market volatility might affect
the borrower's repayment ability, the value of loan collateral, or
otherwise affect the quality of the bank's loan. Banks often advise, and
in some cases require, their loan customers to hedge against risks
underlying their loans by engaging in futures contracts. Performing
futures commission merchant business in agricultural and metals futures
for loan customers' hedging transactions represented a convenient and
useful adjunct to banks' express lending power and was therefore
incidental to the business of banking.

The OCC previously considered virtually the same risk-mitigative
structure that the Bank now proposes. In No-Objection Letter 87-5, a
national bank proposed to enter into cash-settled swap contracts with
producers and users of certain commodities, pursuant to which amounts
would be payable based on a designated commodity price index.[^8] The
bank entered into these transactions only on a matched basis, such that
the bank would be matched as to index, amount, and maturity on each side
of the transaction. If the commodity index decreased, the bank would
make a payment to producers and receive an offsetting payment from a
user. Similarly, if the index increased, the bank would make payments to
commodity users and receive payments from producers. Because the
transactions were matched, the only risk to the bank would be its credit
risk with respect to a particular user or producer. The bank's credit
risk was further minimized by the fact that a producer would be required
to pay only when the price for its commodity had increased. This would
occur at a time when the producer would be in the best financial
position to pay. Conversely, a user would be required to pay only when
the price of a commodity had declined, and the user would be in the best
financial position to pay. The OCC found that engaging in the proposed
commodity price index swaps is an exercise of the express power to lend
and is incidental to the express power to lend. Finally, the proposed
swaps were part of the general "business of banking" as a form of funds
intermediation.

The major difference between the two activities in Letter 87-5 and the
Bank's proposal is the form of the instruments through which the Bank
would engage in financial intermediation activities. Rather than engage
in mirror swaps with agricultural borrowers and separately lend the
notional amounts of the swaps, the Bank would combine the features of
both products into one "hybrid instrument." This difference in form does
not alter the fundamental credit risk management and financial
intermediation features of the activities that the Bank would perform.

The OCC explained the nature of financial intermediation in Letter 87-5.
When the bank acts as principal in arranging a matched set of commodity
price index swaps for two customers, the bank undertakes the credit risk
that would otherwise fall to each party to the transaction. When the
bank acts as principal, each party is provided with confidence that the
swap will be carried out as promised in the contract. The bank supplies
expertise to relieve the parties of the burden of undertaking their own
credit analysis. In each transaction, the bank assumes credit risk
because either party could default in providing its designated payment
to the bank. The bank is not undertaking to make or take delivery of the
underlying commodity or speculating on future price fluctuations in a
commodity. The extension of credit is contingent and analogous to
providing standby letters of credit. *Id*. So also in this case, in
addition to acting as a lender to its agricultural borrowers, the Bank
is intermediating individual, matched payment streams between **\[ \]**
and those same borrowers.

The OCC previously has recognized that national banks have authority to
engage in new forms of transactions designed to address the same
economic risk that the Bank's proposal addresses, *i.e*., the risk to a
borrower's collateral from changes in commodity prices. In Interpretive
Letter No. 896, the OCC found it legally permissible for a national bank
to buy cash-settled options on certain commodity futures contracts where
the underlying commodity is the primary collateral on an agricultural
loan, as long as the bank has an appropriate risk management process in
place. The OCC noted that despite the differences in form, options,
futures, and options on futures serve a similar function: enabling banks
and their customers to hedge against risk of interest rate and price
changes relating to the underlying investments. The use of options on
futures contracts on agricultural commodities to hedge bank permissible
lending activities is not materially different from hedging loans with
futures and options and, therefore, was permissible for national banks.
Although the form of the contract in the Bank's program may differ from
an option on a future, the economic result will be the same. The
customer, and therefore the Bank, will be insulated from price
volatility due to changes in collateral values.

##### Lending Limits

No legal barrier to the Bank's participation in these transactions is
presented by the legal lending limits of 12 U.S.C. § 84 and 12 C.F.R.
Part 32, which provide generally that the total loans and extensions of
credit to any one borrower may not exceed fifteen percent of a bank's
total unimpaired capital and unimpaired surplus.[^9] 12 U.S.C. § 84(a),
12 C.F.R. § 32.3(a).[^10]

Under 12 U.S.C. § 84(b)(1) and 12 C.F.R. § 32.2(k), lending limit
calculations are determined based on a bank's advance of funds to a
person conditioned on an obligation of the person to repay. While the
amounts owed the Bank by either an agricultural borrower or by **\[ \]**
can fluctuate based on changing commodity prices, the lending limit will
be determined based on the amount of funds advanced by the Bank, which
will not be affected by such fluctuations.

Under the Program, for lending limit purposes, the amount of the Bank's
loans to each individual agricultural borrower will be based upon the
amount of funds advanced by the Bank to the borrower. The increase or
decrease of principal as a result of commodity price changes will not
affect lending limit treatment. **\[ \]** is not a borrower from the
Bank because it will have no repayment obligation for the funds the Bank
pays to it under the Program. Nor, as discussed below, is **\[ \]** a
"guarantor" for any agricultural borrower's obligation to the Bank.

(1) Rising principal (when commodity prices increase)

When commodity prices rise, the principal amount of the loan due at
maturity will increase. The borrower will owe the Bank more than the
original face amount of the loan, and the Bank will owe that surplus to
**\[ \]**.

It is our view that the Bank's lending limit to each Program borrower
will be calculated based on the amount of funds advanced by the Bank,
not on the amount the borrower might owe at a later date. Under 12
C.F.R. § 32.2(k), loans and extensions of credit for purposes of the
lending limits are defined as "a bank's *direct or indirect advance of
funds to or on behalf of a borrower based on an obligation of the
borrower to repay the funds...*" (emphasis added).[^11] If the commodity
price rises, a Program borrower will owe more to the Bank, and therefore
the Bank will have greater exposure to that borrower. However, the
lending limit is not affected because the amount of funds advanced by
the Bank remains the same.[^12]

By the same token, in such circumstances, the Bank will owe to **\[ \]**
the surplus amount received from the borrower, but **\[ \]** has no
obligation to repay that surplus to the Bank. The Bank's arrangement
with **\[ \]** is not a "contractual commitment to advance funds" within
the meaning of 12 C.F.R. § 32.2(f) because there is no obligation on
**\[ \]**'s part to repay those funds. It is therefore our view that a
rise in the commodity price does not trigger any lending limit exposure
to **\[ \]**, since **\[ \]** is not a "borrower" with an obligation to
repay.

(2) Falling principal (when commodity prices decrease)

When commodity prices fall, the principal amount of the loan due at
maturity will decrease. The Bank will forgive part of the loan amount
due from the borrower and will recoup the difference from **\[ \]**.

As discussed above, the Bank and **\[ \]** would be entering into a
series of swaps transactions that the Bank represents are generally
exempt from regulation under the commodities laws as
over-the-counter-derivatives. The Bank unquestionably has credit risk
exposure to **\[ \]** in the event of a decrease in commodity
prices.[^13] However, as noted above, a national bank's lending limit is
calculated based on the amount of funds *advanced*. The Bank advances no
funds to **\[ \]** in these circumstances. Instead, it is **\[ \]** who
will be advancing or paying funds to the Bank.

We have also considered whether **\[ \]** should be considered a
"guarantor" on loans made by the Bank under the Program by virtue of
**\[ \]**'s obligation to pay money to the Bank when commodity prices
fall and an agricultural borrower's loan principal decreases. Under 12
C.F.R. § 32.2(a), a "borrower" for purposes of the lending limit
includes a guarantor "who is deemed to be a borrower under the 'direct
benefit' or the 'common enterprise' tests set forth in § 32.5."

We conclude that based on applicable law, **\[ \]** should not be
considered a "guarantor" of an agricultural borrower under the Program.
According to the *Restatement of the Law/ Suretyship and Guaranty*,
American Law Institute (1995) ("Restatement"), status as a guarantor or
surety "gives the secondary obligor a significant set of rights against
both the principal obligor and the obligee." [^14] Restatement § 1
Comment (a). The guarantor/secondary obligor has rights of
reimbursement, restitution and subrogation: it is entitled to be
reimbursed by the primary obligor and it is entitled to be subrogated to
any defenses the primary obligor has against the obligee. Restatement
§§ 17-19.

Obviously this structure and set of rules are inapplicable here. It is
not intended by any of the parties that **\[ \]** will have any rights
of reimbursement or restitution against individual borrowers. On the
contrary, the reduction in the borrower's payment obligation in the
event of a fall in commodity prices is one of the purported benefits of
the Program in the first place. Far from intending that **\[ \]** shall
have rights against an individual borrower in the event of the latter's
"default," the Program contemplates and intends that there be no
"relationship or dealings of any nature between the borrower and **\[
\]** *nor will the bank provide the name or identity of any borrower to*
**\[ \]***.*" Letter from **\[ \]**, to James Sgro, NBE (May 17, 2002)
at 2 (emphasis added). If **\[ \]** does not know the name or identity
of the borrower, it can hardly enforce any suretyship rights as
described in the Restatement.[^15]

#### Safety and Soundness Requirements and Supervisory Office Approval

For the Bank to permissibly engage in the proposed activity, 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. Consequently, in order for the OCC to conclude that
this activity is permissible for the Bank because it is part of the
business of banking or convenient and useful to conducting authorized
banking activities, the Bank must demonstrate to the satisfaction of the
OCC 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*[^16] and
Banking Circular 277,[^17] 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.  The proposed activity has more complex
accounting requirements, and demands a stronger control framework, than
other, more traditional, bank credit programs.  Because the
sophistication level of the bank\'s borrowers will vary, and further
because it is possible that the borrower will have to repay an amount
greater than the original loan amount, the proposed activity poses
significant reputation risks for the bank.  The Bank\'s controls over
reputation risk should include, at a minimum, client education programs,
marketing materials with a balanced assessment of risks and rewards, and
clear product disclosures.  The OCC will closely evaluate the bank\'s
control environment for the proposed activity based upon the supervisory
standards contained in Banking Circular 277 (Risk Management of
Financial Derivatives), with special emphasis on the Bank\'s program for
determining transaction appropriateness and measuring and monitoring
reputation risk. 

The Bank may not commence the proposed activity unless and until its
Supervisory Office has concluded that the foregoing standards are met. 
The OCC will make these determinations regarding the effectiveness of
the Bank\'s control program through the Bank\'s Supervisory Office.

**Conclusion**

The Bank may engage in these proposed transactions as an activity that
is incidental to its existing agricultural lending business, provided
the Bank has established, to the satisfaction of its Supervisory Office,
an appropriate risk measurement and management process for its proposed
transactions. Before engaging in the program, the Bank should satisfy
itself, through consultation with CFTC staff and its own legal advisors,
concerning application of commodity laws to the program and its
responsibilities thereunder. If you have any questions concerning this
letter, please contact Donald Lamson of the OCC's Securities and
Corporate Practices Division at 202-874-5210.

Sincerely,

/s/ Daniel P. Stipano

Daniel P. Stipano

Acting Chief Counsel

[^1]: We express no opinion on whether the Bank's proposed program is
    subject to the commodity laws, *i.e*., the Commodity Exchange Act
    ("CEA") and regulations of the Commodity Futures Trading Commission
    ("CFTC"). The CFTC is the federal regulatory agency with primary
    authority for administering the CEA, including determinations
    whether instruments are subject to regulation as commodity futures.
    The Bank should consult with the CFTC regarding these issues.

[^2]: *See* 12 U.S.C. 24(Seventh) and Interpretive Letter No. 896 (Aug.
    21, 2000).

[^3]: *See, e.g*., Interpretive Letter No. 785 (June 3, 1997)

[^4]: *See* Letter from Ellen Broadman, Director, Securities and
    Corporate Practices Division, OCC to Barbara Moheit (Oct. 29, 1998)
    (unpublished).

[^5]: *See* 12 C.F.R. 7.1006.

[^6]: *Id.* The borrower's obligation to repay principal, however, may
    not be conditioned upon the value of the profit, income, or earnings
    of the business enterprise or upon the value of the warrant
    received. *Id*. That restriction is inapplicable in this case,
    because although principal on the loan may be reduced or increased,
    it is in reaction to a change in the market price of the collateral
    underlying the loan, rather than in reaction to the profit or
    earnings of the borrower.

[^7]: Interpretive Letter No. 356 (Jan. 7, 1986). *See also*
    Interpretive Letter No. 380 (Dec. 29, 1986) (same).

[^8]: No-Objection Letter 87-5 (July 20, 1987).

[^9]: According to the most recent available Consolidated Report of
    Condition and Income ("Call Report"), as of September 30, 2004, the
    Bank's capital and surplus for purposes of calculations under 12
    C.F.R. § 32.2(b) is

    \$ 44,876,000. Its fifteen percent limit on loans and extensions of
    credit to any one borrower under 12 C.F.R. § 32.3(a) would therefore
    be \$ 6,731,400.

[^10]: The statute "is intended to prevent one individual, or a
    relatively small group, from borrowing an unduly large amount of the
    bank's deposits for the use of the particular enterprises in which
    they are engaged." Interpretive Letter No. 15 (Jan. 10, 1978). OCC
    regulations promulgated pursuant to section 84 describe the purposes
    of the lending limits as "protect\[ing\] the safety and soundness of
    national banks by preventing excessive loans to one person, or to
    related persons that are financially dependent, and \[promoting\]
    diversification of loans and equitable access to banking services."
    12 C.F.R. § 32.1(b).

[^11]: The legislative history of 12 U.S.C. § 84 offers no guidance
    regarding the meaning of the phrase "advance of funds." However, the
    term "advance" as used with respect to money generally means to pay
    beforehand with the expectation of future reimbursement or return of
    the money. *See, e.g., Trust Company of Morris County v. Nichols,*
    65 N.J. Super. 495, 163 A. 2d 205, 209 (1960); *Louchheim, Eng. &
    People, Inc. v. Carson,* 35 N.C. App. 299, 241 S. E. 2d 401, 404
    (1978). This meaning is consistent with the emphasis in the statute
    on advances based upon a repayment obligation (12 U.S.C. § 84(b)(1)
    and also with the OCC's position that "loans" under the lending
    limits do not arise from accrued interest on loans (12 C.F.R.
    § 32.2(k)(2)(ii)).

[^12]: According to Statement of Accounting Standards No. 91,
    "Accounting for Nonrefundable Fees and Costs Associated with
    Originating or Acquiring Loans and Initial Direct Costs of Leases"
    ("FAS 91) at ¶ 21, as incorporated in the reporting requirements for
    Call Reports at A-57, the figure a bank would book as the loan
    amount would be the amount advanced to the borrower (plus expenses
    incurred in making the loan and less fees charged to the borrower.)

[^13]: **\[ \]** has offered to put up collateral in any instance where
    the amount it would be required to pay under any swap arrangement
    with the Bank would exceed the Bank's lending limit. Letter from
    **\[ \]**, to James Sgro, NBE (Sept. 20, 2002) at 4. While we
    conclude here that the lending limit does not apply to these
    transactions, we believe as a matter of safety and soundness that
    such collateral should be provided because, depending on the number
    and amount of loans outstanding, the Bank's exposure to **\[ \]**
    could potentially be considerable.

[^14]: The difference between a "guarantor" and a "surety" is not
    significant for this discussion. According to the Restatement,
    "\[d\]ifferences between these two mechanisms have been the subject
    of extended debate, not all of which is illuminating." § 1 Comment
    (c). Generally, a "guarantor" is obligated to fulfill an obligation
    upon the default of the principal obligor, while a "surety" is
    jointly and severally liable with the principal obligor on an
    obligation to which they are both bound. The difference is of little
    importance because the provisions in any particular contract can
    alter the terms of the obligation. Further, some states make no
    distinction between the two at all. *See, e.g.,* California Civil
    Code § 2787 ("The distinction between sureties and guarantors is
    hereby abolished.")

[^15]: Since it seems clear that **\[ \]** cannot be considered a
    "guarantor" of individual borrowers under commonly accepted legal
    principles as expressed in the Restatement, we do not address the
    applicability of the combination rules---the "direct benefit" or the
    "common enterprise tests---referred to in 12 C.F.R. § 32.2(a).

[^16]: *OCC Handbook: Risk Management of Financial Derivatives* (January
    1997).

[^17]: OCC Banking Circular No. 277 (Oct. 27, 1993).