Permissible Activities by Board Order (Section 4(c)(8) of the BHC Act) Section 3600.0

As a general rule, a bank holding company must company must provide the appropriate prior provide 60 days’ prior written notice to its written notice of its proposal to its Reserve Reserve Bank to engage in any nonbanking Bank.1 The Board must review the notice with- activity, or to acquire or retain the shares of a out disapproving it each time the bank holding company engaged in an activity based on sec- company wishes to engage in a proposed activ- tion 4(c)(8) or 4(a)(2). When a bank holding ity. The inspection objective and procedures set company gives notice to a Reserve Bank for forth below can be implemented for each of the approval to engage in, or retain or acquire shares activities summarized in subsequent sections. in a company engaged in, a nonbank activity, the BHC must be of the opinion that the activity is closely related to banking and, assuming this 3600.0.1 INSPECTION OBJECTIVE test is met, that the activitiy is a proper incident thereto. In addition, a BHC that also is an FHC 1. To determine what financial effect nonbank- must provide 60 days’ prior written notice to its ing activities have on the parent and the bank Reserve Bank to engage in an activity that is subsidiaries, and if there is any degree of complementary to a financial activity under sec- exposure in the activities because of a lack of tion 4(k)(1)(B). In considering such a notice, the appropriate audit systems and controls. Board must determine whether performance of the activity can reasonably be expected to pro- duce benefits to the public, such as greater con- 3600.0.2 INSPECTION PROCEDURES venience, increased competition, or gains in effi- ciency, that outweigh possible adverse effects, 1. Review the company’s financial statements such as undue concentration of resources, for accuracy and determine if any factors or decreased or unfair competition, conflicts of trends could have an adverse impact on the interest, or unsound banking practices. parent holding company or the bank As an exception to the general rule, no prior subsidiaries. notice is required for a bank holding company 2. Review the adequacy of the company’s poli- that is qualified under section 4(j)(4) of the cies, procedures, practices, internal controls, BHC Act to engage de novo, directly or through and audit coverage regarding nonbanking a subsidiary, in an activity that the Board permit- activities, and whether they are adhered to. ted under section 225.28 of Regulation Y before November 12, 1999. After passage of the Gramm- Leach-Bliley Act of 1999, this list of activities cannot be expanded. For all bank holding com- panies that are not qualified under section 4(j)(4), for all other nonbanking activities based on sec- 1. A bank holding company that is qualified under section tion 4(c)(8) or section 4(a)(2), and for all activi- 4(j)(4) of the BHC Act may provide 12 calendar days’ prior written notice before engaging by acquisition in an activity ties that are complementary to a financial activ- permitted under section 225.28 or engaging in an activity ity under section 4(k)(1)(B), the bank holding based on section 4(c)(8) and approved by the Board by order.

BHC Supervision Manual June 2000 Page 1 Permissible Activities by Board Order (Operating a ‘‘Pool Reserve Plan’’) Section 3600.1

Two bank holding companies (Company A) and ties would be ‘‘so closely related to banking or (Company B) had requested the Board to deter- managing or controlling banks as to be a proper mine whether their planned nonbank subsidiary incident thereto’’ in accordance with Section activities were of the kind described in Section 4(c)(8) of the BHC Act, as amended by the 4(c)(8) of the BHC Act. The applications had BHC Act Amendments of 1970. The approval been filed prior to the passage of the Bank (1971 FRB 1037) included the following condi- Holding Company Act Amendments of 1970. tions that: The applicants proposed to expand their activi- 1. The subsidiary was to amend its charter so ties under a ‘‘pool reserve plan’’ to include that the charter would authorize it to perform its correspondent banks. Such activities were lim- functions, and make its services available to ited to subsidiary banks. banks, but not to lenders other than banks, and The ‘‘pool reserve plan’’ was described as a to amend its proposed contracts with correspon- method of pooling of loss reserves with respect dent banks; to term loans to small businesses and the estab- 2. Any correspondent banks could terminate lishment of uniform credit standards in that their contract with the subsidiary respecting regard. The ‘‘pool reserve plan’’ permitted banks future transactions upon 90-day prior written to adopt a uniform and liberal credit policy in notice, and that; extending credit and the usual method of 3. The subsidiary be subject to the same lim- exchanging participations between the banks. itations with the respect to the ownership of any The General Counsel of the Board of Gover- collateral acquired in the course of the conduct nors determined, on October 14, 1971, pursuant of its proposed activities as were its parents, to delegated authority, that the proposed activi- (Company A and Company B).

BHC Supervision Manual December 1992 Page 1 Permissible Activities by Board Order (Engaging in Banking Activities via Foreign Branches) Section 3600.5

3600.5.1 NEW YORK INVESTMENT and not accept demand deposits; (2) complying COMPANY with all Board or legislatively imposed reserve and interest-rate requirements; (3) divesting of On May 10, 1977, the Board approved an appli- offices in another state within two years; (4) con- cation of a foreign-owned domestic bank to fining activities of its foreign branch to those form a holding company, and, at the same time, permitted in the Board’s order; and (5) not for that holding company to acquire substan- engaging in the activities of underwriting, sell- tially all of the voting shares of an investment ing, or distributing securities; buying or selling company organized and operating under article coin and bullion; or acting as a financial agent XII of the New York State Banking Law (a New of the U.S. government or as a depositary of York investment company). public moneys of the United States, or in any The investment company at that time was new activity which New York investment com- engaged in providing lending and international panies by subsequent enactment may be permit- banking services, including letters of credit, ted to engage in, without the prior approval of acceptances, and other financing facilities in the Board. (See 1977 FRB 595.) connection with exports and imports, interna- tional transfers of funds, and foreign-exchange services;investmentsandforeign-exchangetrans- 3600.5.2 ENGAGING IN BANKING actions for its own account; leasing improved ACTIVITIES THROUGH FOREIGN real estate and data processing equipment; and BRANCHES OF A NONBANK maintenance of credit balances incidental to or COMPANY related to the foregoing activities. Although the holding company believed that certain of the A bank holding company applied for the Board’s activities of the New York investment company approval to retain direct or indirect ownership had already been determined by the Board to be of a subsidiary, ‘‘CBC,’’ a Delaware-chartered permissible for bank holding companies, it corporation, after it established branches in requested approval of its application on the basis Nassau and Luxembourg, to engage in certain that all the activities that a New York invest- commercial banking activities. The activities ment company is permitted to engage in under included accepting funds in U.S. dollars or for- New York law are closely related to banking. A eign currency in wholesale money markets in New York investment company had not previ- amounts over $100,000, making commercial ously been determined by the Board to be an loans in amounts over $100,000, placing funds activity permissible for bank holding companies. with and making loans and advances to subsidi- The Board noted that the structural and com- ary and affiliated organizations, engaging in petitive circumstances under which a New York foreign-exchange transactions, and other activi- investment company operates are unique to New ties constituting commercial banking outside the York and have served in the past as a means for United States. CBC held the shares of a number foreign-bank entry into New York in cases where of nonbanking subsidiaries of the BHC pursuant entry through a direct branch or agency was to section 4(c)(1)(C) of the BHC Act, which either unavailable or undesirable for the pur- permits a subsidiary of a bank holding company poses sought. Most of the lending and banking to perform services for its parent company. services offered by these companies are also The purpose of the proposal was to provide offered by commercial banks generally and, in the BHC with increased flexibility in funding its this connection, compete with foreign banking domestic operations by allowing CBC to gain organizations and domestic commercial banks access to the offshore wholesale money market. and their Edge corporation subsidiaries. How- The proposed foreign branches of CBC, by ever, under article XII of the New York State obtaining banking licenses, would give direct Banking Law, a New York investment company access to Eurocurrency interbank markets, and is permitted to engage in various other activities the activities of the proposed branches were which the Board does not consider to be closely expected to be viewed as an integral part of a related to banking. large U.S.–headquartered entity, making the Based on the foregoing, the Board’s approval branches competitive in the offshore interbank in this case was limited to and contingent upon markets. the New York investment company’s (1) con- tinuing to engage principally in transactions BHC Supervision Manual December 1998 involving international or foreign commerce, Page 1 Permissible Activities by Board Order (Engaging in Banking Activities via Foreign Branches) 3600.5

The Board decided that the lending and bank- connection, the BHC committed to accepting no ing services that the proposed branches would placement of or deposits from,1 or extending no offer were generally offered by commercial banks, credit to (other than a subsidiary or affiliated and thus are permissible activities of foreign organization) a United States resident.2 The BHC branches of domestic banks and foreign subsidi- committed that the liabilities to CBC of any aries of bank holding companies. The proposed person, other than an affiliate, would not exceed activities of CBC’s branches were substantially 10 percent of the capital and surplus of CBC. similar to activities that the Board had previ- The Board felt that these prudential conditions ously approved under section 4(c)(8) of the were adequate to meet any supervisory concerns BHC Act for the foreign branches of the New to which the proposal might give rise and thus York investment company, incorporated under approved the application, subject to the obtain- article XII of the New York Banking Law (see ing of the necessary licensing requirements of 1977 FRB 595 and 1979 FRB 667). CBC did the countries involved. not propose to engage in any activity that would not be permitted for a separately incorporated foreign subsidiary of a bank holding company. 1. A placement or deposit received from a foreign branch, The Board, therefore, ruled that the proposed office, subsidiary, affiliate, or other foreign establishment activities of CBC were closely related to bank- (‘‘foreign affiliate’’) controlled by one or more domestic cor- ing (1982 FRB 251). porations is not regarded as a placement or deposit received from a U.S. resident if such funds are used in its foreign CBC proposed to engage in no banking branches or that of other foreign affiliates of the controlling activities in the United States, stating that its domestic corporation(s). only U.S. activities would consist of its indirect 2. Credit extended to a foreign affiliate, controlled by one nonbanking activities through subsidiaries. The or more domestic corporations, is not regarded as credit extended to a U.S. resident if the proceeds will be used in its subsidiaries would be funded through funds foreign business or that of other foreign affiliates of the raised by the proposed foreign branches. In this controlling domestic corporation(s).

BHC Supervision Manual December 1998 Page 2 Permissible Activities by Board Order (Operating a Securities Exchange) Section 3600.6

A domestic bank holding company (the BHC) at the end of each business day with the London and a foreign banking organization (the FBO), Clearing House in the name of the appropriate subject to the BHC Act, applied for the Board’s clearing member. London Clearing House then permission to engage in operating a securities becomes the counterparty to each side of the exchange under the authority of section 4(c)(8) trade until the trade is settled. The trade is of the BHC Act and section 225.24 of Regula- settled through a designated system operated by tion Y. The BHC proposed to control approxi- a corporation established by the Bank of England mately 17 percent of the voting shares of group to settle uncertificated U.K. equities. (the group), and the FBO planned to control The exchange is a recognized investment approximately another 11 percent of the voting exchange under section 37(3) of the U.K. Finan- shares of the group. The group owned about cial Services Act of 1986, and is regulated and 54.1 percent of a financial network subsidiary supervised by the U.K.Financial Services Author- (FNS), which operated an electronic securities ity (FSA), under the securities laws of the United exchange (the exchange) for the secondary trad- Kingdom. While FNS makes its services avail- ing of equity and equity-related securities listed able to customers in the United States, the SEC on the London Stock Exchange (LSE). The has granted it a limited volume exception from BHC and FBO indicated that the group planned the registration requirements of the Securities to establish an office in the United States. In Exchange Act of 1934. The SEC exemptive anticipation of the establishment of this office, order permits FNS to operate in the United the BHC and FBO requested the Board’s approval States without registering as a securities exchange to acquire their interests in the group. A BHC provided (1) the exchange’s average daily vol- must obtain the Board’s approval if a foreign ume of trades involving U.S. members does not company held by the BHC seeks to engage in exceed $40 million, and (2) the exchange’s business in the United States. worldwide average daily volume does not exceed The exchange is a screen-based electronic 10 percent of the average daily trading volume market that provides securities trade matching, on the LSE. The SEC exemptive order requires trade execution, and related services to U.S. and the exchange to comply with other conditions foreign market makers, broker-dealers, and that are designed to ensure orderly and fair institutional investors that become members of markets and to protect U.S. investors. the exchange. Members may access the exchange The Board had not previously determined by and enter bid and ask quotations using elec- regulation or order that the operation of a securi- tronic terminals that are linked to designated ties exchange is closely related to banking within financial networks (for example, a Bloomberg the meaning of section 4(c)(8) of the BHC Act. terminal) or through a personal computer linked The principal function of a securities exchange directly to the exchange. The exchange can be is to provide a centralized facility for the execu- accessed from terminals located anywhere in the tion, clearance, and settlement of securities trans- world. Trading, however, may occur only dur- actions. The Board indicated in its order that ing the operating hours of the LSE. Orders banks and BHCs are authorized to provide secu- entered in the exchange’s system appear on rities brokerage services to their customers and, separate electronic order books for each secu- as part of those services, to execute and clear rity, which display the best bid and ask quotes such transactions on a securities exchange. The for the security in descending order. The exchange Board also noted that BHC subsidiaries autho- automatically and continuously matches equal rized to act as dealers in securities (section 20 bid and ask offers for each listed security on a subsidiaries) may provide securities execution, first-come, first-served basis. clearance, and settlement services in connection FNS does not take a principal position in with their dealer operations. In addition, the securities, clear or settle the securities transac- Board noted that broker or dealer subsidiaries of tions executed on the exchange, or assume any banks and BHCs often become members of principal risk for securities trades executed on securities exchanges and thus acquire a small the exchange. FNS and its shareholders are not ownership (less than 5 percent) in a mutually obligated to guarantee any member’s trades. owned exchange (for example, the New York Each member of the exchange must be a mem- Stock Exchange). Through the development of ber of the London Clearing House, or must these relationships, banks and BHCs have gained appoint a member of the London Clearing House to clear the member’s trades on the exchange. BHC Supervision Manual June 2000 Trades matched by the exchange are registered Page 1 Operating a Securities Exchange 3600.6 considerable experience with and knowledge of from other brokers and matches equal bid and the rules and operations of securities exchanges. offer quotes for execution. Market makers on Banks and BHCs also provide services that NASDAQ also publish bid and ask prices at are functionally and operationally similar to which they stand ready to execute transactions those of the exchange. Banks and BHC subsidi- in the relevant security. aries acting as securities brokers may execute For the above reasons, and based on all the cross-trades for their customers and thereby facts on record, the Board concluded that operat- match equal bid and offer orders received from ing a securities exchange is an activity that is them. In addition, section 20 subsidiaries may, if closely related to banking for the purposes of authorized, act as a specialist or market maker section 4(c)(8) of the BHC Act. The application on a securities exchange such as the NYSE or was approved on November 8, 1999. See 2000 NASDAQ. A specialist generally maintains a FRB 61 for the order and more specific informa- book of current buy and sell orders received tion regarding the Board’s approval.

BHC Supervision Manual June 2000 Page 2 Permissible Activities by Board Order (Acting as a Certification Authority for Digital Signatures) Section 3600.7

WHAT’S NEW IN THIS REVISED through the use of public-key cryptography. SECTION In a CA system using public-key cryptogra- phy, a company generates (or is assigned) a Effective January 2007, this section is amended public-key/private-key pair and registers with a to include another Board order in which the CA as the unique ‘‘owner’’ of the key pair.2 Board approved a notice for a foreign bank to Private keys and public keys are a set of differ- act as a certification authority (CA) in connec- ent but related mathematical functions that can tion with financial and nonfinancial transac- be used to encrypt and decrypt electronic com- tions and to engage in related data processing munications. A message encrypted by a particu- activities. The bank planned to engage in the lar private key can be decrypted only by its activities by entering into an agreement with a corresponding public key. Although a private newly organized, wholly owned indirect subsidi- key and its corresponding public key are related, ary of the bank. (See 2006 FRB C150.) The a private key cannot feasibly be derived from its proposed CA nonbanking activities are slightly corresponding public key. Thus, while a private different, but are consistent with those CA non- key must be kept confidential by the company banking activities that were previously approved that is the registered owner of the key pair, the by the Board (discussed below). company’s public key can be made publicly available without jeopardizing the confidential- ity of the company’s private key. 3600.7.1 ACTING AS CERTIFICATION A company sending a business communica- AUTHORITY IN CONNECTION WITH tion (for example, a purchase order) to another FINANCIAL AND NONFINANCIAL entity over an open electronic network like the TRANSACTIONS Internet uses its confidential private key to digi- tally sign the message being sent. A digital A foreign banking organization (FBO)1 subject signature is a compressed and encrypted version to the BHC Act and several bank holding com- of the message to which it is attached. The panies (BHCs), deemed to be BHCs (all referred entity receiving the digitally signed message to as the notificants) within the meaning of the then uses the sender’s public key to decrypt the BHC Act, requested the Board’s approval under digital signature.3 If the receiver successfully section 4(c)(8) of the BHC Act and section decodes the signature with the sender’s public 225.24 of the Board’s Regulation Y (12 C.F.R. key, the receiver can be assured that the mes- 225.24) to retain 12.5 percent of the voting sage was created using the sender’s private key.4 interests in Indent Company (Indent), and to To be assured that the message was actually engage through Indent and other nonbank sub- sentbythepurportedsender,however,thereceiver sidiaries in acting as a CA in the United States must confirm that the private-key/public-key in connection with financial and nonfinancial pair used to sign and decode the message is transactions and other related activities. Indent uniquely ‘‘owned’’ by the purported sender. A represents a joint venture among the notificants CA provides this assurance by issuing ‘‘digital and other commercial banks and foreign bank- certificates’’ certifying that the relevant private- ing organizations. As proposed, Indent would key/public-key pair is uniquely associated with act as the global rulemaking and coordinating the message sender and by verifying upon request body for a network of financial institutions that the validity of such digital certificates. would act as CAs and thereby provide services designed to verify or authenticate the identity of 2. A number of nonbanking companies currently operate customers conducting financial and nonfinancial CA systems that rely on public-key cryptography to provide transactions over the Internet and other ‘‘open’’ identity-authentication services to senders and receivers of electronic networks. To provide these services, electronic communications. 3. The sender’s public key may be attached to the digitally Indent and its network of participating financial signed communication, or the receiver of the message may institutions (the identity system) would use digi- obtain the sender’s public key from a publicly available tal certificates and digital signatures created database. 4. The receiver also can confirm that the message was not altered after it was signed by comparing the message received 1. Foreign banks may engage in permissible nonbanking with the decrypted version of the message text embedded in activities in the United States directly through a U.S. branch the digital signature. or agency. A foreign bank, however, must receive the Board’s approval under section 4(c)(8) of the BHC Act to engage in the United States in activities that are deemed to be closely BHC Supervision Manual January 2007 related to banking. Page 1 Acting as a Certification Authority for Digital Signatures 3600.7

The notificants and other financial institutions CAs and provide related services. The primary participating in the identity system (partici- function of Indent would be to act as the ‘‘root pants)5 would create unique private-key/public- certification authority’’ of the identity system, key pairs for, and issue digital certificates on that is, issuing digital certificates to the partici- behalf of, eligible customers that contract with pants that establish their status as CAs in the one of the participants to receive Indent identity- identity system and authenticating for customers authentication services.6 Each participant would of, and the other participants in, the identity act as a repository for the digital certificates that system the identity of the participants.9 Indent it has issued, that is, it would maintain a data- also would (1) establish and maintain the operat- base containing information on the status of the ing rules governing the identity system, includ- outstanding, expired, or revoked digital certifi- ing the minimum technical requirements for cates that it has issued to customers. The partici- digital certificates and other components of the pants also would verify for third parties the system; (2) monitor compliance by the partici- validity of digital certificates issued to their pants with the identity system’s operating rules customers and, upon request of the third party, and technical standards; and (3) monitor collat- may provide an explicit warranty as to the valid- eral requirements and aggregate warranty expo- ity of the customers’ digital certificates.7 The sure for the participants in the identity system.10 participants also may process and transmit veri- Section 4(c)(8) of the BHC Act provides that fication and warranty requests received from a bank holding company may, with the Board’s customers concerning digital certificates issued approval, engage in any activity that the Board by other participants in the identity system. In determines to be closely related to banking. The addition, the participants may provide custom- Board previously has authorized BHCs under ers with a limited range of software and hard- section 4(c)(8) of the BHC Act to act as CAs ware that is required for customers to use the and provide identity-authentication services in identity system.8 connection with payment-related and other finan- Indent would provide the infrastructure frame- cial transactions conducted over electronic net- work within which the participants would act as works.11 The Board has not previously autho- rized BHCs under section 4(c)(8) to act as CAs 5. Participation in the identity system is available only to or provide identity-authentication services in organizations that are engaged primarily in the business of connection with nonfinancial transactions. providing financial services; are subject to regulation and examination by a government authority in their home country; Banks and BHCs have long provided identity- and that meet certain eligibility criteria, such as minimum authentication services in connection with nonfi- capital requirements and debt-rating criteria. A participant nancial transactions conducted by third parties also must agree to be bound by the identity system operating and for their own traditional banking and lend- rules and to execute certain participation agreements. Finan- cial institutions would not be required to purchase an owner- ing activities. For example, banks and BHCs are ship interest in Indent to become a participant. authorized to provide notary services to custom- 6. The participants may provide identity systemÐrelated ers.12 The role of a notary is to authenticate services only to customers that have agreed to be bound by signatures on financial or nonfinancial docu- applicable provisions of Indent’s operating rules and have 13 signed the appropriate customer agreements. Indent’s operat- ments for the benefit of third parties. To verify ing rules allow the participants to provide identity systemÐ a signature on a paper-based document, a notary related services only to business entities, such as corporations must verify the identity of the person signing and governmental organizations, and not to natural persons. Indent’s operating rules and customer agreements would make each customer contractually responsible for ensuring that its 9. Digital certificates issued by the participant to a cus- private key is kept confidential. tomer are digitally signed by the participant with its own 7. The operating rules of the identity system would provide private key and are accompanied by a digital certificate issued that a company relying on a digital certificate issued by the by Indent. The digital certificates Indent issues would certify participant would have recourse against the participant only if that the participant is an authorized participant in the identity the company purchased an explicit warranty from the partici- system and that the private key the participant uses to digitally pant, and then only up to the amount of the purchased war- sign its certificates is uniquely associated with it, thereby ranty. The participant that issues a digital certificate could authenticating the identity of the participant. refuse to issue a warranty for a digital certificate for any bona 10. The activities of the notificants and Indent would be fide reason. The identity system would limit the aggregate limited to providing the identity-authentication and related amount of warranties that the participant may have outstand- services described above. The notificants and Indent would ing at any one time, and would require each participant to post not provide a general encryption or electronic message ser- collateral with Indent to cover its warranty exposure. vice, or any warranty of the underlying financial or nonfinan- 8. For example, the participants may provide smart cards cial transactions between customers whose identities are containing digital certificates and smart-card readers to their authenticated through the use of the identity system. customers. 11. See Regulation Y, section 225.28(b)(14); 1997 FRB 602, 606; and 1982 FRB 505, 510. BHC Supervision Manual January 2007 12. See 1998 FRB 481. Page 2 13. 58 Am. Jur. 2d Notaries Public ¤ 31 (2d ed. 1989). Acting as a Certification Authority for Digital Signatures 3600.7 the document. The Board noted that the role a the proposed services. For example, banks and CA serves with respect to electronic documents BHCs maintain systems to electronically is functionally similar to the role a notary serves authenticate the identity of persons engaged in with respect to paper-based documents.14 credit and debit card, automated teller machine Banks have traditionally identified their cus- (ATM), home banking, and wire transfer trans- tomers to third parties through the issuance of actions with the institution.19 Banks and BHCs letters of introduction or letters of reference.15 also electronically authenticate the identity of In addition, banks and BHCs routinely authenti- persons in connection with the check and credit cate the identity of customers and noncustomers card verification services they are authorized to in connection with their authorized check- provide to merchants and other businesses.20 cashing functions.16 The Board noted that state banks and national Banks and BHCs also have long been autho- banks have recently been authorized to act as rized to issue signature guarantees to issuers of CAs and to provide identity-authentication ser- securities and their transfer agents in connection vices in connection with financial and nonfinan- with the transfer of securities.17 A bank issuing cial transactions conducted over electronic net- a signature guarantee warrants that the custom- works. Based on the foregoing, the Board er’s signature endorsing a certificated security concludes that acting as a CA and, more gener- or authorizing the transfer of an uncertificated ally, authenticating the identity of customers security is authentic. The issuing bank also war- conducting financial and nonfinancial transac- rants that the signer was an appropriate person tions are activities that are closely related to to endorse the security or authorization (or, if banking within the meaning of section 4(c)(8) the signature is by an agent, that the agent had of the BHC Act. actual authority to act on behalf of the appropri- Indent and the notificants also propose to ate person) and that the signer had legal capac- engage in a number of activities as part of and in ity to sign. In light of these warranties, a bank connection with their proposed CA activities. providing a signature guarantee must verify the These activities include (1) processing, transmit- identity of the customer providing the endorse- ting, and storing data necessary for the opera- ment or signing the instruction.18 tion of the identity system, such as digital cer- Identity-authentication services are an inte- tificates, requests for verification of digital gral part of many traditional banking functions. certificates, and warranty requests; (2) develop- Banks and BHCs have developed sophisticated ing and marketing software and hardware neces- methods for authenticating the identity of cus- sary for operating the identity system; and tomers and noncustomers that transact business (3) complying with, monitoring, and enforcing or communicate with the bank or BHC through the collateral-posting requirements associated electronic means or otherwise. Many of these with identity warranties. In addition, Indent activities are operationally and functionally simi- would establish operating policies, procedures, lar to the proposed activities, and make banks and guidelines for the identity system. and BHCs particularly well equipped to provide The Board’s Regulation Y permits BHCs to provide data processing and data transmission services and facilities (including software and 14. The American Bar Association, for example, has noted that the issuance of digital certificates by CAs is ‘‘analogous hardware) for the processing and transmission to traditional certification processes undertaken by notaries of financial, banking, or economic data, and to with respect to documents executed with pen and ink.’’ ‘‘Digi- engage in activities related to making, acquir- tal Signature Guidelines,’’ published by the Information Secu- ing, brokering, or servicing extensions of credit, rity Committee of the Electronic Commerce and Information Technology Division, Section of Science and Technology, such as posting collateral and monitoring collat- American Bar Association. (Aug. 1, 1996), p. 54. eral requirements.21 Regulation Y also permits 15. Banks have drafted letters of introduction or letters of BHCs to engage in incidental activities that are reference on behalf of their customers for the purpose of introducing the customer to other banks or third parties with 19. Article 4A of the UCC encourages banks to develop which the customer seeks to do business. and maintain commercially reasonable security procedures, 16. Under the Uniform Commercial Code (UCC), a bank such as algorithms or other encryption devices, for authenti- that accepts a check for deposit warrants to the drawee bank cating the identity of customers that transmit wire transfer that all endorsements on the check are genuine, and the bank instructions to the bank. is liable to the drawee bank for the amount of the check plus 20. See Regulation Y, section 225.28(b)(2)(iii) and 1985 expenses and lost interest if an endorsement on the check was FRB 648. forged. 21. See Regulation Y, section 225.28(b)(2) and (14). A 17. Broker-dealer subsidiaries of BHCs also have provided BHC may develop and sell hardware and software that is signature guarantees. 18. A bank issuing a signature guarantee is liable to the issuer of the security or its transfer agent for any loss that BHC Supervision Manual January 2007 results from a breach of any of these warranties by the bank. Page 3 Acting as a Certification Authority for Digital Signatures 3600.7 necessary to the conduct of an activity that is related data processing activities. It was pro- closely related to banking. Indent and the notifi- posed that the agreement be assigned to a newly cants have represented that they would engage organized wholly owned indirect subsidiary of in the additional activities only in connection the bank, CLX. with their CA activities and would not engage in The proposed activities would be undertaken such activities separate or apart from their CA within the Identity Trust System (ITS), which activities. The notificants also have committed would serve as a central rulemaking and coordi- that the data processing and data transmission nating body for a global network of institutions activities of the notificants and Indent, including that would act as digital CAs. The CAs would any proposed development or sale of hardware verify or authenticate the identity of customers and software, will comply with the Board’s conducting financial and nonfinancial transac- regulations and interpretations. In light of the tions over the Internet and on other ‘‘open’’ nature of these additional activities and the fact electronic networks. To provide these services, that they would be conducted only in connec- ITS and its network of participating financial tion with the CA activities of Indent and the institutions would use digital signatures created notificants, and all the other facts of record, the with encryption technology. These digital signa- Board concludes that these activities are encom- tures would uniquely identify participants in the passed within the activities previously approved ITS who send signed messages over electronic by the Board by regulation or are incidental to networks. The CAs would issue digital certifi- the permissible CA activities of Indent and the cates that certify that the digital signature is notificants and, therefore, are permissible under uniquely associated with a particular message Regulation Y.22 sender so that the message recipient can be Based on the facts stated in the Board’s order, assured of the identity of its trading partner. the Board determined that the certification author- As a certification authority, CLX would pro- ity and other activities discussed were closely vide the technical systems and support neces- related to banking under section 4(c)(8) of the sary for banks to verify and authenticate the BHC Act. The Board issued its approval order identity of customers conducting electronic trans- on November 10, 1999. (See 2000 FRB 56). See actions and to register digital certificates to cus- the Board’s order for more specific information tomers. These services would be provided to the and for the more detailed information and refer- foreign banking organization as well as to other ences in the order’s footnotes. banks that enter into contracts with CLX.26 The The Board approved another notice for a for- foreign bank, and any other banks to which eign bank, specifically a foreign banking organi- CLX may provide services, would be respon- zation that is subject to the BHC Act.23 The sible for performing the due diligence on cus- foreign bank had requested the Board’s approval tomers that request digital credentials, a role under sections 4(c)(8) and 4(j) of the BHC Act24 referred to as‘‘registration authority.’’ Bank and and section 225.24 of the Board’s Regulation other registration authorities would register the Y25 to act as a CA in connection with financial digital certificates issued to their customers, and and nonfinancial transactions and to engage in CLX would maintain a database of all certifi- cates issued through its registration authorities. CLX would also provide registration authorities designed and marketed for processing and transmitting finan- with the software and hardware required to use cial, banking, or economic data. It may also develop and sell general purpose hardware so long as it does not constitute the ITS. more than 30 percent of the cost of any packaged offering. In this order, the Board referenced its previ- 22. The notificants may engage in data processing and data ous approval (2000 FRB 56) in which it deter- transmission activities, including the development and sale of mined that the CA activities conducted in con- hardware and software, pursuant to this order only to the extent such activities are necessary to permit the proper nection with financial and nonfinancial operation of the identity system. The notificants and Indent transactions and data processing were activities also must conduct their data processing and data transmission that are closely related to banking for the pur- activities subject to the software and hardware limitations in poses of section 4(c)(8) of the BHC Act. Also Regulation Y. 23. As a foreign bank operating an agency in the United for this latter order, the Board found that the States, the foreign bank is subject to the BHC Act by opera- foreign bank’s proposed activities were consis- tion of section 8(a) of the International Banking Act of 1978 tent with those that it had previously approved. (12 U.S.C. 3106(a)). The foreign bank committed that it would con- 24. 12 U.S.C. 1843(c)(8) and 1843(j). 25. 12 C.F.R. 225.24. duct its proposed nonbanking activities in accor-

BHC Supervision Manual January 2007 26. These banks would also have to enter into agreements Page 4 to participate with ITS. Acting as a Certification Authority for Digital Signatures 3600.7 dance with the limitations set forth in Regula- Board approved the notice on June 8, 2006 tion Y and the Board’s above-mentioned previous (2006 FRB C149). order governing these proposed activities. The

3600.7.2 LAWS, REGULATIONS, INTERPRETATIONS, AND ORDERS

Subject Laws 1 Regulations 2 Interpretations 3 Orders

Acting as a certification author- 12 225.28(b)(14) 2000 FRB 56 ity for financial and nonfinan- U.S.C. 2006 FRB 149 cial transactions and related data 1843(c)(8) processing activities.

1. 12 U.S.C., unless specifically stated otherwise. 3. Federal Reserve Regulatory Service reference. 2. 12 C.F.R., unless specifically stated otherwise.

BHC Supervision Manual January 2007 Page 5 Permissible Activities by Board Order (Private Limited Investment Partnerships) Section 3600.8

A bank holding company (the applicant) applied in any amount. The applicant would continue under section 4(c)(8) of the Bank Holding Com- the company’s practice of allowing existing pany Act and the Board’s Regulation Y to investors in a partnership to add to their invest- engage de novo through a wholly owned subsid- ment in the partnership in any amount. The iary (the company) in privately placing limited application was approved on June 28, 1994 partnership interests in a group of partnerships (1994 FRB 736). having a limited number of investors. The com- Subsequently, another bank holding company pany was to serve as the investment adviser, (the BHC applicant) applied for the Board’s administrator, and sole general partner of a approval under section 4(c)(8) of the BHC Act series of seven partnerships (the partnerships) and section 225.23 of Regulation Y to engage that would be sold to a number of institutional de novo, through a wholly owned asset- investors. The company would maintain an equity management subsidiary (AMS), in establishing interest of approximately 1.25 percent of the and serving as the general partner of limited total capitalization in each partnership. partnerships (the limited partnerships) that would The partnerships were to be engaged solely in invest in a wide variety of commodities and investing in limited amounts of debt and equity exchange-traded and over-the-counter instru- securities, including interests in real estate invest- ments including those specified in the Board ment equity trusts (REITs).1 The partnerships, order. AMS would be the general partner of together with the applicant and its other subsidi- each partnership and would hold a nominal aries, were not to hold more than 5 percent of equity interest in each one. In this case, AMS any class of voting securities of any issuer, would not provide investment advice directly to and not more than 25 percent of the total equity the limited partnerships, but would employ of any issuer.2 The equity investments were unaffiliated investment advisers to manage the to be held in accordance with section 4(c)(6) investments of the limited partnerships, pursu- of the BHC Act and section 225.22(d)(5) of ant to parameters set by AMS. Interests in the Regulation Y. limited partnerships would be privately placed The company also proposed to privately place with institutional customers by the BHC appli- limited partnership interests with new sophisti- cant’s subsidiary banks. cated institutional investors and possibly form One or more of the limited partnerships could similar additional partnerships in the future. The invest a substantial portion of their assets in company was not to privately place debt securi- commodity pools, which would require the appli- ties issued by the partnerships without prior cant to register as a commodity pool operator approval from the Federal Reserve System. The (CPO). The interests purchased by the limited applicant committed that the private placement partnerships would consist of less than 5 percent of limited partnership interests would conform of the outstanding voting securities of any com- to the limitations and conditions for private modity pool and less than 10 percent of the total placements in previous Board orders approving equity of any commodity pool. The applicant private-placement activities (for example, 1990 proposed that the limited partnerships purchase FRB 26 and 1989 FRB 829).3 Each investor was such assets with debt. It further stated that it required to have an initial minimum investment would not permit any limited partnership that of $100,000. Investors with $250,000 or more invested in distressed debt instruments to use under management by the company, however, borrowed funds to purchase or carry distressed would be permitted to invest in any partnership debt instruments or to use the distressed debt instruments as collateral in acquiring other assets. 1. The partnerships were not to invest in futures contracts The applicant also indicated that the leverage or options on futures contracts on any financial or nonfinan- employed by the limited partnerships would cial commodity, or knowingly invest in debt that, upon acqui- sition, is in default without the prior approval of the Federal include margin credit from broker-dealers, re- Reserve System. The applicant further committed that it verse repurchase agreements, and short sales. would not use the investments of the partnerships to obtain or The limited partnerships would invest in debt exercise control over any issuer of securities owned or held by and equity instruments and distressed debt the partnerships. Also, no directors, officers, or employees of 4 the applicant and its affiliates will serve as directors, officers, instruments. The applicant stated that invest- or employees of any issuer of which the applicant and its affiliates held more than 10 percent ownership of total equity. 4. The Board had previously permitted bank holding com- 2. The applicant committed that all subordinated debt of an issuer would be subject to this 25 percent limit. 3. See the current Regulation Y, section 225.28(b)(7)(iii), BHC Supervision Manual June 2000 regarding private-placement services. Page 1 Private Limited Investment Partnerships 3600.8 ments in debt and equity securities and dis- partnerships in the financial statements of AMS tressed debt would be made in accordance with for regulatory capital purposes. In addition, AMS the BHC Act’s limitations and those of pre- was required to establish an appropriate risk- vious Board decisions. (See 1995 FRB 1128 and management structure consisting of investment section 3104.0.) and position limits for each investment adviser The limited partnerships, together with the before engaging in the proposed activities. Com- applicant and its subsidiaries, would make invest- pliance and trading limits would be monitored ments not greater than 5 percent of any class of by computerized systems to be established by voting securities of any issuer, and not greater the applicant. The Board approved the notice on than 25 percent of the total equity, including the April 24, 1996, subject to all the facts of record subordinated debt, of any issuer. No directors, and the commitments furnished. See 1996 FRB officers, or employees of the applicant would 569. For more recent Board orders whereby serve as directors, officers, and employees of bank holding companies propose to act as a any issuer of which the applicant and its subsid- CPO and to control a private limited partnership iaries (that is, the limited partnerships) would that invested solely in permissible investments hold more than 10 percent of the total equity. for a bank holding company, see 1999 FRB 209, For this case, the Board required AMS to con- 1998 FRB 852, and 1998 FRB 361. solidate the assets and liabilities of the limited

panies to sponsor, organize, and manage closed-end invest- ment companies and unregistered limited partnerships that invest in securities.

BHC Supervision Manual June 2000 Page 2 Permissible Activities by Board Order (FCM Activities) Section 3600.13

3600.13.1 SERVING AS AND commodity pool operator (CPO) with the Com- CONTROLLING A PRIVATE LIMITED modity Futures Trading Commission (CFTC). PARTNERSHIP AS A COMMODITY As such, the ASM would register as a CPO with POOL OPERATOR the CFTC, and a portion of the general partner’s activities would become subject to the record- A bank holding company applied for the Board’s keeping, reporting, fiduciary standards, and other approval under section 4(c)(8) of the Bank Hold- requirements of the Commodity Exchange Act ing Company Act (BHC Act) and section 225.23 (7 U.S.C. 2 et seq.), CFTC, and National Futures of the Board’s Regulation Y (12 C.F.R. 225.23) Association. to engage de novo through a wholly owned The Board previously has found that a subsid- asset-management subsidiary (ASM) that would iary of a state member bank may serve as the be established to serve as the general partner of CPO of investment funds engaged in purchasing limited partnerships (the partnerships) that would and selling futures and options on futures on invest in a wide variety of commodities and certain commodities.1 In addition, the Board has exchange-traded and over-the-counter instru- permitted bank holding companies to trade futures ments, including interests in investment funds and options on futures on financial and nonfi- that invest in futures and options on futures on nancial commodities.2 For these reasons, the financial and nonfinancial commodities (com- Board has concluded that serving as a CPO, and modity pools). It was indicated that the partner- controlling as a CPO a private limited partner- ships would not directly invest in futures or ship that invests solely in investments that a options on futures contracts for purposes other bank holding company is permitted to make than hedging. The partnerships would purchase directly, under the circumstances of this case and sell derivative contracts on precious metals (1996 FRB 569) are closely related to banking. and financial commodities, instruments, and See also 1998 FRB 1075, 1998 FRB 852–854, indices for hedging purposes. It was further 1998 FRB 361, and 1994 FRB 736. stated that one of the limited partnerships may invest a substantial portion of its assets in com- modity pools, which would require the ASM 1. See 1996 FRB 239. (the general partner) to become a registered 2. See 1995 FRB 185.

BHC Supervision Manual June 1999 Page 1 Permissible Activities by Board Order (Insurance Activities) Section 3600.17

3600.17.1 ENGAGING IN TITLE The bank holding company applicant was one INSURANCE AGENCY ACTIVITIES of 16 active companies with grandfather rights PURSUANT TO REGULATION Y under exemption G.1 Previously, the Board deter- mined (1985 FRB 171) that those companies A bank holding company applied under section that had received Board approval to engage 4(c)(8) of the BHC Act and section 225.23(a) of in general insurance agency activities before the Board’s Regulation Y to acquire all the 1971 would be grandfathered under exemption outstanding shares of a title insurance agency. G with respect to the sale of any type of insur- The title insurance agency is to conduct activi- ance that is within the scope of general insur- ties pursuant to exemption G of the Garn–St ance agency activities—even an insurance agency Germain Depository Institutions Act of 1982 activity (such as title insurance) not actually (the act) and section 225.28(b)(11)(vii) of Regu- offered by the applicant bank holding company lation Y. Title VI of the act amended section before 1971. The Board found that there is no 4(c)(8) of the BHC Act to provide that insur- requirement in the statute that a company quali- ance agency, brokerage, and underwriting activi- fying for exemption G engage only in those ties are not ‘‘closely related to banking’’ and insurance agency activities it conducted with thus are not permissible activities for bank hold- Board approval before 1971. Thus, although the ing companies, unless the activities are included Board may not have specifically approved title within one of seven specific exemptions insurance before 1971, provided the proposed (A through G) in section 4(c)(8). activity is encompassed within the authorization of insurance agency activities, the activity falls The applicant claimed that it was authorized within exemption G. to operate a title insurance agency under exemp- The Board determined selling title insurance tion G, which authorizes those bank holding through a title insurance agency to be permis- companies that engaged in insurance agency sible pursuant to exemption G and the Board’s activities before 1971 to engage, or control a regulations. The Board approved the application company engaged in, insurance agency activi- on November 17, 1988 (1989 FRB 31). ties. The company has been engaged in the sale of insurance related to extensions of credit by its subsidiary banks since 1939. 1. There are currently 12 companies remaining.

BHC Supervision Manual December 1998 Page 1 Permissible Activities by Board Order (Underwriting and Dealing) Section 3600.21

WHAT’S NEW IN THIS REVISED dealing in commercial paper is closely related to SECTION banking on the same basis as acting as place- ment agent and adviser to issuers in commercial Effective July 2008, this section has been revised paper (1987 FRB 138). Banks provide services to incorporate a name change to the Financial that are operationally and functionally similar Industry Regulatory Authority, or FINRA (for- to the services of underwriting and dealing in merly, the National Association of Securities commercial paper. Banking organizations are Dealers, or NASD). particularly well equipped to provide such ser- vices. In the Board’s view, the underwriting and dealing activity represents a natural extension of 3600.21.1 UNDERWRITING AND commercial lending activities traditionally con- DEALING IN COMMERCIAL PAPER ducted by banks, involving little additional risk TO A LIMITED EXTENT or new conflicts of interest, and potentially yielding significant public benefits in the form A bank holding company applied for the Board’s of increased competition and convenience. approval under section 4(c)(8) of the BHC Act The Board concluded that the applicant could and section 225.21(a) of the Board’s Regula- conduct the activities to the extent and in the tion Y to underwrite and deal in third-party manner described in the order, consistent with commercial paper to a limited extent. As pro- the former section 20 of the Glass-Steagall Act posed, the activity will be conducted through a and section 4(c)(8) of the BHC Act. The Board’s commercial finance subsidiary (the company). approval extended only to commercial paper The company is to act for issuers as an under- underwriting, dealing, placement, and advisory writer of commercial paper, purchasing com- activity conducted in accordance with the limi- mercial paper for resale to institutional investors tations stated in the order (1987 FRB 367). such as banks, insurance companies, mutual funds, and nonfinancial businesses. In addition, the company may place commercial paper as agent for issuers and advise issuers on the rates 3600.21.2 ENGAGE IN and maturities of proposed issues that are likely UNDERWRITING AND DEALING, TO to be accepted in the market—activities previ- A LIMITED EXTENT, IN MUNICIPAL ously approved by the Board (1987 FRB 138). REVENUE BONDS, MORTGAGE- The activities in this order (1987 FRB 367) RELATED SECURITIES, AND differ from those previously authorized (1987 COMMERCIAL PAPER FRB 138) in that the applicant will underwrite and deal in commercial paper as principal. On April 30, 1987, the Board approved by order The Board may not approve a proposal of a the applications of three bank holding com- member bank affiliate if upon consummation it panies to engage through subsidiaries in under- would be ‘‘engaged principally’’ in the flotation, writing and dealing in commercial paper, one- underwriting, public sale, or distribution of com- to four-family mortgage-backed securities, and mercial paper (hereafter referred to as ‘‘under- municipal revenue bonds.1 (For a complete writing and dealing in’’) within the meaning of description of the nonbanking activities autho- the former section 20 of the Glass-Steagall Act rized by the Board in this order, see 1987 FRB (12 U.S.C. 377). The Board concluded that even 473.) The subsidiaries are to be involved in if placement of commercial paper were deemed underwriting and dealing in U.S. government to constitute an activity, the commercial lending securities as their major activity. Board approval subsidiary would not be ‘‘engaged principally’’ in underwriting and dealing in securities. The subsidiary’s activity was not substantial under a 1. The applicants had previously received Board approval under section 4(c)(8) of the BHC Act for the subsidiaries former 5 percent limit on the subsidiary’s gross mentioned in the order to engage in underwriting and dealing income (increased to 25 percent, effective March in U.S. government and agency and state municipal securities 6, 1997) from its commercial paper activities that state member banks are authorized to underwrite and deal and a former 5 percent limit on its market share. in under section 16 of the Glass-Steagall Act. The newly proposed underwriting and dealing activities were approved The company is required to restrict its commer- in addition to the previously approved activities. cial paper activities so it does not exceed these limits. BHC Supervision Manual July 2008 The Board concluded that underwriting and Page 1 Permissible Activities by Board Order (Underwriting and Dealing) 3600.21 could only occur if the affiliates would not be The Board’s approval of the applications ‘‘principally engaged’’ in underwriting and deal- extends only to the activities conducted within ing in ‘‘securities’’ under the provisions of the the limitations of the order and is subject to the former section 20 of the Glass-Steagall Act. gross revenue limitation discussed above. Two A hearing was held on February 3, 1987, of the applicants also proposed to underwrite because of the important legal and factual issues and deal in consumer-receivable-related securi- involved. The Board reaffirmed its finding in its ties (CRRs). Although the companies noted cer- previous decisions (1987 FRB 138 and 367) that tain similarities between these securities and the applicants were not principally engaged in mortgage-related securities, the Board did not the proposed securities activities if they limited believe that the record before the Board pro- their underwriting and dealing income from vided a sufficient basis for it to make a formal these securities to 5 percent of the total gross finding (as required by the BHC Act) that under- income of the affiliate, and if they limited their writing and dealing in CRRs is closely related to market share in each of these securities to 5 per- banking and a proper incident thereto. The Board cent of the total domestic market.2 The Board noted that the market for CRRs was relatively established a number of conditions to ensure new and untested compared with the market for that the underwriting activity would be consis- one- to four-family mortgage-related securities tent with safe and sound banking practices and and municipal revenue bonds. The Board indi- would avoid conflicts of interest, undue concen- cated that it would reconsider the matter within tration of resources, and other adverse effects. 60 days on the basis of more complete informa- The Board determined, consistent with its tion to be submitted by the applicants regarding previous underwriting and dealing decisions in the types of assets that would be securitized, the administering the Glass-Steagall Act, that a manner in which this would be accomplished, range of between 5 percent and 10 percent of and other matters bearing on risk. gross revenue and market share is the appropri- In a subsequent order, six BHCs applied for ate framework for determining whether an affili- and received the Board’s conditional approval ate is engaged principally in securities activities. (1987 FRB 731) for the activity, but the Board The lower end of the range—5 percent—was stayed its order for the same period of time the level applied at the time. The Board noted applicable to the stay issued by the Second that it would review this level within a year Circuit Court of Appeals (see footnote 2 and on the basis of experience gained from opera- section 3600.21.3). After approving the order tions to determine whether a higher level would set out in 1987 FRB 731, the Board approved be permissible. On September 21, 1989, the several other orders that rely on this order and Board modified section 20 orders to increase the limitations imposed therein. (See the follow- from 5 percent to 10 percent the revenue limit ing Board orders: 1987 FRB 607, 616, 618, 620, on the amount of total revenues a section 20 622, 731, 738, 742, 928; 1988 FRB 133, 500, subsidiary may derive from ineligible securities 699, 700, 706, 819; 1989 FRB 33, 190, 396, underwriting and dealing activities (increased to 398, 520, 645, 647; 1990 FRB 79, 158, 256, 25 percent, effective March 6, 1997) (1989 FRB 461, 554, 568, 573, 652, 682, 756; 1991 FRB 751).3 954; 1992 FRB 338; 1993 FRB 141, 716; and 1994 FRB 249, 346.) The major difference between the three 2. The U.S. Court of Appeals for the Second Circuit upheld the Board’s determination that the underwriting subsidiaries applications decided on April 30, 1987, and would not be engaged principally in ineligible securities the two applications previously approved by underwriting and dealing under the above revenue limitation; the Board (1987 FRB 138 and 367) is that the the U.S. Supreme Court declined to review that decision underwriting would take place in an affiliate (Securities Industry Association v. Board of Governors of the Federal Reserve System, 839 F.2d 47 (2d Cir. 1988), cert. engaged in underwriting and dealing in U.S. denied, 108 S.Ct. 697 (1988)). The Supreme Court also let government securities. This arrangement raised stand the lower court’s determination that the 5 percent mar- the major legal question of whether these gov- ket share limitation was not adequately supported by the facts ernment securities could serve as a basis for of record, thus sustaining elimination of the market share test that had been invalidated by the U.S. Court of Appeals. measuring the principal activity of the affiliate. Accordingly, the Board decided not to impose a market share In its approval, the Board took into account the limitation on orders approved on August 4 and 8, 1988. fact that the Glass-Steagall Act specifically 3. The Board in this order also modified its section 20 orders to permit underwriting and dealing in securities of ally recognized rating organization or are issued or guaranteed affiliates if the securities are rated by a nonaffiliated, nation- by the Federal National Mortgage Association, the Federal Home Loan Mortgage Corporation, or the Government BHC Supervision Manual July 2008 National Mortgage Corporation, or represent interests in such Page 2 obligations. Permissible Activities by Board Order (Underwriting and Dealing) 3600.21 allows member banks to underwrite U.S. gov- investors. Banks also advise issuers of CRRs ernment securities and that the act intends affili- and assist issuers in privately placing these ates to have a broader scope for underwriting securities. than member banks. On that basis, the Board Because of the similarity between securities had previously allowed affiliates of member involved in CRRs and the previously approved banks to engage in underwriting of U.S. govern- bank-ineligible one- to four-family mortgage- ment securities. related securities nonbanking activities set forth in a previous order (1987 FRB 473), the Board required that this activity be conducted in accor- 3600.21.3 ENGAGE IN LIMITED dance with the same requirements established in UNDERWRITING AND DEALING IN that order. This includes a requirement that the CONSUMER-RECEIVABLE-RELATED securities be rated for investment quality by a SECURITIES nationally recognized agency. The Board concluded, based on the reasons Six bank holding companies applied for the set forth in its previous order (1987 FRB 473), Board’s approval to engage in limited under- that the approved activity would not result in a writing and dealing in consumer-receivable- violation of the former section 20 of the Glass- related securities (CRRs). CRRs, which were Steagall Act and is closely related and a proper first issued in 1985, consist of debt obligations incident to banking. The Board’s approval of that are secured by or represent an interest in a these applications is restricted to underwriting diversified pool of loans to or receivables from and dealing to a limited extent in securities consumers, such as loans to individuals to finance representing an interest in or backed by a diver- the purchase of automobiles or personal credit sified pool of loans to or receivables from indi- card accounts. viduals for the purchase of consumer goods and The Board concluded that underwriting and services, and the limitations of section dealing in CRRs is an activity closely related to 225.25(b)(16) of Regulation Y (1987 FRB 731). banking on the basis that banks provide services that are operationally and functionally so similar to the services proposed that banking organiza- 3600.21.4 LIMITED UNDERWRITING tions are particularly well equipped to provide AND DEALING IN DEBT AND them. In accordance with section 16 of the EQUITY SECURITIES Glass-Steagall Act, banks underwrite and deal in certain mortgage-related securities that are Five bank holding companies applied for the issued or guaranteed by the United States or by Board’s approval under section 4(c)(8) of the U.S. government agencies. Some of the securi- BHC Act for their wholly owned subsidiaries to ties represent interests in pools of mortgage underwrite and deal in, on a limited basis— loans for residential housing purposes made by banks and other financial institutions. Such 1. debt securities, including, without limitation, securities are very similar to CRRs. sovereign debt securities, corporate debt, debt Both CRRs and bank-eligible mortgage- securities convertible into equity securities, related securities represent interests in pools of and securities issued by a trust or other vehi- loans made by financial institutions to individu- cle secured by or representing interests in als to finance the purchase of housing or con- debt obligations; and sumer goods and services. 2. equity securities, including, without limita- The techniques involved in underwriting and tion, common stock, preferred stock, Ameri- dealing in bank-eligible mortgage-related secu- can Depositary Receipts, and other direct and rities are also very similar to those that would be indirect equity ownership interests in corpo- involved in conducting the approved activity rations and other entities. with respect to CRRs. In each case, the under- writer must perform substantially identical func- Section 16 of the Banking Act of 1933 tions of evaluating prepayment risk, analyzing (the Glass-Steagall Act) prohibits a member credit and cash flow from a pool of numerous bank from underwriting and dealing in these individuals’ loans, negotiating or bidding, and securities (referred to hereafter as ‘‘bank- distributing and dealing. ineligible securities’’). However, as far as the In addition, banks now directly perform some Glass-Steagall Act is concerned, an affiliate of a of the functions involved in the approved activity. Banks select the consumer loans that BHC Supervision Manual July 2008 form the pool of interests that are then sold to Page 3 Permissible Activities by Board Order (Underwriting and Dealing) 3600.21 member bank may underwrite and deal in ties, and broad financial skills that make them bank-ineligible securities so long as it is not well equipped to provide the new services. engaged principally or substantially in that The Board’s approval of each application is activity (12 U.S.C. 377). subject to the conditions stated in previous The applicants had previously received Board orders (see 1989 FRB 192; 1990 FRB 158, 455, approval to underwrite and deal in U.S. govern- 573, 652, 683, 756; 1991 FRB 672; 1993 FRB ment and agency securities and state and 133, 719; and 1994 FRB 249, 449). The condi- municipal securities that state member banks are tions consist of structural and operating limita- specifically authorized to deal in under section tions designed to avoid conflicts of interest and 16 of the Glass-Steagall Act (referred to hereaf- potential adverse effects, and other conditions ter as ‘‘bank-eligible securities’’). The Board designed to ensure safe and sound operations. had also authorized the subsidiaries to under- The conditions include requirements, limita- write and deal in commercial paper, one- to tions, and prohibitions with regard to— four-family mortgage-backed securities, munici- pal revenue bonds, and consumer-receivable- 1. capital adequacy; related securities—all securities that member 2. credit extensions to customers of the under- banks may not underwrite or deal in under sec- writing subsidiary; tion 16 of the Glass-Steagall Act.4 3. maintaining the separateness of an under- To ensure that the subsidiaries would not be writing affiliate’s activity; principally or substantially engaged in under- 4. disclosures by the underwriting subsidiary; writing or dealing in the ineligible securities in 5. marketing activities on behalf of an under- violation of the former section 20 of the Glass- writing subsidiary; Steagall Act, the Board’s approval was made 6. investment advice by bank or thrift subject to the requirement that gross revenues affiliates; from those ineligible securities activities would 7. extensions of credit to the underwriting sub- not exceed 5 percent of the subsidiary’s total sidiary and to purchasers or issuers of ineli- gross revenues on average (moving average) gible securities (or to major users of projects over any two-year period. (See 1989 FRB 192 funded by industrial revenue bonds); and 196–197.) The Board increased this level to 8. transfers of information; 10 percent on September 5, 1989. 9. reporting and recordkeeping requirements; The subsidiaries are also subject to a frame- 10. transfer of activities and formation of sub- work of structural and operating limitations sidiaries of an underwriting subsidiary to established to avoid the potential for conflicts of engage in underwriting and dealing; and interest, unsound banking practices, unfair com- 11. reciprocal arrangements and prohibitions petition, loss of public confidence in affiliate against discriminatory treatment regarding banks, and other adverse effects from the con- unaffiliated securities firms. duct of the bank-ineligible securities underwrit- ing and dealing activity. The Board recognized that underwriting and dealing in securities is a natural extension of 3600.21.5 ACTING AS A activities currently conducted by banks, involv- DEALER–MANAGER IN ing manageable risks and potential conflicts of CONNECTION WITH CASH-TENDER interest when conducted in an organizational AND EXCHANGE-OFFER structure that insulates these activities from TRANSACTIONS banking activities supported by the federal safety net of deposit insurance and access to Federal In connection with a bank holding company Reserve lending. The Board has acknowledged application to underwrite and deal in, to a lim- that certain bank holding companies have an ited extent, all types of equity securities through existing expertise in securities underwriting, its section 20 nonbanking subsidiary, an appli- dealing, brokerage, investment advisory activi- cant also proposed to act as a dealer–manager in connection with cash-tender and exchange-offer 4. See the following Board orders: 1987 FRB 473, 607, transactions. Dealer–managers generally act as 616, 618, 620, 622, 731, 738, 742, 928; 1988 FRB 133, 500, agent for tender or exchange offerors in arrang- 699, 706, 819; 1989 FRB 33, 190, 396, 398, 520, 645, 647; ing or facilitating mergers, acquisitions, and 1990 FRB 79, 158, 256, 461, 554, 568, 573, 652, 682, 756; 1991 FRB 672; 1993 FRB 133, 719; and 1994 FRB 249, 449. other corporate transactions. All-cash tender offers do not, of themselves, involve the issu- BHC Supervision Manual July 2008 ance, public sale, or distribution of securities. Page 4 The Board thus concluded that all revenues Permissible Activities by Board Order (Underwriting and Dealing) 3600.21 derived from the section 20 company acting as a bank holding companies previously requested dealer–manager in connection with such tender approval to underwrite and deal in only munici- offers may be treated as bank-eligible revenues pal revenue bonds, as opposed to a full range of for purposes of determining compliance with debt securities. Their requests were limited to the Board’s 10 percent revenue limitation underwriting and dealing in industrial develop- (changed to 25 percent, effective March 6, 1997) ment bonds that are ‘‘public ownership’’ indus- on bank-ineligible securities activities. The Board trial development bonds. Public ownership indus- approved the application on November 24, 1993 trial development bonds are those ‘‘tax-exempt (see 1994 FRB 49, footnote 5). bonds where the issuer, or the governmental unit on behalf of which the bonds are issued, is the sole owner for federal income tax purposes 3600.21.6 UNDERWRITING of the financed facility.’’7 ‘‘PRIVATE OWNERSHIP’’ The notificant plans to engage through the INDUSTRIAL DEVELOPMENT company in underwriting private ownership BONDS industrial development bonds issued solely for the provision of traditional governmental ser- A bank holding company (the notificant) pro- vices. It committed to conduct this activity sub- vided notice under section 4(c)(8) of the Bank ject to the same limitations and other conditions Holding Company Act (BHC Act) (12 U.S.C. that govern underwriting and dealing in public 1843(c)(8)) and section 225.23 of the Board’s ownership industrial development bonds.8 Regulation Y (12 C.F.R. 225.23) of its proposal The underwriting risk and the risk analysis to engage de novo through its section 20 subsid- required to underwrite private ownership indus- iary (the company) in underwriting, to a limited trial development bonds issued for traditional extent, certain ‘‘private ownership’’ industrial governmental services is essentially the same as development bonds. The bonds are issued for the risk and analysis related to underwriting the provision of the following governmental traditional public ownership bonds. For each, services: water facilities, sewer facilities, solid the funds for the repayment of the bonds are waste disposal facilities, electric energy and gas derived from revenue generated by the financed facilities, and local district heating or cooling facility, including revenue resulting from a ser- facilities (collectively, traditional governmental vice contract between the owner/lessor of the services). The notificant controls one bank financed facility and a state or local government subsidiary. or political subdivision, pursuant to which the The company is currently engaged in limited state or local government or political subdivi- underwriting and dealing in certain municipal sion agrees to purchase the output of the facil- revenue bonds, activities permissible under sec- ity.9 The notificant committed that all the pri- tion 20 of the Glass-Steagall Act (12 U.S.C. 377).5 The company is a broker–dealer regis- tered with the Securities and Exchange Com- Securities Industry Ass’n v. Board of Governors of the Fed- eral Reserve System, 839 F.2d 47 (2d Cir.), cert. denied, 486 mission (SEC) under the Securities Exchange U.S. 1059 (1988), as modified by order approving modifica- Act of 1934 (15 U.S.C. 78a et seq.) and is a tions to section 20 orders, 1989 FRB 751 (‘‘Citicorp/Morgan/ member of the Financial Industry Regulatory Bankers Trust’’). See also J.P. Morgan & Co. Incorporated, et Authority (FINRA). Thus, the company is sub- al., 1989 FRB 192, aff’d sub nom. Securities Industry Ass’n v. Board of Governors of the Federal Reserve System, 900 F.2d ject to the recordkeeping and reporting obliga- 360 (D.C. Cir. 1990). tions, fiduciary standards, and other require- 7. See 1987 FRB 502. Examples of financed facilities ments of the Securities Exchange Act of 1934, include airports and mass-commuting facilities. the SEC, and the FINRA. The notificant engages 8. Citicorp/Morgan/Bankers Trust. All the bonds that the notificant proposed that the company underwrite would qualify directly and through subsidiaries in other per- as ‘‘exempt facility bonds’’ under the Internal Revenue Code missible nonbanking activities. (the code). See 26 U.S.C. 142. The types of exempt facility The Board previously determined that the bonds that the company would underwrite may, subject to activities of underwriting and dealing in munici- certain volume caps and other limitations, be tax-exempt under the code even if the proceeds of the bonds are used to pal revenue bonds, including industrial develop- finance facilities that are privately owned. See 26 U.S.C. 103, ment bonds, are so closely related to banking as 141, 142, 146, and 147. to be proper incidents thereto within the mean- 9. Typically, in the case of public ownership bonds, the ing of section 4(c)(8) of the BHC Act.6 Certain governmental unit that issues the bonds owns the financed facility and repays the bonds from the revenue generated by the facility and this service contract. The governmental unit 5. See 1993 FRB 716. 6. Citicorp, J.P. Morgan & Co. Incorporated, and Bankers BHC Supervision Manual July 2008 Trust New York Corporation, 1987 FRB 473, aff’d sub nom. Page 5 Permissible Activities by Board Order (Underwriting and Dealing) 3600.21 vate ownership bonds that the company would sible activity if conducted subject to the condi- underwrite would be rated ‘‘investment quality’’ tions and prudential limitations set forth in by a nationally recognized rating agency to the Citicorp/Morgan/Bankers Trust (1987 FRB 473 same extent as are the municipal revenue bonds and 1989 FRB 751 (Modification Order)) and that the company currently underwrites. agreed to in 1993 FRB 716. The notification Considering these circumstances, the Board was approved on October 24, 1995 (see 1995 concluded that underwriting and dealing in pri- FRB 1116). vate ownership bonds issued for the provision of traditional governmental services is a permis-

may also enter into a contract with a third party to operate the financed facility. In the case of the private ownership bonds that the notificant plans to underwrite, the governmental unit that issues the bonds either uses the proceeds of the bonds to acquire or construct a facility, which the governmental unit then leases to a third party, or lends the proceeds of the bonds to a third party to acquire or construct the facility. The third party agrees to make lease payments or loan repayments to the governmental unit that enable the governmental unit to pay debt service on the bonds. As security for the lease or loan agreement, the third party assigns and pledges the rev- enues generated by the facility and a service contract with a state or local government or political subdivision.

BHC Supervision Manual July 2008 Page 6 Permissible Activities by Board Order (Issuance & Sale of Mortgage- Backed Securities Guaranteed by GNMA) Section 3600.23

A foreign bank subject to the Bank Holding related to banking (1988 FRB 573). In addition, Company Act applied for the Board’s approval the Board determined that the statutory exemp- to engage in various nonbanking activities, one tion reflects a Congressional determination that being to purchase mortgage loans and to issue GNMA securities are not the type of securities securities for its own account, through a wholly that would lead to unsound speculation or that owned subsidiary or third party servicers, and to the public interest in the issuance and sale of sell securities guaranteed by the Government GNMA securities by banks outweighs any National Mortgage Association (GNMA). potential harm resulting therefrom. Also, the Because National Banks are specifically autho- Board previously determined that underwriting rized under the Glass–Steagall Act (12 U.S.C. and dealing in GNMA certificates is of suffi- 24) to issue and sell securities guaranteed by ciently low risk to be generally permissible GNMA, as well as to underwrite and deal in activities for bank holding companies (12 C.F.R. such securities, the Board concluded that the 225.25(b)(16)). issuance and sale of GNMA securities is closely

BHC Supervision Manual December 1992 Page 1 Permissible Activities by Board Order (Sales Tax Refund Agent and Cashing U.S. Dollar Payroll Checks) Section 3600.24

A foreign bank, subject to Section 4 of the BHC the State and local tax authorities refund to the Act, applied for the Board’s permission to acquire, company the amount of tax refunds advanced. through its wholly owned subsidiary, all the The Board found the activity to be closely shares of a company located in New York, New related to banking since banks: (1) routinely York. The acquired company would engage in forward to taxing authorities tax receipts deliv- several nonbanking activities. Two of the activi- ered to the bank on taxes due; (2) commonly act ties, not previously approved by the Board for as fiscal agent for government authorities which BHCs, consisted of acting as a sales tax refund involves disbursing funds on behalf of state and agent for the State of Louisiana and Cashing local governments. U.S. Dollar Payroll Checks Drawn on Unaffili- ated Banks. Both activities were found to be closely related to banking subject to the facts 3600.24.2 CASHING U.S. DOLLAR and conditions found in the Board order and PAYROLL CHECKS DRAWN ON briefly discussed below. The application was UNAFFILIATED BANKS approved on August 15, 1990 (1990 FRB 860). The company being acquired also cashes, and the Applicant plans to continue cashing, U.S. 3600.24.1 ACTING AS A SALES TAX dollar payroll checks on a limited basis, pri- REFUND AGENT FOR THE STATE OF marily to accommodate employees in airport LOUISIANA facilities that lack banking services, but where the company maintains offices. Since check The company being acquired serves as the State’s cashing is a fundamental banking activity per- exclusive sales tax refund agent for its tax-free formed routinely by banks, and the company shopping program for foreign visitors. Under being acquired proposed to cash only checks theprogram,foreignvisitorspresentsalesinvoices drawn on unaffiliated banks, the Board found evidencing sales taxes paid in Louisiana to the the activity to be closely related to banking. The company’s office in the state. It refunds the tax Board stipulated, however, that the Applicant in U.S. dollars to the visitor, less a handling fee. was not to use the acquired company’s offices as A portion of the handling fee is then remitted to branches of the Applicant or any affiliated bank.

BHC Supervision Manual December 1992 Page 1 Permissible Activities by Board Order (Providing Government Services) Section 3600.25

A bank holding company (the notificant) The Board noted that banks are permitted to requested the Board’s approval, under section provide customer access to the type of govern- 4(c)(8) of the BHC Act and section 225.24(a) of ment services involved in the proposal, whereby Regulation Y, to acquire through its wholly the banks may be acting in an agency capacity owned subsidiary a cash-express company, cer- or accomplishing the distribution of some of the tain assets of an exchange company, and another services using automated teller machines firm to engage in various nonbanking activities. (ATMs).1 The Board thus concluded that the Many of the nonbanking activities had previ- proposed nonbank activities are closely related ously been determined by the Board to be closely to banking. Based on all the facts and commit- related to banking in Regulation Y, by order, or ments provided by the notificant, and the repre- by interpretation. In addition to those nonbank- sentations and conditions relied upon in reach- ing activities already approved, the notificant ing a decision, the Board approved the proposal requested the Board’s approval to engage in on April 2, 1998 (1998 FRB 481). providing various governmental service activi- ties at the offices of the cash-express company:

1. postage stamps and postage-paid envelopes 2. vehicle registration services, including the 1. See 12 C.F.R. 7.1010 and OCC Interpretive Letter No. sale, distribution, and renewal of license 718 (March 14, 1996) (postage stamps, acting as an agent for plates and license tags for motor vehicles the state in selling and renewing license plates and license 3. public-transportation tickets and tokens tags, and public-transportation tickets from ATMs). See also OCC Conditional Approval Letter No. 267 (January 12, 4. notary public services 1988)(notary services).

BHC Supervision Manual June 2000 Page 1 Permissible Activities by Board Order (Real Estate Settlement Through a Permissible Title Insurance Agency) Section 3600.26

A BHC Applicant requested the Board’s permis- In reviewing the proposed activity, the Board sion under section 4(c)(8) of the BHC Act to noted that real estate settlement services are acquire all the outstanding shares of a company provided by the Applicant’s bank subsidiaries in engaged in title insurance agency and real estate connection with their origination of mortgage settlement activities. The Board previously loans, and banks within the Applicant’s state are determined that title insurance agency activities generally permitted to conduct real estate settle- are permissible under section 4(c)(8)(G) of ment activities. It was further noted that banks the BHC Act, for which the BHC Applicant routinely prepare collateral security agreements qualifies. and other documentation required to close loans The real estate settlement services consist of: in accordance with federal and state lending (1) reviewing the status of the title in the title requirements as part of the general lending commitment, resolving any exceptions to the activities authorized under the Board’s Regula- title, and reviewing the purchase agreement to tion Y. identify any requirement in it in order to ensure The Board concluded that aspects of the pro- compliance with them; (2) verifying payoffs on posed real estate settlement activities are directly existing loans secured by the real estate and linked to permissible title insurance agency ac- verifying the amount of and then calculating the tivities by BHCs. These activities can directly pro rating of special assessments and taxes on affect the insured risks under a title insurance the property; (3) obtaining an updated title policy. Title insurance agents have special expe- insurance commitment to the date of closing, rience in assessing potential title defects that preparing the required checks, deeds, affidavits, can arise in real estate settlement. Title insur- and obtaining any authorization letters needed; ance agents thus have the expertise to generally (4) establishing a time and place for the closing, engage in real estate settlements. conducting the closing, and ensuring that all For these reasons, the proposed real estate parties properly execute all appropriate docu- settlement activities conducted through a per- ments and meet all commitments; (5) collecting missible title insurance agency, were deemed by and disbursing funds for the parties, holding the Board to be closely related to banking for funds in escrow pending satisfaction of certain purposes of section 4(c)(8) of the BHC Act. The commitments, preparing the HUD settlement Board approved the application by order on statement, the deed of trust, mortgage notes, the October 15, 1990 (1990 FRB 1058). Truth-in-Lending statement, and purchaser’s affidavits; and (6) recording all of the docu- ments required under law.

BHC Supervision Manual December 1992 Page 1 Providing Administrative and Certain Other Services to Mutual Funds Section 3600.27

A bank holding company (the applicant) applied The Board also found, however, that the Glass- under sections 3(a)(3) and 4(c)(8) of the BHC Steagall Act does not prohibit all relationships Act to acquire another company (the company), between a bank holding company and a mutual thereby indirectly acquiring its subsidiary (the fund and that it is permissible, under the BHC subcompany) as well as the subsidiary bank and Act and the Glass-Steagall Act, for bank hold- nonbank companies of the company and the ing companies to provide investment advice to subcompany. Upon consummation of the trans- mutual funds. Also, the Board found that the action, the company and subcompany would be Glass-Steagall Act does not prohibit bank hold- subject to the provisions of the BHC Act. Both ing companies from providing certain other ser- companies applied for permission under section vices to mutual funds, such as acting as custo- 3(a)(1) of the BHC Act to become a bank hold- dian, transfer agent, or registrar.1 Banks and ing company. affiliates of banks may serve as investment ad- The applicant also applied for the Board’s viser, transfer agent, custodian, and registrar. permission to engage, through one subsidiary of They may not act as distributor to the fund. The the subcompany (the adviser), in providing application raised the question whether it was administrativeandcertainotherservicestomutual consistent with the Glass-Steagall Act for an funds, nonbanking activities that the Board has affiliate of a member bank to act as an adminis- not previously considered under section 4(c)(8) trator to a mutual fund. of the BHC Act. The applicant also applied for the Board’s permission to acquire certain other nonbanking subsidiaries of the company (as 3600.27.2 PERMISSIBILITY OF listed in appendix B of the order) to engage in PROPOSED ADMINISTRATIVE- making or servicing loans, providing trust ser- SERVICES ACTIVITIES vices, and providing investment advisory non- banking services pursuant to section 225.28(b)(1), The adviser furnishes a variety of services to (b)(5), and (b)(6) of Regulation Y. open-end investment companies (mutual funds) In addition, the applicant provided notice of and closed-end investment companies in the its intent to indirectly acquire a foreign trust United States. Because certain of the activities company, a trust administration company, and of the adviser and its affiliates are prohibited by an advisory company. The companies engage in the Glass-Steagall Act, the applicant has taken activities that are permissible under section steps and has committed to terminate the 211.10 of Regulation K. 1. The Board imposed a number of restrictions on the relationship between bank holding companies and mutual funds to avoid conflicts of interest and to address potential 3600.27.1 GLASS-STEAGALL ACT safety-and-soundness concerns. The Board’s rule includes ISSUES IN PROVIDING restrictions preventing a bank holding company or any of its ADMINISTRATIVE SERVICES subsidiaries from— • acting as investment adviser to any investment company The administrative services the applicant pro- that has a name similar to the holding company or any of its posed to provide through the adviser and its subsidiary banks; • purchasing for its own account shares of any investment affiliates raised a number of issues under the company for which the holding company serves as invest- Glass-Steagall Act. Under that act, a company ment adviser; that owns a member bank may not control • purchasing in its sole discretion in a fiduciary capacity ‘‘through stock ownership or in any other man- shares of an investment company advised by the holding company; or ner’’ a company that engages principally in dis- • extending credit to an investment company advised by the tributing, underwriting, or issuing securities. holding company as collateral for a loan used to purchase Because mutual funds continuously issue and shares of the investment company. redeem securities, the Board in 1972 issued an In addition, the rule requires that, in cases in which a cus- interpretation setting out its position on the tomer purchases or sells securities of the fund through the Glass-Steagall Act as it governs the relationship holding company or is advised by the holding company to between mutual funds and companies that own purchase shares of the fund, the customer be informed in writing of the holding company’s involvement with the fund, member banks (12 C.F.R. 225.125). The Board and be informed that the shares of the fund are not federally found that the Glass-Steagall Act prohibits insured and are not guaranteed by, or obligations of, a bank. affiliates of banks from sponsoring, organizing, or controlling mutual funds or distributing their BHC Supervision Manual June 2002 shares. Page 1 Providing Administrative and Certain Other Services to Mutual Funds 3600.27 adviser’s role as a sponsor of new mutual funds. ies and other shareholder communications, The applicant also committed that it would not and reviewing prospectuses acquire those of the adviser’s subsidiaries that 6. providing legal and regulatory advice to the engaged in the distribution of mutual fund fund in connection with its other adminis- shares. The applicant further committed that it trative functions would not be involved in the distribution of the 7. providing office facilities and clerical sup- shares of any mutual fund. The applicant repre- port for the fund sented to the Board, that, after the acquisition of 8. developing and implementing procedures the company, neither the adviser nor any of its for monitoring compliance with regulatory affiliates would be obligated by any agreement requirements and compliance with the fund’s to engage in any sales activities in connection investment objectives, policies, and restric- with any mutual fund’s shares and would not tions as established by the fund’s board enter into any distribution agreement with any 9. providing routine fund accounting services mutual fund, unless permitted to do so by a and liaison with outside auditors change in current law. 10. preparing and filing tax returns The adviser will not— 11. reviewing and arranging for payment of fund expenses 1. engage in the development of marketing 12. providing communication and coordination plans except to give advice to the distributor services with regard to the fund’s invest- regarding regulatory compliance; ment adviser, transfer agent, custodian, dis- 2. engage in advertising activities with respect tributor, and other service organizations that to the funds and will not be involved in the render recordkeeping or shareholder com- preparation of a fund’s sales literature, except munication services to review it for the sole purpose of ensuring 13. reviewing and providing advice to the dis- compliance with pertinent regulatory tributor, fund, and investment adviser requirements; or regarding sales literature and marketing plans 3. permit employees of the adviser to engage to ensure regulatory compliance in sales activities at meetings or seminars 14. providing the distributor’s personnel (such activities would be conducted solely with information about fund performance by the fund’s distributor). and administration 15. participating in seminars, meetings, and con- It was noted that the applicant did not propose ferences designed to present information to providing administrative services to those mutual brokers and investment companies, but not funds that are marketed and sold primarily to in connection with the sale of shares of the customers of any of the applicant’s subsidiary funds to the public, concerning the opera- banks. tion of the funds, including administrative The Board believes that it is permissible services provided by the bank holding com- under the Glass-Steagall Act for the applicant to pany to the funds provide the following administrative services to 16. assisting existing funds in the development mutual funds as proposed: of additional portfolios 17. providing reports to the fund’s board 1. maintaining and preserving the records of regarding fund activities the fund, including financial and corporate records A mutual fund administrator provides ser- 2. computing the fund’s net asset value, divi- vices that are essentially ministerial or clerical. dends, and performance data and financial The administrator does not have policymaking information regarding the fund authority or control over the mutual fund. The 3. furnishing statistical and research data policymaking functions rest with the board of 4. preparing and filing with the Securities and directors of the mutual fund. The board of direc- Exchange Commission (SEC) and state tors is responsible for the selection and review securities regulators registration statements, of the major contractors to the fund, including notices, reports, and other material required the investment adviser and, in certain circum- to be filed under applicable laws stances, the administrator. 5. preparing reports and other informational The Investment Company Act of 1940 materials regarding the fund, including prox- requires that at least 40 percent of the board of directors of a mutual fund be disinterested per- BHC Supervision Manual June 2002 sons who are not affiliated with the investment Page 2 adviser, with any person that the SEC has deter- Providing Administrative and Certain Other Services to Mutual Funds 3600.27 mined to have a material business or profes- to a mutual fund and also in essence provides sional relationship with the fund, with any ministerial or supporting functions as employee or officer of the fund, with any regis- administrator to that fund would not signifi- tered broker or dealer, or with any other inter- cantly increase the bank holding company’s ested or affiliated person. These unaffiliated ability to control the mutual fund. In other board members must approve the fund’s con- words, the adviser would not, by virtue of tracts with its investment adviser, underwriter, becoming an administrator to a fund that it or an and often its administrator. The applicant com- affiliate advises, become involved in policy- mitted that the adviser will provide administra- making functions of these funds to a greater tive services only to mutual funds whose board extent than when it provides solely investment of directors consists of a majority of disinter- advisory services. The Board believes that con- ested persons. trol would continue to rest with the board of In situations in which the applicant’s subsidi- directors of the mutual fund. aries serve as administrator to the mutual fund, With regard to providing a combination of the Board permitted one representative of the advisory and administrative services, the appli- administrator to serve as a director of the fund. cant further committed that it would not have The applicant contended that such an interlock- any director or officer interlocks with these ing director would facilitate the provision of mutual funds. It would also not have any direc- administrative services by providing the fund tor or officer interlocks with mutual funds to with a person knowledgeable in the operation of which it provides both advisory and administra- the fund who would be in a position to advise tive services. the board of directors on administration. In providing the combination of services, the The applicant proposed that a director inter- applicant would be subject to the Board’s inter- lock would be used only in situations in which a pretation on investment advisory activities company unaffiliated with it serves as the invest- (12 C.F.R. 225.125) and would therefore be ment adviser to the mutual fund. With regard to required to conform the adviser’s activities to the adviser’s serving as an administrator, this the interpretation within two years. On this con- interlocking director would be deemed an inter- dition, and subject to the commitments made by ested person and would be excluded from those the applicant, the Board concluded that the pro- actions that must be taken by disinterested board posal was permissible under the Glass-Steagall members, such as the approval of an investment Act. advisory contract or a contract for the adminis- trator. The applicant committed that the adviser would serve as administrator only to mutual 3600.27.3 BOARD’S CONCLUSION funds for which a majority of the board of ON PROVIDING ADMINISTRATIVE directors are disinterested individuals. The Board SERVICES believed that, in this proposed arrangement, the applicant would not control a mutual fund if one The Board found the applicant’s proposed employee of the adviser or an affiliate2 would activities to be closely related to banking because serve as a director of a mutual fund to which the (1) it had previously determined by regulation advisor provides administrative services. that a bank holding company could act as invest- The applicant plans, in a small number of ment adviser to a mutual fund; (2) national cases, to provide mutual funds with a combina- banks, including national bank trust depart- tion of administrative, investment advisory, and ments, provide administrative services to mutual other services. The OCC has permitted national funds; and (3) it had also permitted bank hold- banks that serve as investment adviser to mutual ing companies to provide certain individual funds also to provide some administrative ser- financial data processing services (calculation of vices to those mutual funds. In addition, a num- investment values and tax consulting) by a ber of national banks have been providing these mutual fund administrator. The Board thus and other services as ‘‘subadministrator’’ to approved the application on April 21, 1993 mutual funds that are advised by the bank or an (1993 FRB 626), based on the facts of record affiliate. and all of the commitments and representations In the Board’s opinion, permitting a bank made by the applicant, and subject to the terms holdingcompanythatservesasinvestmentadviser and conditions set forth in the order.

2. This director cannot serve as an officer, director, or employee of the applicant, its bank, or any subsidiary bank or BHC Supervision Manual June 2002 bank holding company of the applicant. Page 3 Developing Broader Marketing Plans and Advertising and Sales Literature for Mutual Funds Section 3600.28

WHAT’S NEW IN THIS REVISED holding company from providing advisory and SECTION administrative services to a mutual fund.2 The proposed promotional and marketing Effective July 2008, this section has been revised activities would not, it was believed, cause the to incorporate a name change to the Financial FBO to control the funds or to be involved in Industry Regulatory Authority, or FINRA (for- the underwriting and distribution of the funds’ merly, the National Association of Securities securities to the public. The proposed promo- Dealers, or NASD). tional activities involved contact only with finan- cial intermediaries. The activities are similar to A foreign banking organization (FBO), subject the activities previously approved by the Board. to the provisions of the Bank Holding Company The Board had previously permitted bank hold- Act, had requested the Board’s approval to ing companies to present information about the acquire, through a wholly owned subsidiary (the operations of the mutual funds advised and company), substantially all the assets of an administered by the bank holding company at asset-management partnership (the partnership). meetings or seminars for brokers of mutual The company would be an investment adviser funds.3 In addition, the Office of the Comptrol- registered with the Securities and Exchange ler of the Currency (OCC) had also authorized Commission (SEC) under the Investment Com- subsidiaries of national banks to provide mar- pany Act of 1940. The company’s acquisition of keting and advertising support to mutual funds the partnership would also include a member- in connection with their brokerage and advisory ship interest in a services firm that would pro- services. vide transfer-agency services to mutual funds As for the distribution and sales of the funds, advised by the company (the funds). it was proposed that an independent distributor The FBO, among other things, proposed to be given that responsibility.4 The independent provide marketing support to a mutual fund by distributor would serve as the principal under- directly contacting broker-dealers, 401(k) plan writer of the funds and would enter into sales providers, financial planners, insurance compa- agreements with financial intermediaries to sell nies, and other financial intermediaries to rec- shares of the funds on their behalf.5 Actual sales ommend the funds. It would be primarily would be conducted by the independent dis- responsible for the development of marketing tributor or by an independent broker–dealer for plans and the preparation of advertising and the funds. sales literature materials for the funds. The The FBO did not propose to solicit retail Board had not previously considered whether a customers to purchase shares in particular funds, bank holding company could provide promo- to accept orders for the purchase of shares, or to tional or marketing services to the extent that engage in any retail sales activities. Neither the was proposed. company nor any of its employees would receive transaction-based income or commissions in connection with the company’s promotional or 3600.28.1 CONTROL marketing activities. CONSIDERATIONS INVOLVING The company would have primary responsi- PROMOTIONAL AND MARKETING bility for preparing the advertising and market- ACTIVITIES ing materials. The independent distributor, how- ever, would be responsible for placing all Under the Glass-Steagall Act, a company that owns a member bank may not own or control 2. See 12 C.F.R. 225.28(b)(6) and 12 C.F.R. 225.125. 3. See 1993 FRB 626 (footnote 15). ‘‘through stock ownership or in any other man- 4. The FBO committed that none of its U.S. affiliates, ner’’ a company that engages principally in dis- including the company, would be obligated by any agreement tributing, underwriting, or issuing securities.1 to engage in any sales activities with regard to shares of the The Board has found that this provision prohib- funds, nor would such affiliates enter into any distribution agreement with the funds without the prior approval of the its affiliates of banks from sponsoring, organiz- Board. ing, or controlling a mutual fund. The Board 5. The funds could enter into distribution agreements with previously has determined, however, that the intermediaries, but in no event could the company enter into Glass-Steagall Act does not prohibit a bank such agreements.

BHC Supervision Manual July 2008 1. 12 U.S.C. 221a and 377. Page 1 Broader Marketing Plans and Advertising and Sales Literature for Mutual Funds 3600.28 advertisements. The independent distributor ity at the funds and would not be responsible would also have legal responsibility, under the for, or involved in, making recommendations on rulesoftheFinancialIndustryRegulatoryAuthor- policy decisions. No employee or officer of the ity (FINRA), for the form and use of all adver- company would serve as a senior-level officer tising and sales literature prepared by the com- of the funds. pany, and would also be responsible for filing The Board had previously authorized a bank these materials with the FINRA or SEC. holding company to have director and officer For the reasons cited, the Board believed that interlocks with mutual funds that the bank hold- the promotional and marketing activities pro- ing company advises or administers.6 The Board posed by the FBO would not involve the com- concluded that the proposed interlocks between pany in the underwriting or distribution of shares the company and the funds, in this case, would of the funds for the purposes of the Glass- not compromise the independence of the boards Steagall Act. of trustees of the funds, compromise the inde- pendent distribution of the funds, or result in control of the funds by the FBO. 3600.28.2 MANAGEMENT Based on the facts given, the Board con- INTERLOCK CONTROL cluded that the control of the funds would rest CONSIDERATIONS with the independent members of the boards of trustees of the funds and that the proposed inter- The FBO also proposed that the chief executive locks between the company and the funds would officer serve as the chairman of the four-member not compromise the independence of the boards board of trustees of the funds and that no more of the funds or permit the FBO to control the than three officers or employees of the company funds. The Board concluded that the proposal serve as junior-level officers of the funds. The was consistent with the Glass-Steagall Act. The employees would serve as assistant secretary, notice was approved on June 16, 1997. See assistant treasurer, or assistant vice president of 1997 FRB 679, 1998 FRB 1075–77, 1998 FRB the funds and would be supervised by the board 852–853, and 1998 FRB 680–82. of trustees or senior-level officers. These employees would have no policymaking author- 6. See 1996 FRB 1129.

BHC Supervision Manual July 2008 Page 2 Permissible Activities by Board Order (Providing Employment Histories to Third Parties) Section 3600.29

A bank holding company gave notice under grantors for use in making decisions to extend section 4(c)(8) of the Bank Holding Company credit is an activity that is closely related to Act (BHC Act) (12 U.S.C. 1843(c)(8)) and sec- banking. tion 225.23 of the Board’s Regulation Y (12 C.F.R. 225.23) of its intention to engage de novo through its mortgage subsidiary in pro- 3600.29.2 NON-CREDIT-RELATED viding employment histories to third parties for EMPLOYMENT HISTORIES a fee. The employment histories to be provided by The bank holding company also intends to pro- the mortgage subsidiary would include the names vide employment histories to third-party deposi- of past and current employers of an individual tory institutions and their affiliates, including and the salary and length of employment for credit unions and their affiliates, for use in the each position, if the individual has consented to regular course of their business, including the the release of such information. The mortgage hiring of employees. The mortgage subsidiary subsidiary would compile an individual’s would provide this information to such entities employment history from information available only with the express consent of the individual from state departments of employment services involved. Regardless of whether the customer is and other similar sources. This information would a third-party depository institution or other credit be provided for a fee to any third-party credit grantor, the activity would only involve provid- grantor for the purpose of assessing the credit- ing employment information. The bank holding worthiness of a prospective borrower.1 company does not plan to provide any addi- tional service, such as analyzing an individual’s creditworthiness. The bank holding company 3600.29.1 CREDIT-RELATED committed that its mortgage subsidiary will EMPLOYMENT HISTORIES comply with the FCRA and all applicable state and federal laws and regulations in performing The mortgage subsidiary will provide employ- the proposed activity. ment histories to third-party credit grantors, The Board had not previously determined including depository and nondepository grant- whether providing such employment informa- ors, for use in making decisions to extend credit tion to third parties for a fee is closely related to only with the express consent of the individual banking under section 4 of the BHC Act and, involved. The bank holding company commit- therefore, permissible for bank holding compa- ted that the mortgage subsidiary will comply nies. The Board had previously permitted bank with the Fair Credit Reporting Act (15 U.S.C. holding companies to provide employment 1681 et seq.) (FCRA) and all applicable state information, including employment histories, to and federal laws and regulations. depository institutions and their affiliates in con- In the normal course of their lending activi- nection with the provision of career counseling ties, banks collect and analyze employment and services (see section 3600.15.1.1).3 To the extent salary information, including names of past and that these organizations use the information to current employers and salary histories. The Board be provided by the mortgage subsidiary for previously determined that providing past credit other purposes, it will only be used in con- information, which includes employment his- nection with the operation of their banking tory information, to a credit grantor who is business. considering a borrower’s application for credit The Board thus concluded that providing is an activity that is closely related to banking employment histories for use by depository and permissible for bank holding companies.2 institutions and their affiliates in the regular Accordingly, the Board concluded that provid- course of their business is an activity that is ing employment histories to third-party credit closely related to banking. For these reasons, the Board, on May 8, 1995, approved the bank holding company’s notice to provide such 1. Credit grantors could include lessors if the leasing trans- employment information (1995 FRB 732). The action was the functional equivalent of an extension of credit. 2. See Regulation Y, section 225.25(b)(24) (12 C.F.R. 3. See 1994 FRB 51. 225.25(b)(24)). The bank holding company committed that it would not promote its mortgage subsidiary as a provider of employment information to non–depository institutions for BHC Supervision Manual December 1996 general business purposes unrelated to credit decisions. Page 1 Permissible Activities by Board Order (Providing Employment Histories to Third Parties) 3600.29 approval was specifically conditioned on com- pliance with the commitments made in connec- tion with the notice.

BHC Supervision Manual December 1996 Page 2 Permissible Activities by Board Order (Title Abstracting) Section 3600.30

3600.30.1 REAL ESTATE TITLE under section 4(c)(8) of the BHC Act and, there- ABSTRACTING ACTIVITIES fore, permissible for bank holding companies. The Board believes that the proposed real A bank holding company (the notificant) gave estate title abstracting activities are integrally notice under section 4(c)(8) of the Bank Hold- related to the provision of loans secured by real ing Company Act (the BHC Act) (12 U.S.C. estate. A bank must be aware of any encum- 1843(c)(8)) and section 225.23 of the Board’s brances on property that serves as collateral for Regulation Y (12 C.F.R. 225.23) of its intention a loan made by the bank. Banks in the state to acquire a title abstracting company (the com- typically rely on an attorney’s opinion, based on pany) and thereby engage in real estate title information in an abstract of title, to determine abstracting in the state of Iowa.1 Real estate title that they have a secured position in real estate abstracting, as proposed by the notificant, is serving as collateral. The abstract of title pro- limited to reporting factual information concern- vides information necessary to determine the ing the interests or ownership of selected real adequacy of the real estate collateral for the loan property. An abstracter obtains this information and is an integral part of secured real estate by performing a title search of records main- lending in Iowa. Thus, the bank has a particular tained at a local public records office to deter- need for the information in the abstract of title. mine the ownership history of the property, Accordingly, the Board believes that the pro- including any liens, encumbrances, mortgages, posed activities are integrally related to the or future interests affecting it. The abstracter provision of secured real estate lending and, then prepares a written report, also known as an therefore, are closely related to banking. ‘‘abstract of title,’’ that recites the results of the The Office of the Comptroller of the Cur- title search. Because Iowa state law does not rency (OCC) has authorized national banks to permit the sale of title insurance, real estate conduct this activity.3 The OCC has concluded lenders obtain the opinion of an attorney certify- that the performance of a title search and the ing that title to a particular parcel of real prop- preparation of an abstract of title are necessary erty is free of defects. The abstract of title parts of the real estate lending process and that provides the factual information necessary for it would be convenient and useful under the the attorney to determine whether a lender would applicable standards in the National Bank Act have an unencumbered security interest in the for national banks to be able to perform these property to be mortgaged. tasks themselves.4 The notificant proposes to provide real estate The proposed activities are not equivalent to title abstracting services to affiliated and unaf- providing title insurance—an activity that is not filiated lenders in an Iowa county. The company generally permissible under section 4(c)(8) of would perform the proposed activities in con- the BHC Act.5 Title insurance generally includes nection with real estate loans made by affiliates providinganindemnificationagainstlossesresult- or unaffiliated companies and, in certain cases, ing from a title defect discovered after the con- when no financing is provided, such as in con- veyance of property. Title insurance typically nection with intrafamily transfers of real estate protects a purchaser or lender against claims not and property distributed as part of estate planning. identified by a title search or claims not specifi- The notificant would not provide any insurance cally exempted by the title insurance policy. The against title defects, guarantee any title, or pro- notificant does not propose to certify or guaran- vide any certification with respect to a title. The tee title and would not be liable to the purchaser notificant would be liable for damages caused or the lender for any title defects. by negligence in performing a title search but would not be responsible for any defects in the title.2 The equivalent of title insurance in Iowa 3. OCC Interpretative Letter No. 450, September 22, 1988. is provided by the attorney who certifies that the 4. National banks are not permitted to sell title insurance. title is free from defects. The Board has not 5. Section 4(c)(8) provides that insurance agency, broker- previously determined that providing real estate age, and underwriting activities are not ‘‘closely related to title abstracting is closely related to banking banking’’ and, thus, are not permissible activities for bank holding companies, unless the activities are included within one of seven specific exemptions (A through G) in sec- tion 4(c)(8) (12 U.S.C. 1843(c)(8)(A)Ð(G)). 1. The notificant would merge the company into its wholly owned leasing subsidiary. 2. Title abstracters may insure against liability for negli- BHC Supervision Manual December 2003 gence by purchasing an errors and omissions policy. Page 1 Permissible Activities by Board Order (Title Abstracting) 3600.30

The Board concluded, based on all the facts concerning the existing title owner of the air- of record, that the proposed activities are closely craft, previous transfers of the aircraft’s title, related to banking and approved the notice on and the existence of any liens or encumbrances June 30, 1995. (See 1995 FRB 805.) Approval affecting title to the aircraft.6 The subsidiary of the proposal was specifically conditioned on would provide the information to affiliated and the notificant’s compliance with the commit- unaffiliated lenders and other parties in connec- ments made in connection with the notice. tion with aircraft financing and sales transac- tions. The aircraft title abstracting activities would not include providing insurance against 3600.30.2 AIRCRAFT TITLE defects in the title of any aircraft, guarantee any ABSTRACTING ACTIVITIES aircraft title, or provide any certification with respect to an aircraft title. Based on facts and An attorney representing a bank holding com- information provided and other facts, the Legal pany (BHC) requested an opinion as to whether Division staff issued an opinion on October 7, the providing of title abstracts on U.S.-registered 2002, that concluded that the proposed aircraft aircraft would be a permissible activity for a title abstracting to be conducted by the subsidi- new subsidiary of a BHC. The aircraft title ary would be within the scope of the title abstracting activities would be limited to report- abstracting activities previously authorized by ing factual information concerning the owner- the Board on June 30, 1995. (See 1995 FRB ship history of the relevant aircraft and the 805, 806.) existence of liens or encumbrances affecting the aircraft. The information would be obtained by performing a title search of records. The title search would be documented in a written report, 6. The attorney requesting the opinion reported that federal law requires that all changes in title of, and liens and encum- known as an ‘‘abstract of title,’’ describing the brances affecting, U.S.-registered aircraft must be filed with factual information located by the title search the Federal Aviation Administration.

BHC Supervision Manual December 2003 Page 2 Section 4(c)(8) of the BHC Act (Board Staff Legal Interpretation—Financing Customers’ Commodity Purchase and Forward Sales) Section 3610.1

A bank holding company (BHC), that has elected tively be limited to counterparty credit risk. The to be a financial holding company within the BHC would subject any prospective CPFS coun- meaning of the Bank Holding Company Act of terparty to the same credit-review process used 1956 (12 U.S.C. 1841 et seq.) (the BHC Act) for loan applicants, and the BHC’s internal inquired if it would be permissible under the credit-review personnel would also review out- BHC Act and the Board’s Regulation Y (12 standing CPFS arrangements. As proposed, the C.F.R. 225) for the BHC to engage in ‘‘com- BHC would never enter into an agreement to modity purchase and forward sale’’ (CPFS) trans- purchase a commodity unless it simultaneously actions as a method of financing the commodity enters into an agreement to sell the commodity inventories of its customers.1 to a creditworthy counterparty on a fixed future Two alternative structures were described for date at a fixed price. The BHC indicated that a the CPFS transactions. In the first structure, the fixed future sale price would be equal to the BHC would purchase a commodity from its initial purchase price plus a fixed interest com- customer and simultaneously enter into a for- ponent (and thus would not vary based on move- ward sale agreement under which the customer ments in the price of the commodity). In other would be obligated to repurchase the commod- words, unless the ultimate purchaser defaults, ity from the BHC at a predetermined price on a the BHC would be repaid its principal plus a predetermined future date. The second structure fixed amount of interest at maturity of the trans- is similar to the first structure except that it action. In addition, the BHC would not bear any would involve a third party, either as the initial commodity price risk; the price it would receive seller of the commodity to the BHC or as the for the commodities on the maturity date of the ultimate purchaser of the commodity from the transaction would be fixed on the date it enters BHC. During the term of a CPFS transaction, into the transaction. If the ultimate purchaser the BHC would hold title to the underlying defaults on its obligation to purchase the under- commodity, would mark the commodity to mar- lying commodity upon maturity, the BHC would ket on a daily basis, and would call for addi- have a claim against this purchaser to recover tional margin if the market value of the com- the equivalent of principal and interest. The modity falls below a specific collateral threshold. BHC could then sell the commodity into the The BHC Act permits bank holding compa- market to mitigate credit losses in the same nies to engage in any activity that the Board had manner as it would liquidate any collateral sup- determined by regulation or order as of Novem- porting a loan in default. Any commodities ber 11, 1999, ‘‘to be so closely related to bank- acquired by the BHC as a result of counterparty ing as to be a proper incident thereto.’’2 The default would be held in accordance with the Board had determined by regulation issued prior limits applicable to assets acquired by a BHC in to November 11, 1999, that ‘‘[m]aking, acquir- the course of collecting a debt previously ing, brokering, or servicing loans or other exten- contracted.4 sions of credit (including factoring, issuing let- Moreover, the BHC represented that all non- ters of credit and accepting drafts) for the price risks and costs of owning the commodity company’s account or for the account of others’’ during the term of the CPFS transaction, such as is such an activity.3 storage risk and the cost of insurance, would be Under the proposed CPFS transactions, the borne by the ultimate purchaser. In all cases, BHC would earn a fixed return on a CPFS although the BHC would take title to the under- transaction, just as it would on an ordinary lying commodity at the inception of a CPFS secured loan, and its risk exposure would effec- transaction, it would take title in the form of a warehouse receipt only; that is, the commodity would continue to be stored in a licensed ware- 1. The BHC indicated that the commodities involved in these transactions would include agricultural commodities house owned and operated by an entity other (such as corn, wheat, soybeans and other legumes, cotton, than the BHC. The commodity would not be cocoa, coffee, sugar, various oilseeds and oils, and dairy physically moved as a result of the transaction. products), live cattle, timber, and exchange-traded metals. The The BHC would acquire title to the underlying BHC’s CPFS transactions would, in all cases, involve com- modities (1) for which contracts have been approved for commodity in a CPFS transaction as an incident trading on a U.S. futures exchange by the Commodity Futures Trading Commission or (2) which the BHC can show, to 4. See 12 C.F.R. 225.22(d)(1). Board staff’s satisfaction, have readily-available price quotes and are traded regularly in global commodity markets. 2. See 12 U.S.C. 1843(c)(8). BHC Supervision Manual July 2006 3. See 12 C.F.R. 225.28(b)(1). Page 1 Board Staff Legal Interpretation—Financing Customers’ Commodity Purchase and Forward Sales 3610.1 to the financing it provides to its customers and of coal used, at a price equal to the BHC’s not for speculative purposes. The BHC repre- acquisition cost for the coal plus a fixed amount sented that the BHC does not and will not hold of interest. The utility explicitly bore the risk of itself out as making a market in the commodity. loss or damage to the coal during storage. If the In addition, the BHC also represented that the utility defaulted, the BHC had the right to sell BHC does not and will not (1) own, operate, or the coal to cover its losses and the right to sue invest in facilities for the extraction, transporta- the utility for any shortfall in the liquidation tion, storage, or distribution of commodities or proceeds. As with the proposed CPFS transac- (2)process,refine,orotherwisealtercommodities. tions, the utility’s motive for the transaction was The BHC would account for the CPFS trans- to obtain financing for its commodities inventory. action as an ‘‘asset purchased under an agree- Based on the information the BHC provided ment to resell’’ and would recognize profit and and the Board’s precedents, Board legal staff loss on the transaction on an accrual basis, in a opined that the proposed CPFS transactions are manner similar to a traditional loan. During the within the scope of permissible lending activi- term of the transaction, the ultimate purchaser ties for BHCs under section 225.28(b)(1) of counterparty in a CPFS transaction would gen- Regulation Y. The BHC should have policies erally record the underlying commodity as an and procedures to identify whether a CPFS asset on its balance sheet and would record its transaction would create heightened legal or obligation to purchase the commodity as a short- reputational risk to the BHC, and to manage any term debt liability. such risk. In particular, the BHC should have The interpretation noted that the Board had policies and procedures to identify whether a previously found a three-party commodity financ- particular CPFS transaction (1) lacks economic ing arrangement similar to the BHC’s proposed substance or business purpose; (2) may be three-party CPFS transactions to be an exten- designed by the counterparty for questionable sion of credit permissible for BHCs under Regu- accounting, regulatory, or tax purposes; or (3) may lation Y. In a 1973 order, the Board approved as be accounted for or disclosed by the counter- a permissible lending activity for bank holding party in a way that is misleading or inconsistent companies an arrangement under which a BHC with the substance of the transaction or applica- would finance a utility’s coal purchases by pur- ble regulatory or accounting requirements. chasing from a third party, and taking title to, a The Board legal staff’s opinion is limited quantity of coal on a monthly basis at the direc- solely to the permissibility of the proposed tion of the utility customer. (See 1973 FRB CPFS activities described above under Regula- 698.) The BHC would store the coal on the tion Y and does not address the permissibility of premises of the utility under a lease arrange- any other activities or authorize the BHC to ment with the utility. The utility would use the engage in any other activities in the United coalcontinuouslythroughoutthefollowingmonth States. (See the Board’s staff legal interpretation and would pay the BHC monthly for the amount dated May 15, 2006.)

BHC Supervision Manual July 2006 Page 2 Section 4(c)(8) of the BHC Act (Board Staff Legal Interpretation—Certain Volumetric- Production-Payment Transactions Involving Physical Commodities) Section 3610.2

A foreign bank (that qualifies as a financial agreement, the BHC arranges to sell it, either holding company under section 4(k) of the BHC back to the customer or into the marketplace, at Act and is treated as a bank holding company the then-current market price for the commodity. (BHC) under section 4(c)(9) of the BHC Act The BHC also may decide to temporarily requested a confirmation from the Board’s legal retain hydrocarbons it acquires pursuant to a staff on whether certain volumetric-production- VPP in order, for example, to take advantage of payment (VPP) transactions involving physical an anticipated rise in price for the relevant com- commodities would be considered as extensions modity. The BHC agreed that any hydrocarbons of credit that are permissible for a BHC under acquired under a VPP will be counted against section 4(c)(8) of the BHC Act and section the BHC’s 5 percent of tier 1 capital limit under 225.28(b)(1) of the Board’s Regulation Y.1 the order if they are not immediately sold to a In 2004, the Board approved a proposal by third party. The BHC represented that it hedges the BHC to engage in physical-commodity trad- its commodity-price risk from the VPP by enter- ing as an activity that is complementary to the ing into a fixed-rate commodity swap with a BHC’s commodity derivatives activities.2 The third party (which may be the customer) that order limited the value of physical commodities converts the BHC’s variable proceeds from the that the BHC may hold under this authority to periodic sale of the oil or gas into fixed-rate 5 percent of the BHC’s tier 1 capital. The BHC payments. Accordingly, in the absence of coun- also requested confirmation that VPP transac- terparty defaults, by the end of the VPP term the tions and any physical commodities delivered to BHC will have recouped the original amount the BHC under a VPP would not count against advanced to the customer plus a fixed return. the 5 percent of tier 1 capital limit. The BHC stated that the VPP transactions A VPP is a royalty interest, typically in a generally are treated as loans for U.S. federal hydrocarbon (such as oil or natural gas) reserve income tax purposes. In addition, the BHC indi- that entitles the VPP holder, in exchange for an cated that it will treat VPP transactions as loans upfront payment, to receive specified quantities for accounting purposes. Board staff stated that of hydrocarbons on a regular basis during the it expects (1) the BHC will follow generally life of the VPP transaction. A VPP is considered accepted accounting principles in reporting any to be a real property interest in most states. VPP transactions and (2) all of the BHC’s VPP Relying on its physical-commodity trading transactions will be entered into for legitimate authority, the BHC had already entered into two business purposes. VPP transactions in the United States. In each of The BHC argued that a VPP transaction is these transactions, a wholly owned, consoli- very similar to a traditional lending arrangement dated, U.S. special-purpose-vehicle subsidiary because the discounted present value of the of the BHC (the SPV) had acquired a VPP from hydrocarbons to be delivered to the BHC over a hydrocarbon producer (the customer) in the life of a VPP transaction is estimated to exchange for cash.3 The VPP transactions are equal the purchase price paid by the BHC for designed to provide funding to the customers. the VPP interest plus a margin meant to cover The VPP does not give the BHC the right to the BHC’s cost of funds, risk associated with control production of the oil or gas, and the the transaction, and a fixed profit. Importantly, BHC is therefore dependent on the customer the VPP does not give the BHC any variable meeting its contractual obligation to produce the upside potential if there is excess production agreed-upon volume of oil or gas according to from the producer’s hydrocarbon reserve.4 More- the agreed-upon schedule. over, the commodity-price swap hedges the Simultaneously with its purchase of the VPP BHC’s commodity-price risk associated with interest from the customer, the SPV and the the VPP, thus guaranteeing the BHC a return of BHC enter into an agreement under which the principal and a fixed amount of interest if nei- BHC makes an upfront payment to the SPV and the SPV agrees to deliver to the BHC the vol- 4. If the reserve produces more hydrocarbons than are umes of oil or gas to be received by the SPV subject to the VPP, the production is for the benefit of the from the customer under the VPP. As the SPV producer. If the reserve underproduces in a given period during the life of the VPP, the BHC would be entitled to an delivers the oil or gas to the BHC under this appropriate amount of overproduction in subsequent months (and extra reimbursement to reflect default interest). 1. 12 C.F.R. 225.28(b)(1). 2. See 2004 FRB 215. BHC Supervision Manual July 2006 3. [TEXT REDACTED] Page 1 Board Staff Legal Interpretation—Certain Volumetric-Production-Payment Transactions Involving Physical Commodities 3610.2 ther the producer nor the swap counterparty entered into for the purpose of providing financ- defaults. Accordingly, the VPP transactions are ing to a third-party customer. Any commodities not designed to serve as a vehicle for the BHC that the BHC receives pursuant to a VPP trans- to take on commodity-price risk, own commodi- action and that are not immediately sold to third ties, or engage in commodity dealing.5 parties would be subject to the 5 percent of tier As described above, as part of a VPP transac- 1 capital limit on the value of commodities that tion, the BHC will hold a royalty interest in a the BHC may hold under its physical-commodity- hydrocarbon reserve and will periodically take trading authority. title, if only momentarily, to physical commodi- The staff opinion informed the BHC that it ties. The Board has previously concluded, how- should have in place policies and procedures to ever, that ownership of commodities in connec- (1) identify whether a VPP transaction would tion with a financing transaction does not prevent create heightened legal or reputational risk to the transaction from being treated as a form of the BHC and (2) manage any such risk. In credit extension permissible for a BHC if the particular, the BHC should have policies and economics of the transaction are substantially procedures to identify whether a particular VPP the same as those of a loan.6 transaction (1) lacks economic substance or Based on the information provided by the business purpose; (2) may be designed by the BHC’s counsel, Board legal staff opined that the counterparty for questionable accounting, regu- above-described VPP transactions are a form of latory, or tax purposes; or (3) may be accounted permissible lending activity for BHCs under for or disclosed by the counterparty in a way section 225.28(b)(1) of Regulation Y when that is misleading or inconsistent with the sub- stance of the transaction or applicable regula- tory or accounting requirements. The staff opinion is limited solely to the per- 5. As noted above, the BHC has the authority to engage in missibility of the VPP transactions described in physical-commodity trading, including making and taking the opinion under Regulation Y. The opinion delivery of physical commodities, and may use this authority does not address the permissibility of any other to retain ownership of hydrocarbons delivered under a VPP in activities or authorize the BHC to engage in any order to benefit from anticipated changes in hydrocarbon prices. other activities in the United States. (See the 6. See 1973 FRB 698. Board legal staff’s opinion dated May 15, 2006.)

BHC Supervision Manual July 2006 Page 2 Impermissible Activities Section 3700.0

The BHC Act states that a nonbank activity is holding company may be granted an exemption impermissible unless explicitly exempt from the from section 4 of the Act (i.e., family, hardships, general prohibition of section 4. While this etc.) which allows it to engage in activities that could cause an unlimited list of impermissible would otherwise be impermissible. Because of activities, the Board has compiled a list of activ- the variety of factors which must be considered, ities which have been specifically determined to the examiner should exercise care when deter- be impermissible (see Manual section 3000.0, mining the permissibility of an activity for a Appendix 3). bank holding company. The inspection objective is to determine The subsections of this chapter present a whether a specific activity conducted by a bank selected number of those activities which have holding company or its subsidiary is permissible been determined to be impermissible for bank for the bank holding company. The Board has holding companies. While an activity is permis- ruled specific activities to be impermissible sible only after it has been determined as such although it has stated also that certain imper- by the Board, it must be remembered that in missible activities may be engaged in under determining permissibility, the Board has in limited special circumstances. some instances (i.e., data processing services, In addition, a bank holding company may be courier services, etc.) included restrictions which entitled to grandfather privileges which are con- would limit the overall nature or performance of sidered as either permanent (where there is no the activity. Therefore, even the permissible deadline for termination of an activity) or tem- activitiesmaybecomeimpermissibleiftheactions porary, in which case the activity must have of the bank holding company are not in accor- been terminated prior to December 31, 1980. A dance with the stated restrictions.

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Land Investment and Development) Section 3700.1

The Board of Governors has ruled that land closely related to banking as to be a proper development1 is impermissible for bank holding incident thereto, and that insofar as the applica- companies. However, for land acquired through tion pertains to those activities, it should be foreclosure, a limited amount of development denied.’’ may be allowed in an effort to minimize the The determination that limited development potential loss on the project. Each case must be for land acquired through foreclosure is permis- considered separately to determine if it warrants sibleiscontainedinaBoardorderdatedNovember additional development. 1, 1973, in connection with an application by The basic determination of impermissibility Liberty National Corporation, Oklahoma City, was established by the Board in denying a por- Oklahoma, to retain Liberty Mortgage Com- tion of the application by UB Financial Corp., pany, Oklahoma City, Oklahoma (1973 FRB Phoenix, Arizona, to retain the H. S. Pickrell 919), in which it is indicated that a limited Company, Phoenix, Arizona (1972 FRB 429). amount of real estate development might be The order stated in part, ‘‘The Board is of the permissible if necessary to minimize losses on opinion that the activities of purchasing and real estate acquired in connection with debts selling of land or participating as a joint ven- previously contracted. turer in real estate development are not so

1. The Board, by specific order, has permitted a limited incursion into this area as an accommodation to BHCs acquir- ing thrifts or to thrifts that qualify as ‘‘banks’’ and seek to BHC Supervision Manual December 1992 form bank holding companies (1986 FRB 487, 731) Page 1 Impermissible Activities (Insurance Activities) Section 3700.2

3700.2.1 PREMIUM FUNDING the application of First Oklahoma Bancorpora- tion, Inc., Oklahoma City, Oklahoma, for prior Insurance premium funding, sometimes known approval pursuant to section 4(c)(8) of the Act as equity funding, is the financing of the sales of to acquire sufficient additional shares of Under- mutual fund shares and life insurance policies as writers Life Insurance Company, Oklahoma City, a package. It should not be confused with loans Oklahoma, so as to own at least 80 per cent of made to an insured for the purpose of paying the outstanding shares and thereby to engage in premiums on hazard insurance (insurance pre- the activity of underwriting life insurance not mium financing); in that case the lender may be sold in connection with a credit transaction by a named loss payee or owner of the policy and the bank holding company or a subsidiary. lender has the right to submit the policy for In acting on the First Oklahoma application, cancellation in order to collect the amount owed. the Board relied on an earlier decision denying Insurance premium financing is a permissible an application by Transamerica Corporation, activity pursuant to Section 225.25(b)(1) of San Francisco, California, to retain its shares of Regulation Y (Refer to 1974 FRB 310). Occidental Life Insurance Company of Califor- The Board has determined insurance pre- nia (1957 FRB 1014). In the Transamerica case, mium funding to be impermissible for bank a hearing examiner found that the life insurance holding companies (12 C.F.R. 225.126). This underwriting activities of Occidental were not determination is based on the policies contained so closely related to banking to be a proper in sections 20, 21, and 32 of the Banking Act of incident to managing and controlling banks. In 1933 (the Glass–Steagall Act Provisions) as the First Oklahoma case, the application was described in the opinion of the United States presented on the question of whether the activi- Supreme Court in Investment Company Insti- ties of Underwriters Life were so closely related tute v. Camp, 401 U.S. 617 (1971). to banking or managing or controlling banks as ‘‘In the Board’s opinion, the Glass–Steagall to be a proper incident thereto. The Board deter- Act provisions, as interpreted by the U.S.Supreme mined in First Oklahoma, that there was no Court, forbid a bank holding company to spon- reasonable basis for the contention that the ac- sor, organize or control a mutual fund’’ (12 tivities of Underwriters Life were permissible. C.F.R. 225.125). In enacting the Glass–Steagall The activity of acting as an underwriter (rein- Act, Congress indicated that affiliations of com- surer) for credit life and credit accident and mercial banks and securities companies give health (disability) insurance is, however, consid- rise to a potential conflict of interest and un- ered a permissible activity (12 C.F.R. 225.135). sound banking practices. Pursuant to section 4(c)(8) of the Act, the Board is required to consider whether the performance of a particu- 3700.2.3 SALE OF LEVEL-TERM LIFE lar nonbank activity by a holding company pro- INSURANCE duces benefits to the public that outweigh possi- ble adverse effects, such as potential conflict of The Board has stated that the sale of level-term interest and unsound banking practices. There- life insurance is not covered by section fore, the potential conflict of interest and un- 225.25(b)(8)(ii) of Regulation Y. This position sound banking practices arising in the affiliation was stated in its order approving the application of commercial banks and mutual funds pre- by Fidelity Corporation of Pennsylvania, Rose- cludes the Board from approving insurance pre- mount, Pennsylvania, to acquire Local Finance mium funding as a permissible banking activity. Corporation, Providence, Rhode Island, except- ing those proposed activities of level-term life insurance sales (1973 FRB 472). Insurance that 3700.2.2 LIFE INSURANCE does not decline in coverage as the outstanding UNDERWRITING loan balance is reduced results in the insured party carrying more insurance than is necessary The life insurance discussed in this section is to cover the outstanding loan balance. Because that life insurance which is not sold in connec- of this position, the Board would not allow the tion with a credit transaction by a bank holding sale of this type of insurance by the applicant company or its subsidiary. The Board has ruled and its subsidiary. that this activity is impermissible for bank hold- ing companies (12 C.F.R. 225.126). The Board BHC Supervision Manual December 1992 developed its position during consideration of Page 1 Impermissible Activities (Insurance Activities) 3700.2

3700.2.4 UNDERWRITING REAL Superior Claim Service, both of Florence, North ESTATE MORTGAGE GUARANTEE Carolina. These companies engaged, respec- INSURANCE tively in the activities of underwriting property and casualty insurance related to extensions of Mortgage guaranty insurance is essentially a credit by NCNB’s affiliates, in adjusting insur- limited guarantee of a mortgage loan. Such in- ance claims and in appraising and valuing prop- surance typically covers the top 20 or 25 percent erty in connection therewith. Neither of these of a mortgage loan. In the event of default by activities had previously been determined by the the borrower, the lender acquires title to the Board to be closely related to banking. The property and then submits a claim to the insurer. Board concluded that the circumstances pre- The insurer then has a choice of two options: sented did not provide a reasonable basis for (1) take title to the property and pay the lender believing that the proposed activity was closely the unpaid principal and interest; or (2) pay the related to banking or managing and controlling lender the 20 or 25 percent insured portion of banks (1978 FRB 506). the loan, with the lender retaining title to the property. The Board has determined that ‘‘the under- 3700.2.6 TITLE INSURANCE writing of mortgage guarantee insurance is prin- cipally a credit determination, similar to those The Board issued a letter (See Board letter re made by banks in their regular course of business’’ Independence Bancorp, Inc., dated 3/17/86) to a (1974 FRB 727). Therefore, this activity is con- bank holding company which filed an applica- sidered closely related to banking for purposes tion with the Board to acquire a de novo title of permissibility under section 4(c)(8) of the abstract company which planned to engage in, Act. However, the Board noted that the private among other things, the sale of title insurance. mortgage insurance industry was relatively young The sale of title insurance had not been previ- and still developing with a limited, untested, ously approved by the Board as a permissible operating history. In addition, the Board be- nonbanking activity. In responding to the appli- lieved that the times were such that it was cation, the Board determined that the proposed ‘‘desirable for bank holding companies gener- title insurance activities were not closely related ally to slow their present rate of expansion and to banking. direct their energies toward strong and efficient The Board’s discretion to decide what types operations within their existing activities, rather of insurance activities are closely related to than toward expansion into new activities’’ (the banking was removed by the Garn–St Germain go-slow policy), and, therefore, concluded that Depository Institutions Act of 1982 (‘‘Garn it would not be appropriate to adopt the under- Act’’), which amended section 4(c)(8) of the writing of mortgage guarantee insurance as per- BHC Act. The Garn Act stated that ‘‘it is not missible for bank holding companies. closely related to banking or managing or con- trolling banks for a bank holding company to provide insurance as a principal, agent, or 3700.2.5 UNDERWRITING PROPERTY broker....’’TheGarn Act lists certain specific AND CASUALTY INSURANCE exceptions to this general prohibition, none of which permits the sale of title insurance. The On May 12, 1978, the Board denied NCNB Board thus concluded that the Garn Act does Corporation’s application to retain its indirect not allow it the discretion to approve this type of subsidiaries, Superior Insurance Company and nonbanking activity.

BHC Supervision Manual December 1992 Page 2 Impermissible Activities (Real Estate Brokerage and Syndication) Section 3700.3

3700.3.1 BROKERAGE the application of BankAmerica Corporation, San Francisco, California, for prior Board ap- Real estate brokerage is the negotiating of a real proval to engage de novo under section 4(c)(8) estate contract between a buyer and seller for of the Act in the activity of real estate syndica- which the broker receives a fee or commission tion through a subsidiary, BankAmerica Realty and in which the broker takes no possessory Services, Inc., San Francisco, California. The interest in the subject matter of the contract. The Board concluded that the subsidiary’s proposed Board has stated that this activity is considered activities of organizing, promoting, selling part- impermissible for bank holding companies. The nership interests, and acting as the sole general Board’s position was expressed in its order partner of real estate syndicates went beyond approving an application by Boatmen’s Banc- the functions performed by an advisory com- shares, Inc., St. Louis, Missouri, to acquire pany to a real estate investment trust permissi- Williams, Kurrus and Company, St. Louis, Mis- ble under section 225.25(b)(4) of Regulation Y. souri (1972 FRB 428). The Board stated that it The Board also stated that it felt that the had determined that real estate brokerage activi- policies contained in sections 20 and 32 of the ties were not so closely related to banking or Banking Act of 1933 (the Glass–Steagall Act managing or controlling banks as to be a proper Provisions) must be considered in conjunction incident thereto. Since Boatman’s had not dem- with section 4(c)(8) of the Act. These policies, onstrated to the Board’s satisfaction that the real described in the opinion of the United States estate brokerage field activities are so closely Supreme Court in Investment Company Insti- related to banking or managing or controlling tute v. Camp, 401 U.S. 617 (1971), forbid a banks as to be a proper incident thereto, the bank holding company to sponsor, organize or Board approved the Boatman’s application on control an open-ended investment company the condition that Boatman’s terminate its real (mutual fund) or a closed-end investment com- estate brokerage activities. pany primarily or frequently engaged in the issuance, sale and distribution of securities. Because the activities of real estate syndication 3700.3.2 SYNDICATION resemble the issuance, sale and distribution of securities of a closed-end investment company, The Board ruled that this activity is not permis- this activity is not permissible for a bank hold- sible for bank holding companies. The Board’s ing company (12 C.F.R. 225.125). position was developed during consideration of

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (General Management Consulting) Section 3700.4

The Board has stated that general management unwanted conflict of interest situations for BHCs consulting is not so closely related to banking or that advised clients that were also customers of managing or controlling banks as to be a proper its own subsidiary banks. The Board also desired incident thereto. This ruling is contained in the to maintain a distinct separation between bank- Board’s order denying the application of First ing and commerce. Commerce Corporation, New Orleans, Louisi- In its order denying the application of Marine ana, to acquire W. R. Smolkin & Associates, Midland Banks, Inc., Buffalo, New York, to Inc., New Orleans, Louisiana. In its order the acquire Carter H. Golembe Associates, Inc., Board describes general management consulting Washington, D.C., the Board further defines the as follows: concept of management consulting by stating ‘‘. . . including, but not limited to, the provi- that Golembe, ‘‘. . . provides consulting services sion of analysis or advice as to a firm’s on a confidential basis to banks, bank holding (i) purchasing operations, such as inventory con- companies and bankers’ associations. It makes trol, sources of supply, and cost minimization bank feasibility studies and renders advice with subject to constraints; (ii) production opera- respect to geographic expansion, product exten- tions, such as quality control, work measure- sion, mergers and acquisitions and applications ment, product methods, scheduling shifts, time to State and federal regulatory agencies. A por- and motion studies, and safety standards; tion of Golembe’s consulting services also relates (iii) marketing operations, such as market test- to internal bank operations, such as marketing, ing, advertising programs, market development, trust and bank credit card operations and loan or packaging, and brand development; (iv) plan- interest rate policies. Other studies and analyses ning operations, such as demand and cost are performed upon request of individual banks. projections, plant location, program planning, Golembe also provides advice with respect to corporate acquisitions and mergers, and deter- the organization and operation of State Bankers’ mination of long-term and short-term goals; associations and serves as a consultant to vari- (v) personnel operations, such as recruitment, ous banking groups with respect to legislative training, incentive programs, employee compen- and regulatory matters affecting the banking sation, and management-personnel relations; industry. The foregoing consulting services fur- (vi) internal operations, such as taxes, corporate nished by Golembe are considered by the Board organization, budgeting systems, budget con- to be but a specialized form of management trol, data processing systems evaluation, and consulting.’’ (1972 FRB 676) efficiency evaluation; or (vii) research opera- Management consulting to nonaffiliated com- tions, such as product development, basic mercial banks and nonbank depository institu- research, and product design and innovation.’’ tions has been determined by the Board to be a (1972 FRB 674) The Board denied the case and permissible activity for bank holding companies determined that the activity of providing general under section 4(c)(8) of the Act (Regulation Y, management consulting services could lead to section 225.25(b)11, as amended).

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Property Management) Section 3700.5

The Board has ruled that this activity is imper- subsidiary concerning property management, missible for bank holding companies. However, the Board described in its order the three types bank holding companies may conduct property of property, as shown above, for which a hold- management activities for three types of prop- ing company or its subsidiary could engage in erty as follows: property management activities (1972 FRB 652). 1. Property held in a fiduciary capacity; In addition to the prohibition of property 2. Property owned by the holding company management activities in general, the Board has or its subsidiary for its own bank and bank- ruled that the operation of a commercial parking related operations; lot is impermissible. In its order approving the 3. Property acquired by the holding company application by Multibank Financial Corpora- or its subsidiary as a result of a default on a debt tion, Boston, Massachusetts, to acquire the previously contracted. B. M. C. Durfee Trust Company, Fall River, The Board announced on June 30, 1972, that Massachusetts, a commercial bank, the Board it would not include this general activity on the stated that operating a commercial parking lot list of permissible activities. Because the Board was not considered closely related to banking did not intend to limit any authority given by and conditioned its approval on divestment of statute or regulation to a holding company or its the parking lot operation (1973 FRB 679).

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Travel Agencies) Section 3700.6

The Board through its rulemaking authority did authority to engage in travel agency activities not include operating a travel agency on the list under the Act unless grandfathered. of permissible activities for bank holding com- On April 2, 1979, the Board issued a letter, a panies. This activity is considered not to be copy of which went directly to all bank holding closely related to banking or managing or con- companies engaging in the activity of operating trolling banks (1976 FRB 148). The Board refer- a travel agency pursuant to section 4(c)(5) of the enced a decision of the United States Court of Act, indicating that no bank holding companies Appeals for the District of Columbia, Courier could engage in the activity solely pursuant to Association vs. Board, 516 F. 2d 1229 (1975). section 4(c)(5) and that those engaged in such The Board felt the only relevant criteria for activity had to terminate the activity by Decem- this activity was whether banks have generally ber 31, 1980 (Z–8421 on office copy only). provided the service. The Board noted that there Subsequently, a bank holding company applied were few bank-affiliated travel agencies, most to the Board to acquire a company (‘‘Company’’) of which had only been recently established. that engages in a variety of data processing and The Board concluded that operating a travel data transmission activities for customers. The agency was not closely related to banking. Company’s data bases that are provided to cus- On June 1, 1978, the Comptroller of the Cur- tomers included a program by which customers rency issued Banking Circular No. 108, which could receive airline and hotel information and requested all national banks then operating travel could make airline and hotel reservations. The agencies, to divest themselves of those agencies Board determined that the receipt of such infor- within a reasonable period of time not to exceed mation and the ability to make airline and hotel three years. The Comptroller’s office concluded reservations was not closely related to banking. that the continued operation of a travel agency Accordingly, the Board required, as a condition by a national bank is inappropriate and may for approval of the application, the bank holding expose the bank to a substantial risk of loss by company to eliminate the travel reservation ser- litigation. This action by the Comptroller pre- vice from the roster of third party data base cludes bank holding companies from relying on programs provided by Company (Refer to 1986 section 4(c)(5) of the Act to conduct travel FRB 497). agencies. Thus, holding companies have no

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Providing Credit Ratings on Bonds, Preferred Stock, and Commercial Paper) Section 3700.7

As part of the Security Pacific Corporation’s fore proposed a number of techniques for isolat- (bank holding company) application to acquire ing the credit rating activities of the Company Duff & Phelps, Inc. (Company), which engaged from influence by the Applicant, including the in investment advisory, investment manage- establishment of a separate corporation with a ment, and financial advisory services, the Board, number of independent directors, a prohibition on December 11, 1984, denied the Applicant’s on contacts between the Applicant and the mem- request to engage in the activity of providing bers of the Company’s Credit Rating Commit- credit ratings on bonds, preferred stock and tee, and also certain record keeping require- commercial paper. Private credit ratings were ments for that committee. included as part of the investment research The Board considered these positive sugges- reports sold to institutional investors. The Com- tions as well as others to assure full disclosure pany also provided credit ratings on a fee basis of the relationships between the Applicant and for companies that request public disclosure. any of the companies that would be rated by the As part of the public rating process, the rated Company as well as a prohibition on the Com- company is given the opportunity to make a pany rating the Applicant’s securities, securities presentation to the Company’s Credit Rating which the Applicant has underwritten, or securi- Committee. ties for which the Applicant provided a guaran- In this situation, the Security Pacific Corpora- tee or backup letter of credit. The Board, how- tion had a vested interest in the ratings of the ever, believed that the conflicts in the relationship corporations to which it lends in the ratings of between a major lender and a credit rating com- municipal bonds it underwrites, in the ratings of pany were so pervasive that they could not be the commercial paper and municipal bonds for overcome through adoption of an information which it provides backup lines of credit, and in barrier. The employees of the Company would the ratings of fixed-income securities which it inevitably be aware of interests of the Applicant holds for trades. Numerous potential conflicts in firms being rated by them and, it seems existed such as: possible inadvertent releases of reasonable to assume that this knowledge could, confidential information obtained during the at times, influence their decisions. credit rating process; the advance release to the The Board’s concerns regarding conflicts of Applicant of credit ratings for companies to interest with respect to the credit rating activity which the Applicant had very large loans out- were not based on any doubts regarding the standing; the potential for pressures by the Appli- integrity of the parties to the application, but cant on the Company to modify favorably the rather were based on the Board’s responsibility credit rating of one of the Applicant’s major to assess the possible adverse effects that might customers; and the subtle pressure on the Com- be associated with an affiliation between a bank pany’s staff resulting from ownership by Appli- holding company and a public credit rating cant about companies in which the Applicant organization. Thus the Board was acting in fur- had a substantial interest. Similar conflicts could therance of one of the general purposes of the have also arisen between the Company’s credit Bank Holding Company Act, ‘‘to prevent possi- rating function and the Applicant’s investment ble future problems rather than to solve existing of trust assets. ones.’’ The Board, in view of the pervasive The Applicant acknowledged the potential conflicts of interest between the Applicant’s conflicts but argued that various steps could be existing operations and the Company’s credit taken to ameliorate them and bring them within rating business, decided against approving the a manageable framework. The Applicant there- performance of public credit ratings.

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Acting as a Specialist in Foreign- Currency Options on a Securities Exchange) Section 3700.8

Currency options are a new and innovative ists (17 C.F.R. 240.11(b)(1)). In addition, the aspect of foreign exchange. A currency option IRS formerly granted special tax treatment to represents the contractual right (but not the obli- specialists transactions. gation) to purchase or sell a predetermined The rules of the PHLX require that odd-lot amount of currency at a specific price at any orders must be given to the specialist. The spe- time before a specific date. Currency-options cialist functions as a broker with respect to advocates argue that currency options eliminate certain transactions that cannot be executed by the risk of a loss due to exchange movements floor traders immediately, for example, stop-loss and give the holder a chance to profit if the orders and limit orders. All such orders are currency fluctuation is favorable. They require a given to the specialist for execution and become premium to be paid when the contract is entered part of his ‘‘book’’; PHLX rules address priority into. The premiums can run from about 1.5 per- of orders (customers’ orders receive priority) cent to 5 percent, depending on the expiration and conflicts of interest by governing special- date and the exercise price of the option. ists’ trades and those of affiliated persons and Currency options are traded on two types of firms in ‘‘securities’’ in which the person is markets: the over-the-counter, or interbank designated as specialist. market, and on three regulated exchanges, the There is one specialist position for each cur- Chicago Mercantile Exchange (CME), the Chi- rency option traded on the PHLX, and the pri- cago Board Options Exchange (CBOE), and the mary function of a specialist is to act as market Philadelphia Exchange (PHLX). The CBOE, a maker, as necessary, for its assigned currency securities exchange, uses multiple ‘‘market mak- option. The specialist thus undertakes all activ- ers’’ instead of specialist positions; the CME, a ity, including dealing for its own account, to the commodities exchange, like other commodities extent necessary, as required to maintain a fair exchanges, does not use specialist positions. and orderly market in options on a particular Most of the writing of currency options is currency. In essence, the specialist makes a con- currently done by banks which will customize tinuous two-sided market in the assigned cur- the option, with maturity dates and currency rency option when market forces do not. values in excess of the standardized exchange Although currency options are functionally contracts. Banks developed the over-the-counter equivalent to other instruments which banks market where they trade currency options among regularly deal in for their own account, the themselves, and banks are also the largest cus- applicant’s proposed activities were not consid- tomers on the exchanges where they hedge the ered as closely related to banking. The appli- risks associated with their foreign-exchange cant’s analysis did not focus on the critical positions. components of the proposed specialist activities, In general, the specialist system is unique to which are distinct from the foreign-exchange securities exchanges, and specialists exist for brokerage and dealing activities generally con- the purpose of achieving certain market results. ducted by banks. Because the proposed special- Commodity exchanges do not use the services ist activities are to be carried out in the context of specialists. The rules of the Securities and of market making on a regulated exchange, they Exchange Commission permit the designation were significantly different from the foreign- of specialists to ‘‘engage in a course of dealings exchange activities currently conducted by banks. for...their...ownaccount to assist in the When a bank engages in foreign-exchange trad- maintenance, so far as practicable, of a fair and ing, it does so to service the needs of its custom- orderly market...’’provided that the securities ers and to generate trading profits. However, exchanges adopt the following types of rules unlike traditional foreign-exchange trading, bank governing specialists: minimum capital require- customers are not serviced directly by a special- ments, rules to suspend or remove specialists if ist. Instead, the exchange benefits from the they fail to perform their designated market specialist’s efforts if markets are perceived functions, rules restricting dealing activities to to be deep and liquid. Depth and liquidity make those reasonably necessary to permit the spe- the contracts viable and the exchange profitable, cialist to maintain a fair and orderly market or and do not directly benefit the bank’s customers. necessary to permit him or her to act as an The applicant’s original proposal implicitly odd-lot dealer, provisions governing his or her acknowledged that banks have not traditionally brokerage activities in specialist securities, and procedures to provide for the effective and sys- BHC Supervision Manual December 1998 tematic surveillance of the activities of special- Page 1 Impermissible Activities (Specialist in Foreign-Currency Options on a Securities Exchange) 3700.8 been involved with trading on stock exchanges, ary 1984, the Office of the Comptrol- and thus have not generally possessed the expe- ler of the Currency granted permission for Bank rience and expertise in trading, hedging, and of America to act as the specialist in PHLX- managing aggregate exposure required for the traded options on the Deutschemark through a successful operation of a specialist position. The joint venture subsidiary with Tague Securities applicants originally proposed to engage in the Corporation. The Board, however, was not bound activities through a joint venture because they to a determination that specialist activities were lacked the requisite trading expertise to profit- closely related to banking simply because one ably undertake the activity alone. In its discus- bank engages in the activity. Bank of America sion of the management of risk exposure of the apparently considered it necessary to conduct its specialist, the applicants originally stated, ‘‘The specialist activity through a joint venture with a choice of the appropriate hedge to start with and securities firm, which reinforced the view that the monitoring over the life of the option of that the activity requires experience and expertise hedge are specialized and difficult tasks that not generally possessed by banks. require expertise and experience.’’ Conducting Given the applicant’s acknowledgment of the exchange specialist activities requires the floor- importance of floor-trading expertise and experi- trading experience and back-office capabilities ence to the specialist function, and the substan- of an experienced exchange member. tive absence of bank involvement in such an As of December 1984, only one commercial activity, the Board concluded that the proposed bank, Bank of America, acted as a specialist in activities were not closely related to banking exchange-traded currency options. In Janu- and thus denied the applicant’s request.

BHC Supervision Manual December 1998 Page 2 Impermissible Activities (Design and Assembly of Hardware for Processing or Transmission of Banking and Economic Data) Section 3700.9

A bank holding company applied to acquire all bly of the hardware that provides the quotation the voting shares of a company (‘‘Company’’) information. In support of the argument, the that engages in a variety of data processing and bank holding company asserted that competitors data transmission activities for customers such of Company also design and assemble the hard- as securities and commodities exchanges, bro- ware that provides the Company service. kerage firms, commercial banks, savings and In view of the fact that finished hardware of loan associations, insurance companies, and the type provided by Company is available, and, investment managers. In addition to engaging in in fact, is marketed by companies providing other nonbanking activities, the company designs services similar to Company, the Board found and assembles the hardware that is used in con- that the continuation of Company’s design and nection with the services it provides. The Board assembly of hardware activities could not be had not previously considered whether the as- considered ‘‘necessary’’ to the Company’s pro- sembly of hardware designed for the processing vision of its permissible data processing ser- and transmission of banking, financial and eco- vices, and thus could not be considered inci- nomic data is closely related to banking or per- dental to Company’s provision of permissible missible as an incidental activity. services. As a condition for approval of the bank The bank holding company stated that Com- holding company’s application to acquire all of pany’s assembly of hardware was incidental to the voting shares of Company, the Board required its provision of data processing services because the bank holding company to divest of Compa- such assembly was necessary to assure the avail- ny’s hardware assembly activities within two ability, reliability, and quality of components years of the acquisition (Refer to 1986 FRB used by Company, and that stock quotation 497). firms like Company could only assure such product characteristics by the design and assem-

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Armored Car Services) Section 3700.10

In 1971 and again in 1984, the Board issued for found that none of the National Courier criteria public comment proposals to expand the activi- were demonstrated by the record. The ALJ’s ties permissible to bank holding companies conclusion relied on certain operational distinc- under section 4(c)(8). Included in those propos- tions between the proposed armored car services als was the provision of armored car services. and the services banks traditionally perform The proposals would have authorized bank hold- themselves. ing companies to provide fully insured trans- Following receipt of exceptions to the recom- portation of cash, securities, and valuables (pri- mended decision, the Board reviewed the entire marily between commercial customers and record of the proceedings and determined that financial institutions) and such ancillary ser- the ALJ had erred in concluding that armored vices as coin wrapping, change delivery, mail car services were not ‘‘closely related to bank- delivery, payroll-check cashing, servicing of ing.’’ The Board concluded that, even accepting automatic teller machines, and leasing safes to the factual findings, the slight operational dis- commercial customers. tinctions cited in the recommended decision In response to both the 1971 and 1984 pro- were not significant. The Board found that posals, the Board received various comments although there may be some distinctions between against adding this activity to the Regulation Y bank-provided armored car services and the pro- list of permissible nonbanking activities, prima- posed full-service, for-hire armored car service, rily from armored car operators and their trade the nature of the customers served and the eco- associations. The commenters maintained that nomic basis of the services provided do not the activity is not closely related to banking but, fundamentally alter the nature of the services. It rather, is essentially a transportation activity was therefore clear to the Board that the ser- requiring no banking expertise. vices then provided by the applicant as well as In view of the issues raised by the comments other banks and bank holding companies to on this activity and the minimal interest by bank themselves and their customers are sufficiently holding companies, the Board decided not to ‘‘operationally and functionally similar’’ to the add the activity to the Regulation Y list of proposed service as to equip banking organiza- permissible activities. However, the Board stated tions particularly well to perform the proposed it would consider individual applications for service, and hence fulfill the second National this activity (1973 FRB 898); 51 Federal Regis- Courier test. ter 39,999 (1986). The Board expressed no The Board also noted that bank holding com- opinion as to whether the activity would meet panies are permitted to provide courier services the National Courier test and would be a proper forunaffiliatedpartiesundersection225.25(b)(10) incident to banking. of Regulation Y. The only essential difference In 1988, a bank holding company (the appli- between the two services relates to the intrinsic cant) filed an application to engage in armored value of the materials transported. The Board car activities through a de novo nonbank subsid- concluded that the services themselves were iary. After notice of the application was pub- certainly functionally and operationally similar, lished, the Board received comments opposing thereby lending additional support to its favor- the proposal and was requested to order a for- able finding under the second National Courier mal hearing. In response, the Board published test. an order requiring a formal public administra- The Board also found that the third National tive hearing on the application. One issue, among Courier test was met, that the applicant had others, that the Board directed to be considered demonstrated ‘‘the dependence of banks on a was whether the proposed armored car services specialized form of the proposed services.’’ The were ‘‘so closely related to banking or manag- Board found that the record amply demonstrated ing or controlling banks as to be a proper inci- that banks are highly dependent upon the spe- dent thereto’’ under section 4(c)(8) of the BHC cialized transportation services provided by Act. armored cars, which transport cash and valu- An administrative hearing was held on ables with a high degree of security. The appli- June 16 and July 11, 1989, before an administra- cant was proposing to engage in just those spe- tive law judge (ALJ). The ALJ issued a recom- cialized services; it did not propose to start a mended decision in which he concluded that general moving or trucking service. The record the proposed armored car activities were not ‘‘closely related to banking’’ and recommended BHC Supervision Manual December 1993 that the Board deny the application. The ALJ Page 1 Impermissible Activities (Armored Car Services) 3700.10 therefore supported a determination that the tured, with section 23B of the Federal Reserve third National Courier test was also satisfied. Act. Accordingly, the Board found, based on the In its order, the Board stressed that the burden record before it, that providing for-hire armored of proof is upon an applicant to establish that car services to the general public was an activity the nonbanking activity it proposes to conduct— that is closely related to banking. in this case the provision of armored car This determination, however, is only one of services—is not only closely related to banking, two steps needed for the Board to approve a but also a ‘‘proper incident thereto.’’ The Board’s nonbank activity for a bank holding company. review of the entire proceeding disclosed certain The Board must also find that the activity is a aspects of the application that appeared on its ‘‘proper incident thereto.’’ On this issue, the face to violate the arm’s-length transaction ALJ declined to make any factual or legal deter- requirement of section FRA 23B. In the Board’s minations concerning the proper-incident test or view, a proposal to engage in nonbanking activ- state branching laws. However, under the Board’s ities pursuant to section 4(c)(8) will not produce rules (12 C.F.R. 262.4 (1990)), the ALJ was net benefits to the public, as required under the required to provide a recommended decision public-benefit test, if it violates the kind of with regard to all unresolved issues prior to a statutory requirement, such as section 23B, that final Board determination (12 C.F.R. 263.11). A was specifically intended to prevent unsafe or final disposition on the application therefore unsound banking practices when a bank affiliate was not possible at that juncture, and the Board engages in nonbanking activities. remanded the case to the ALJ for a recom- The first potential violation would arise from mended decision on the proper-incident stan- the fact that the proposed service by the bank dard and other unresolved issues (see 1990 FRB holding company’s nonbank subsidiary to its 676). bank affiliate would cost more than the bank In accordance with the Board’s remand order, was paying for similar armored car services a second formal hearing was held before the provided by an unaffiliated provider. The Board ALJ. Additional evidence and post-hearing briefs noted that although there may be a justification were submitted, including evidence on the proper- for the higher pricing structure that would meet incident test, in support of this and other unre- the standards set forth in section 23B, no justifi- solved issues. The ALJ then issued his supple- cation appeared in the record. The Board could mental decision, which again recommended therefore only conclude that the bank may not denial of the application. The ALJ found that, in be obtaining services from the nonbank provider this case, the applicant’s record failed to provide ‘‘on terms...atleast as favorable to such bank a definitive proposal on which the Board could ...asthose prevailing for comparable transac- make a determination under the proper-incident tions with or involving other nonaffiliated com- test. The ALJ found that the applicant had panies,’’ as required by section 23B. offered only a skeletal structure and operation The second potential violation of section 23B plan that was fleshed out only to a limited extent arose from the absence of a ‘‘precise breakdown at the hearings. In addition, the ALJ found the of the services the nonbank subsidiary will pur- application and other facts of record to be defi- chase from the bank holding company’s subsid- cient with regard to possible public benefits and iary bank and the projected cost of those ser- adverse effects. The ALJ further determined that vices,’’ as called for in the Board’s prior order in the record had not shown that the proposed this matter. The applicant provided no detailed activity, as structured, would be lawful under cost figures for the wide variety of services the the branch-banking laws of the states in which applicant’s banking subsidiary was to provide to the applicant proposed to operate. the nonbank subsidiary. The bank holding com- Based on its review of the ALJ’s supplemen- pany proposed to charge the bank subsidiary an tal decision and the remainder of the record, the ‘‘estimated’’ percentage (the fee was admitted Board determined that the record failed to sup- to have had no ‘‘factual basis’’ reflected in the port a finding that the proposed armored car record) of the nonbank subsidiary’s direct oper- activities, in this particular instance, would be a ating expenses to cover all of the services pro- ‘‘proper incident’’ to banking. The Board there- vided by the bank holding company’s banking fore adopted the ALJ’s recommendation to deny subsidiary to its nonbanking subsidiary. Under the application, but only on the narrow grounds section 23B, the provision of services by a bank of inconsistency of the proposal, as then struc- to an affiliate must be paid for on an arm’s- length basis. This requires, where there are no BHC Supervision Manual December 1993 comparable transactions between a bank and a Page 2 nonaffiliate, that the bank’s provision of ser- Impermissible Activities (Armored Car Services) 3700.10 vices to its affiliate be on terms that in good potential violations of section 23B, on their faith would be offered to, or would apply to, face, constrained the Board to deny the applica- nonaffiliated companies. The Board found that tion as it was structured (see 1993 FRB 352). the banking subsidiary would not in good faith The Board noted its denial did not affect the have provided back-office services to an unaffil- Board’s prior ruling in the case that armored car iated armored car company by charging a flat services are closely related to banking, and was fee that had no factual basis and without deter- without prejudice to the filing of a new proposal mining the relationship of the fee to the actual from which a favorable proper-incident finding costs of providing the services. Therefore, the could be made.

BHC Supervision Manual December 1993 Page 3 Impermissible Activities (Computer Output Microfilm Service) Section 3700.11

The authority of bank holding companies under tutions,suchasmortgagecompanies.Withrespect section 225.25(b) of the Board’s Regulation Y to this activity, the Board issued an interpreta- to engage in data processing activities is intended tion that authorizes bank holding companies to to limit those activities to providing facilities provide the formatting for computer output that perform banking functions, such as check microfilm only as an output option for data collection, or other similar functions for custom- otherwise permissibly processed by the holding ers that are depository or other similar insti- company system (1982 FRB 552).

BHC Supervision Manual December 1992 Page 1 Impermissible Activities (Clearing Securities Options and Other Financial Instruments for the Accounts of Professional Floor Traders) Section 3700.12

A foreign banking organization subject to the formance of its customers to the clearing organi- BHC Act applied for the Board’s approval under zation of the exchanges on which it operates.3 section 4(c)(8) to engage de novo through its After the start of trading on any day, Com- subsidiary (Company), in the exchange and clear- pany would be obligated to settle each trade ance of: (1) exchange traded securities options entered into by its customers even when the and other securities and (2) futures and options customer may not have the financial resources on futures that relate to financial instruments. to honor its obligation. Since the trades have The proposed customer base was comprised pri- already been executed by the time that they marily of market makers and other professional would be presented to Company by these pro- floor traders dealing for their own accounts. fessional floor traders, Company would be un- Most of the professional traders were expected able to decline transactions that posed unaccept- to be market makers and specialists, including able risk. On an intraday basis, professional individuals, small partnerships, or small corpo- traders, who are not employees of Company and rations, that were to trade primarily on the Chi- who trade in relatively volatile instruments, cago Board of Options Exchange (CBOE).1 could expose Company to financial risks be- Previously, the Board approved the execution yond the trader’s capacity to repay and beyond and clearance of financial instruments as a Company’s own resources. permissible nonbanking activity.2 Under Board The applicants proposed to limit the risk ex- precedent, the nonbanking subsidiary engaged posure created by Company’s activities through in such services has generally serviced a broad the establishment of risk guidelines and proce- range of retail and/or institutional customers. dures that were intended to monitor the intraday Under this proposal, Company was to clear trading activities of its floor traders. No such trades for a specialized customer base com- system had been developed for the industry for prised primarily of professional floor traders monitoring the intraday activities of floor trad- that executed trades for their own accounts. ers on a real-time basis. Most of Company’s Nonbanking subsidiaries of BHCs, operating traders would primarily operate on exchanges in accordance with prior Board approvals, have that used an open outcry system rather than an generally performed both execution and clear- electronic trading system. As a result, Company ance services. By performing both services, the may not know its real-time committed positions nonbank subsidiary is able to control risk until the end of the trading day and therefore the because it executes the majority of the trans- possibility existed that a floor trader could ex- actions that it clears. The nonbank subsidiary ceed Company’s risk limits and incur substan- can refuse to execute an order that it deems tial losses before Company could act to mitigate inappropriate or it can require additional funds its credit risk exposure. Professional floor trad- or collateral from the customer in advance of ers generally operate with much higher levels of and as a condition to executing the transaction. leverage than the average brokerage customer of Unlike prior Board cases, Company plans to a securities firm. Since most of Company’s cus- provide primarily clearing services. As a clear- tomers were to be market makers, such traders ing agent, it would guarantee the financial per- could at times take positions contrary to the market.

3. With this arrangement clearing firms may also be liable for the obligations of other members of the exchange. Gener- ally, losses of a failed member firm are covered in the follow- ing order: 1. by the assets of the failed firm; 1. Market makers on the CBOE are floor traders that 2. by the excess capital of the clearing organization; perform a dealer function by trading for their own accounts, at 3. by the guarantee fund of the clearing organization; their own risk, and for their own profit. Market makers and compete with other market makers assigned to the same class 4. by direct assessments made on surviving member of options. In contrast, floor brokers on the CBOE generally firms. act only as an agent, executing customer and firm proprietary Since member clearing firms are the ultimate source of capital orders. for both the clearing association and the guarantee fund, the 2. Refer to sections 225.25(b)(3) (trust companies engag- surviving firms will bear the ultimate burden of any loss. ing in agency activities related to the clearing of securities); 225.25(b)(15) (securities brokerage activities); 225.25(b)(18) (execution and clearance of futures and options on futures) of BHC Supervision Manual December 1992 the Board’s Regulation Y. Page 1 Impermissible Activities (Clearing Securities Options and Other Financial Instruments for the Accounts of Professional Floor Traders) 3700.12 Such circumstances potentially expose the similar activities on foreign exchanges, and clearing firms to substantial losses. If the clear- Company’s proposed risk management systems. ing firm exhausts all or most of its capital in The Board concluded that the proposal, as it was funding the obligations of floor traders that have currently structured (including the absence of an lost substantial amounts of money in trading, effective means to monitor and limit the poten- parent companies of the clearing firm may have tial credit risk exposure to the parent bank hold- to cover the firm’s remaining contingent liabili- ing company) involved potential adverse effects ties. Such risks may be acceptable for some that outweighed the potential public benefits. nonbanking institutions currently providing these The Board thus determined that the balance of services, but they may be inappropriate for U.S. public interest factors that it is required to con- domiciled banking organizations. sider under section 4(c)(8) of the BHC Act were The Board carefully considered the benefits not favorable. The application was denied by of the proposal, including the Applicants entry the Board on January 9, 1991 (1991 FRB 189). into a concentrated market, its experience with

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